Sectoral Infrastructure Investments in an
Unbalanced Growing Economy:
The Case of Potential Growth in India
CHETAN GHATE,GERHARD GLOMM, AND JIALU LIU STREETER
∗
We construct a two-sector (agriculture and modern) overlapping generations
growth model calibrated to India to study the effects of sectoral tax rates, sectoral
infrastructure investments, and labor market frictions on potential growth in
India. Our model is motivated by the idea that because misallocation depends on
distortions, policies that reduce distortions raise potential growth. We show that
the positive effect of a variety of policy reforms on potential growth depends on
the extent to which public and private capital are complements or substitutes.
We also show that funding more infrastructure investments in both sectors by
raising labor income taxes in the agriculture sector raises potential growth.
Keywords: Indian economic growth, misallocation, public capital, structural
transformation, two-sector OLG growth models, unbalanced growth
JEL codes: H21, O11, O20, O41
I. Introduction
How do sectoral tax policies and labor laws distort the sectoral allocation
of labor and capital to prevent developing economies from realizing their growth
potential? Lewis (1954) famously argued that economic development means growth
of the modern sector. If so, what prevents the development and expansion of the
modern sector in growing economies? What are the impediments to the reallocation
of labor to sectors of high productivity? Will a tax on agriculture income that funds
higher public investment inhibit the rise of the modern sector? These questions have
policy importance as distortions in the agriculture and the nonagriculture (modern)
sectors constrain growth in developing economies by preventing the full productivity
effect of factor reallocation.
∗
Chetan Ghate (corresponding author): Economics and Planning Unit, Indian Statistical Institute Delhi. E-mail:
cghate@isid.ac.in; Gerhard Glomm: Department of Economics, Indiana University, Indiana. E-mail: gglomm
@indiana.edu; Jialu Liu Streeter: Department of Economics, Allegheny College, Pennsylvania. E-mail: jstreeter
@allegheny.edu. The authors would like to thank Partha Sen, K. P. Krishnan, Pawan Gopalakrishnan, Pedro de
Araujo, participants at the Asian Development Outlook–Asian Development Review Conference held in Seoul in
November 2015, the managing editor, and an anonymous referee for helpful comments. Gerhard Glomm gratefully
acknowledges very generous hospitality from the Indian Statistical Institute Delhi, especially the Policy and Planning
Research Unit for financial assistance related to this project. The usual disclaimer applies.
Asian Development Review, vol. 33, no. 2, pp. 144–166
C
2016 Asian Development Bank
and Asian Development Bank Institute
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SECTORAL INFRASTRUCTURE INVESTMENTS IN INDIA 145
We address these questions within the context of an unbalanced growing
economy, India, that is undergoing fundamental changes in the structure of
production and employment. We build a two-sector overlapping generations (OLG)
neoclassical growth model calibrated to India. The two sectors are an agriculture
sector and a modern (nonagriculture) sector that merges the manufacturing and
service sectors together.
1
In our model, all individuals work when young and retire
when old. Individuals pay taxes on their labor income in both sectors, and receive
an excise subsidy for the consumption of agriculture products. The remaining tax
revenues are allocated as infrastructure investments across both sectors. In each
sectoral production technology, the stock of public infrastructure is a productive
input, and is combined with sector specific capital and labor in accordance with a
constant elasticity of scale (CES) production function. Public and private capital
can be complements or substitutes. To incorporate the drag on modern sector
output because of the presence of labor laws, we subtract a term that increases
proportionately with the amount of labor employed in the modern sector. We think
of this loss occurring because of bureaucratic problems related to a large labor force
in the modern sector. Labor and capital are assumed to be perfectly mobile across
sectors.
Given this setup, we show that exogenous fiscal policies (sectoral taxes and
subsidies) and labor market frictions can play an important role in misallocating
factors of production, which affects potential growth. Since less misallocation would
suggest that the economy can produce more with the same factors of production
and production technology, policy reforms that induce greater efficiency are key to
understanding India’s growth and growth potential.
A. India’s Pattern of Structural Transformation
Most economies have undergone substantial structural changes that involved
shifts of resources across the agriculture, manufacturing, and service sectors, and
very large changes in the capital–output ratios of all three sectors. In the context of
the development process, India stands out for three reasons.
2
As can be seen from
Figure 1, India’s service sector has grown rapidly in the last 3 decades, constituting
55% of the gross domestic product (GDP) in 2010, with a share close to 53% in
2015.
3
The large size of the service sector in India is comparable to the size of the
service sector in developed economies where services often provide more than 60%
of total output and an even larger share of employment. Since many components
1
This identification is not necessary as we just need two sectors whose output and employment shares in the
total economy rise and fall, respectively, and whose capital–output ratios are not constant over relatively long time
horizons.
2
These structural shifts are documented in Verma (2012).
3
Industry comprises value added in mining, manufacturing, construction, electricity, and water and gas.
In 2014, value added in industry was 30% of GDP. Manufacturing value added was 17% of GDP, comprising
approximately 57% of industry’s share.
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146 ASIAN DEVELOPMENT REVIEW
Figure 1. Structural Transformations in India
GDP = gross domestic product.
Source: World Bank. World Development Indicators. http://data.worldbank.org/indicator/
of services (e.g., financial services, business services, hotels, and restaurants) are
income related and increase only after a certain stage of development, the fact that
India’s service sector is very large relative to its level of development is puzzling.
Second, the entire decline in the share of ag r iculture in India’s GDP in the last 2
decades has been accounted for by an expanding service sector. The manufacturing
sector’s share of GDP has stayed constant at around 15% of GDP over the past
30 years.
4
In general, such a trend is experienced by high-income economies and
not by developing economies. In developing economies, the typical patter n is for
the manufacturing sector to replace the agriculture sector’s declining share of GDP
initially. Only at higher levels of aggregate income does the service sector play an
increasingly large role. In addition, in spite of the rising share of services in both
GDP and trade, there has not been a corresponding rise in the share of services
in India’s total employment. In other words, India’s service sector has not been
sufficiently employment generating.
5
4
In comparison, in 2010, manufacturing value added as a percentage of GDP was 29.5% in the People’s
Republic of China, 24.8% in Indonesia, 24.5% in Malaysia, and 33.6% in Thailand (UN National Account Statistics
2015). Gupta and Kumar (2012) provide a comprehensive review of the factors inhibiting India’s manufacturing sector
in the postreform period. Hsieh and Klenow (2009) show that firm heterogeneity in productivity and distortions have
led to misallocation in Indian firms.
5
While there will always be issues with modeling three disparate sectors such as services, manufacturing, and
agriculture, one can think of agriculture in our model—and other models of economic transformation—as being the
one truly traditional sector and the rest of the economy as the more modern sector. These models typically capture
the shrinking of the agriculture sector as the economy develops.
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SECTORAL INFRASTRUCTURE INVESTMENTS IN INDIA 147
Table 1. Data on Structural Transformation in India, 1970–2000
Agriculture Agriculture Manufacturing Manufacturing Services Services
Variable 1970 2000 1970 2000 1970 2000
Employment
Share
77% 62% 12% 19% 12% 20%
GDP
Share
48% 25% 23% 27% 29% 48%
K/Y Ratio 3.3 0.9 0.6 4.3 11.0 1.8
Gross
Capital Formation
18% 9% 33% 30% 49% 61%
GDP = gross domestic product.
Note: “K/Y Ratio” refers to the capital–output ratio.
Source: Verma. 2012. Structural Transformation and Jobless Growth in the Indian Economy. In C. Ghate, ed. The
Oxford Handbook of the Indian Economy. Oxford University Press: New York.
Third, unlike the case of aggregate data in advanced economies where
capital–output ratios are often constant over time, the sectoral capital–output ratios in
India exhibit large changes over time (Table 1).
6
While agriculture’s capital–output
ratio fell from 3.3 to 0.9 between 1970 and 2000, the manufacturing sector’s
capital–output ratio rose from 0.6 to 4, and the service sector’s capital–output ratio
fell from 11 to 1.8.
Figure 2 shows agriculture employment in Brazil, the People’s Republic of
China, and India during 1980–2015. What is apparent is that the relative decline of
agriculture’s share of employment is slower in India than in these economies. Taking
Figure 1 and Figure 2 together, what stands out is that the changes in India’s GDP
structure are asymmetric to its sectoral employment intensity.
Figure 3 shows that when measured in constant 2005 United States dollars,
the growth of India’s GDP has risen persistently since 1980.
B. Description of the Main Results
The observations in the previous section suggest that, in the context of India
over the last 50 years, the balanced growth assumption does not seem appropriate.
First, the growth rate of GDP seems to be increasing over the sample period.
Moreover, the transition out of agriculture seems to have accelerated after 1975. We
therefore abandoned the strategy of balanced growth and instead pursued a strategy
of matching the transition out of agriculture with growth in the modern sector
(manufacturing and services).
7
In our model, growth will not be balanced since
the production technologies do not exhibit constant returns in all the augmentable
6
See Verma (2012).
7
In models of capital accumulation, balanced growth typically prevails when there are constant returns to
all augmentable factors. In such a case, all variables that can grow will grow at the same constant rate forever, and
all variables that are bounded are constant over time. In growth models of structural transformation such as Gollin,
Parente, and Rogerson (2002), balanced growth in the sense defined above typically is not obtained since the perpetual
shifting of resources from the traditional to the modern sector prevents the growth rate of GDP from being constant
over time. It is still possible, however, to define something like balanced growth in terms of a constant rate of labor
migration from the traditional to the modern sector.
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148 ASIAN DEVELOPMENT REVIEW
Figure 2. Agriculture Employment in Select Emerging Market Economies
PRC = People’s Republic of China.
Source: World Bank. World Development Indicators. http://data.worldbank.org/indicator/
Figure 3. Indian GDP and GDP Growth (Constant 2005 Prices)
GDP = gross domestic product.
Source: World Bank. World Development Indicators. http://data.worldbank.org/indicator/
factors. In our model, both physical and infrastructure capital are augmentable.
The labor’s share of value added differs across the two sectors, so the retur ns to
the two augmentable factors differ across the two sectors as well. It is this difference
in the returns to augmentable factors that helps us match the transition out of
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