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srcset="https://ippr-org.transforms.svdcdn.com/production/Cover-Image/iStock-2013089711.jpg?w=800&h=288&q=100&auto=format&fit=crop&crop=focalpoint&fp-x=0.4956&fp-y=0.3108&dm=1730307504&s=b5cc26cf5eb74b8947eaf11d5d81aa15" media="(min-width: 600px)"><source srcset="https://ippr-org.transforms.svdcdn.com/production/Cover-Image/iStock-2013089711.jpg?w=600&h=440&q=100&auto=format&fit=crop&crop=focalpoint&fp-x=0.4956&fp-y=0.3108&dm=1730307504&s=6b1282c6bebd3b6ce028f41afa92c6c1" media="(max-width: 600px)"><img class="o-image__img" src="https://ippr-org.transforms.svdcdn.com/production/Cover-Image/iStock-2013089711.jpg?w=600&h=440&q=100&auto=format&fit=crop&crop=focalpoint&fp-x=0.4956&fp-y=0.3108&dm=1730307504&s=6b1282c6bebd3b6ce028f41afa92c6c1" alt="" ></picture></div><div class="c-page-header__container"><h1 class="c-page-header__title "> Second round effects: Why the OBR is likely underestimating the growth effects of public investment </h1></div></header></div><div class="o-sidebar-grid__menu" id="page-menu"></div><aside class="o-sidebar-grid__sidebar "></aside><div class="o-sidebar-grid__content" id="page-content"><section class="o-grid"><h2 class="h-accessibility">Article</h2><div class="o-block o-text o-text--intro o-grid__item"><p>The Office for Budgetary Responsibility has outlined a new approach to modelling the growth impacts of public investment.</p></div><div id="block-294802" class="o-block o-text o-text-block o-grid__item h-colstart--1 h-colend--9 h-phone-colstart--1 h-phone-colend--13 has-h-col o-block--row-1" data-block='[]'><p>Unlike before, this allows them to better reflect the economic benefits of spending items, such as infrastructure investment, rather than just the costs of funding them. This is particular important given the new Labour government’s plan to raise public investment by an additional 0.7 percentage points of GDP annually over the next five years. This keeps public sector net investment (PSNI) stable, compared to the previous government’s plans under which it would have fallen by more than a third. The question though will be how much this might raise growth. <br /></p></div><div id="block-294902" class="o-block o-text o-text-block o-grid__item h-colstart--1 h-colend--7 h-phone-colstart--1 h-phone-colend--13 has-h-col o-block--row-2" data-block='["text"]'><p>Today the OBR has, for the first time, explicitly used its new methodology to assess the GDP effect of the government's increase in public investment. This is hugely welcome. Their approach is thorough and a big improvement on the previous status quo that did not explicitly analyse the effects of public investment. They estimate that the level of potential growth will be 0.14 per cent higher than without the higher investment, clearly confirming the case that it is growth enhancing.</p></div><div id="block-294903" class="o-block o-grid__item o-grid__item--force-space h-colstart--7 h-colend--13 h-phone-colstart--1 h-phone-colend--13 has-h-col o-block--row-2" data-block='["text"]'><blockquote class="c-quote"><p class="c-quote__text"> [The OBR's new] approach is thorough and a big improvement on the previous status quo </p></blockquote></div><div id="block-294904" class="o-block o-text o-text-block o-grid__item h-colstart--1 h-colend--9 h-phone-colstart--1 h-phone-colend--13 has-h-col o-block--row-3" data-block='["text","quote"]'><p>Their baseline estimate is based on underlying modelling that a 1 per cent increase in public investment, over a 10-year horizon, increases GDP by 1.8 per cent cumulatively. However, <strong>their methodology does not follow standard practice in the economic literature,</strong> which usually involves modelling the ‘second round effects’ in which businesses and households respond to higher public investment by increasing investment and labour force participation. These are known as the ‘general equilibrium effects’ of an increase an investment (see <a href="http://ippr.org/articles/second-round-effects#annex">technical annex</a>). The result is that the OBR’s longer-term returns to public investment are lower than those found in the literature (see <a href="https://econweb.ucsd.edu/~vramey/research/The_Macroeconomic_Consequences_of_Infrastructure_Investment.pdf">Ramey</a>). Instead of modelling how businesses respond, the OBR makes a ‘manual adjustment’ to business investment numbers, which seems low.</p></div><div id="block-294905" class="o-block o-text o-text-block o-grid__item h-colstart--1 h-colend--7 h-phone-colstart--1 h-phone-colend--13 has-h-col o-block--row-4" data-block='["text"]'><p>The recent US experience is instructive in this regard, with fiscal policy being expansionary and going hand in hand with strong manufacturing investment increase. Industrial policy spending crowded in a multiple of private investment (see <a href="https://www.whitehouse.gov/briefing-room/blog/2023/08/16/the-economics-of-public-investment-crowding-in-private-investment/">Boushey</a> and <a href="https://rhg.com/wp-content/uploads/2024/08/Clean-Investment-Monitor_Tallying-the-Two-Year-Impact-of-the-Inflation-Reduction-Act-1.pdf">Clean Investment Monitor</a>). Overall manufacturing investment tripled since the inception of Biden's industrial policy package, reversing years of stagnation. <a href="https://www.blackrock.com/us/financial-professionals/insights/exploring-us-manufacturing">Blackrock calls this 'the rebirth of American manufacturing'</a>. On the surface, this provides strong evidence that the Inflation Reduction Act and Biden's other two pieces of industrial policy legislation were able to crowd in private investment.</p></div><div id="block-294906" class="o-block o-grid__item o-grid__item--force-space h-colstart--7 h-colend--13 h-phone-colstart--1 h-phone-colend--13 has-h-col o-block--row-4" data-block='["text"]'><blockquote class="c-quote"><p class="c-quote__text"> Overall manufacturing investment tripled since the inception of Biden's industrial policy package, reversing years of stagnation </p></blockquote></div><div id="block-294907" class="o-block o-text o-text-block o-grid__item h-colstart--1 h-colend--9 h-phone-colstart--1 h-phone-colend--13 has-h-col o-block--row-5" data-block='["text","quote"]'><p><strong>In future work, the OBR could seek to model such general equilibrium effects in line with the economics literature</strong>, as it does better reflect how second round effects of productive public investment can lead to higher private investment, labour force participation and consumption).</p><p>The below analysis shows what how this could impact the OBR’s analysis. It builds on the analysis from Valerie Ramey - the leading US scholar in this field. It shows that more properly modelling the returns to public investment could yield more than double the overall returns than the OBR suggests, over a 10 year period. In the final year of the forecast, by 2029/30, the GDP impacts could be between 1.9 and 3.8 times higher than the OBR central case suggests. The upper estimate number could be more likely, given the low existing public capital stock in the UK, which according to much of the literature indicates that returns to investment should be higher (given diminishing marginal returns). Using the average of our upper and lower estimate, we find that potential output could be 0.39 per cent of GDP (£14 billion) higher in the final year of the forecast - almost three times the amount that the OBR projects as a result of the chancellor’s public investment increase.</p><h4>Figure 1: Properly modelling general equilibrium effects mean that returns to investment could be more the double than what the OBR is expecting over a 10-year horizon</h4><p><em>Cumulative per cent of GDP returns, of a 1 per cent investment increase, over 10 years</em></p></div><div id="block-294803" class="o-block o-image-block o-grid__item h-colstart--1 h-colend--9 h-phone-colstart--1 h-phone-colend--13 has-h-col o-block--row-6" data-block='["text"]'><figure class="o-figure"><div class="o-figure__image"><div class="o-image" style="--intrinsic-width:771px"><img class="o-image__img" src="https://ippr-org.transforms.svdcdn.com/production/Carsten-blog-chart-01.png?w=400&h=257&q=100&auto=format&fit=crop&dm=1730306837&s=64f1a93d4319e93f6b12304c6ecf7017" width="771" height="495.53782581055" loading="lazy" itemprop="image" alt="" srcset="https://ippr-org.transforms.svdcdn.com/production/Carsten-blog-chart-01.png?w=771&h=495&q=100&auto=format&fit=crop&dm=1730306837&s=d86206aae01961678bcef2dcbf471710 771w, https://ippr-org.transforms.svdcdn.com/production/Carsten-blog-chart-01.png?w=640&h=411&q=100&auto=format&fit=crop&dm=1730306837&s=e1797e8004ec61ea59fa83d5763a8662 640w, https://ippr-org.transforms.svdcdn.com/production/Carsten-blog-chart-01.png?w=400&h=257&q=100&auto=format&fit=crop&dm=1730306837&s=64f1a93d4319e93f6b12304c6ecf7017 400w" sizes="(min-width: 901px) 771px, (max-width: 900px) and (min-width: 601px) 640px, (max-width: 600px) 400px, calc(100vw - 40px)" ></div></div></figure></div><div id="block-294843" class="o-block o-text o-text-block o-grid__item h-colstart--1 h-colend--9 h-phone-colstart--1 h-phone-colend--13 has-h-col o-block--row-7" data-block='["image"]'><p class="h-text--small">Source: IPPR analysis of <a href="https://econweb.ucsd.edu/~vramey/research/The_Macroeconomic_Consequences_of_Infrastructure_Investment.pdf">Ramey </a>and <a href="https://obr.uk/docs/dlm_uploads/Public-investment-and-potential-output_August-2024.pdf">OBR</a></p></div><div id="annex" class="o-block o-download o-grid__item h-colstart--1 h-colend--9 h-phone-colstart--1 h-phone-colend--13 has-h-col o-block--row-8" data-block='["text"]'><h3 class="o-block__heading">Technical annex</h3><div class="o-utility-list o-utility-list--icon"><ul class="o-utility-list__list o-list"><li class="o-utility-list__item"><a data-sc-gtm-category="Download" data-sc-gtm-action="294937" data-sc-gtm-label="Second round effects annex" data-sc-gtm-value="" class="o-utility-list__link" href="https://www.ippr.org/index.php/actions/tools/tools/download-file?id=294937" @click="downloadEvent()"><h4 class="o-utility-list__title"> Download </h4><span class="o-utility-list__icon"><span class="icon i-file-pdf i-download"><svg xmlns="http://www.w3.org/2000/svg" width="50" height="50" viewBox="0 0 50 50"><path fill="currentColor" d="M30.0469484,23.7089202 L30.0469484,16.1971831 L32.5117371,16.1971831 L32.5117371,23.7089202 L30.0469484,23.7089202 Z M4.92957746,9.97652582 L4.92957746,45.0704225 L40.0234742,45.0704225 L40.0234742,50 L4.92957746,50 C3.59936751,50 2.44523192,49.5109595 1.46713615,48.5328638 C0.489040526,47.5547681 0,46.4006325 0,45.0704225 L0,9.97652582 L4.92957746,9.97652582 Z M17.4882629,18.7793427 L17.4882629,16.1971831 L19.9530516,16.1971831 L19.9530516,18.7793427 L17.4882629,18.7793427 Z M46.2441315,16.1971831 L46.2441315,12.4413146 L38.7323944,12.4413146 L38.7323944,27.4647887 L42.4882629,27.4647887 L42.4882629,22.5352113 L46.2441315,22.5352113 L46.2441315,18.7793427 L42.4882629,18.7793427 L42.4882629,16.1971831 L46.2441315,16.1971831 Z M36.2676056,23.7089202 L36.2676056,16.1971831 C36.2676056,15.1799662 35.915493,14.2996883 35.2112676,13.5563418 C34.5070423,12.8129878 33.6072038,12.4413146 32.5117371,12.4413146 L26.2910798,12.4413146 L26.2910798,27.4647887 L32.5117371,27.4647887 C33.6072038,27.4647887 34.5070423,27.0931155 35.2112676,26.3497615 C35.915493,25.606415 36.2676056,24.7261371 36.2676056,23.7089202 Z M23.7089202,18.7793427 L23.7089202,16.1971831 C23.7089202,15.1799662 23.3372469,14.2996883 22.593893,13.5563418 C21.8505465,12.8129878 20.9702685,12.4413146 19.9530516,12.4413146 L13.7323944,12.4413146 L13.7323944,27.4647887 L17.4882629,27.4647887 L17.4882629,22.5352113 L19.9530516,22.5352113 C20.9702685,22.5352113 21.8505465,22.163538 22.593893,21.420184 C23.3372469,20.6768376 23.7089202,19.7965596 23.7089202,18.7793427 Z M45.0704225,2.27373675e-13 C46.400631,2.27373675e-13 47.5547718,0.489044131 48.5328676,1.46713239 C49.5109559,2.44522817 50,3.59936901 50,4.92957746 L50,34.9765258 C50,36.3067343 49.5109559,37.4804357 48.5328676,38.4976526 C47.5547718,39.5148695 46.400631,40.0234742 45.0704225,40.0234742 L15.0234742,40.0234742 C13.6932657,40.0234742 12.5195643,39.5148695 11.5023474,38.4976526 C10.4851305,37.4804357 9.97652582,36.3067343 9.97652582,34.9765258 L9.97652582,4.92957746 C9.97652582,3.59936901 10.4851305,2.44522817 11.5023474,1.46713239 C12.5195643,0.489044131 13.6932657,2.27373675e-13 15.0234742,2.27373675e-13 L45.0704225,2.27373675e-13 Z"/></svg></span></span><span class="o-utility-list__subtitle"> 690Kb | PDF </span></a></li></ul></div></div><div id="block-294847" class="o-block o-divider o-grid__item h-colstart--1 h-colend--13 h-phone-colstart--1 h-phone-colend--13 has-h-col o-block--row-9" data-block='["downloads"]'><hr/></div></section></div><aside class="o-sidebar-grid__sidebar " id="page-sidebar"><div class="o-block c-meta c-meta--article"><dl class="c-meta__list"><div class="c-meta__item c-meta__item--date"><dt class="c-meta__key">Date</dt><dd class="c-meta__value"><strong>30 October 2024</strong></dd></div><div class="c-meta__item c-meta__item--type"><dt class="c-meta__key">Type</dt><dd class="c-meta__value"><strong>Blog</strong></dd></div><div class="c-meta__item c-meta__item--type"><dt class="c-meta__key">Authors</dt><dd class="c-meta__value"><strong>Carsten Jung</strong></dd></div></dl><div class="c-meta__logos"><a href="/" class="c-meta__logo" aria-label="IPPR"><span class="icon i-logo"><svg fill="none" xmlns="http://www.w3.org/2000/svg" viewBox="0 0 169 202"><path d="M169 202v-17h-13.3l-13-24 3.4-2c3.7-2.5 6.8-6 9.2-10.5 2.4-4.6 3.6-9.7 3.6-15.3 0-9.9-3.4-17.7-10.2-23.5a43.6 43.6 0 0 0-29-8.7h-1.2V84h-13.1V64.2h9.7c7.3 0 13.3-.4 18.1-1.3 4.9-1 9.2-2.6 12.9-5 3.7-2.5 6.8-6 9.2-10.6 2.4-4.5 3.6-9.6 3.6-15.2 0-9.9-3.4-17.7-10.2-23.5a43.6 43.6 0 0 0-29-8.7H65.7v17h13v67h-13v18c-3.7-.6-7.6-1-12-1h-1.2V84h-13V17h13V0H0v17h13v67H0v34h13v67H0v17h52.6v-17h-13v-19.7h9.8c7.2 0 13.2-.4 18-1.3 4.2-.8 8-2.2 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