The unseen costs of Amazon’s HQ2 Site Selection

Earlier this year Amazon narrowed down the list of potential cities to site its second headquarters. Applicants are now waiting out the selection process. It’s unclear when Amazon will make its choice, but that hasn’t stopped many from speculating who the likely contenders are. Varying sources report Atlanta, Boston, and Washington D.C. at the top of the list. The cities that didn’t make the cut are no doubt envious of the finalists, having just missed out on the potential for a $5 billion facility and 50,000 jobs. The second HQ is supposed to be as significant for economic growth as the company’s first site, which according to Amazon’s calculations contributed an additional $38 billion to Seattle’s economy between 2010 and 2016. There is clearly a lot to be gained by the winner.  But there are also many costs. Whichever city ends up winning the bid will be changed forever. What’s left out of the discussion is how the bidding process and corporate incentives affect the country.

Although the details of the proposals are not made public, each finalist is likely offering some combination of tax breaks, subsidies, and other incentives in return for the company’s choice to locate in their city. The very bidding process necessitates a lot of time and effort by many parties. It will certainly seem “worth it” to the winning party, but the losers aren’t getting back the time and effort they spent.

This practice of offering incentives for businesses has been employed by states and localities for decades, with increased usage over time. Targeted economic development incentives can take the form of tax exemptions, abatements, regulatory relief, and taxpayer assistance. They are but one explicit cost paid by states and cities looking to secure business, and there is a growing literature that suggests these policies are more costly than meets the eye.

First, there’s the issue of economic freedom. Recent Mercatus research suggests that there may be a tradeoff to offering economic development incentives like the ones that Amazon is receiving. Economists John Dove and Daniel Sutter find that states that spend more on targeted development incentives as a percentage of gross state product also have less overall economic freedom. The theoretical reasoning behind this is not very clear, but Dove and Sutter propose that it could be because state governments that use more subsidies or tax breaks to attract businesses will also spend more or raise taxes for everyone else in their state, resulting in less equitable treatment of their citizens and reducing overall economic freedom.

The authors define an area as having more economic freedom if it has lower levels of government spending, taxation, and labor market restrictions. They use the Fraser Institute’s Economic Freedom of North America Index (EFNA) to measure this. Of the three areas within the EFNA index, labor market freedom is the most affected by targeted economic development incentives. This means that labor market regulation such as the minimum wage, government employment, and union density are all significantly related to the use of targeted incentives.

Economic freedom can be ambiguous, however, and it’s sometimes hard to really grasp its impact on our lives. It sounds nice in theory, but because of its vagueness, it may not seem as appealing as a tangible economic development incentive package and the corresponding business attached to it. Economic freedom is associated with a series of other, more tangible benefits, including higher levels of income and faster economic growth. There’s also evidence that greater economic freedom is associated with urban development.

Not only is the practice of offering targeted incentives associated with lower economic freedom, but it is also indicative of other issues. Economists Peter Calcagno and Frank Hefner have found that states with budget issues, high tax and regulatory burdens, and poorly trained labor forces are also more likely to offer targeted incentives as a way to offset costly economic conditions. Or, in other words, targeted development incentives can be – and often are – used to compensate for a less than ideal business climate. Rather than reform preexisting fiscal or regulatory issues within a state, the status quo and the use of targeted incentives is the more politically feasible option.

Perhaps the most concerning aspect of Amazon’s bidding process is the effect it has on our culture. Ideally, economic development policy should be determined by healthy economic competition between states. In practice, it has evolved into more of an unhealthy interaction between private interests and political favor. Economists Joshua Jansa and Virginia Gray refer to this as cultural capture. They find increases in business political contributions to be positively correlated with state subsidy spending. Additionally, they express concern over the types of firms that these subsidies attract. There is a selection bias for targeted incentives to systematically favor “flighty firms” or firms that will simply relocate if better subsidies are offered by another state, or potentially threaten to leave in an effort to extract more subsidies.

None of these concerns even address the question of whether targeted incentives actually achieve their intended goals.  The evidence does not look good. In a review of the literature by my colleague Matthew Mitchell, and me, we found that of the studies that evaluate the effect of targeted incentives on the broader economy, only one study found a positive effect, whereas four studies found unanimously negative effects. Thirteen studies (half of the sample) found no statistically significant effect, and the remaining papers found mixed results in which some companies or industries won, but at the expense of others.

In addition to these unseen costs on the economy, some critics are beginning to question whether being chosen by Amazon is even worth it. Amazon’s first headquarters has been considered a catalyst for the city’s tech industry, but local government and business leaders have raised concerns about other possibly related issues such as gentrification, rising housing prices, and persistent construction and traffic congestion. There is less research on this, but it is worth considering.

It is up to each city’s policymakers to decide whether these trade-offs are worth it. I would argue, however, that much of the evidence points to targeted incentives – like the ones that cities are using to attract Amazon’s business – as having more costs than benefits. Targeted economic development incentives may seem to offer a lot of tangible benefits, but their unseen costs should not be overlooked. From the perspective of how they benefit each state’s economy as a whole, targeted incentives are detrimental to economic freedom as well as our culture surrounding corporate handouts. Last but not least, they may often be an attempt to cover up other issues that are unattractive to businesses.

The use of locally-imposed selective taxes to fund public pension liabilities

Many eyes are on Kentucky policymakers as they grapple with finding a solution to their $40 billion state-reported unfunded public pension liability. As talks of a potential pension bill surface, various proposals have been made by legislators, but very few have gained traction. One such proposal stands out from the rest. A proposal that has since been shut down suggested imposing selective taxes on tobacco, prescription opiates, and outsourced labor to generate revenue to direct towards paying down the state’s pension debt. Despite its short-lived tenure, this selective tax proposal reflects a recent trend in pension funding reform; a trend that policymakers should be wary of. Implementing new taxes on select goods or services may seem like a good idea as it could, in theory, potentially raise additional revenues, but experience at the local level suggests otherwise.

In chapter 12 of a new Mercatus book on sin taxes, NYU professor Thad Calabrese examines the practice of locally-imposed selective taxes that are used to fund public pension liabilities and doesn’t find much evidence to support their continued usage.

Selective taxes are sales taxes that target specific goods and are also known as ‘sin taxes’ because of their popular usage in taxing less healthy goods such as cigarettes, junk food, or alcohol. In the examples that Calabrese examines, selective taxes are used to target insurance premiums as revenue sources for pensions.

Only a select few states have begun this practice – including Illinois, Pennsylvania, as well as municipalities in West Virginia and Missouri – but it may become more popular if courts begin to restrict the way in which current pension benefits can be modified. Once benefits are taken off the table as an avenue for reform, like in Illinois, policymakers will feel more pressure to find new revenue sources.

The proposal in Kentucky may seem appealing to policymakers, especially because of its potential to raise $600 million a year, but this estimate overlooks the unintended effects that such new taxes could facilitate. Thankfully, the proposal did not go through, but I think some time should be spent looking at what similar proposals have looked like at the local level, so that other states do not get tempted pick up where Kentucky left off.

Calabrese draws on the experiences in Pennsylvania and Illinois to examine how these taxes have operated, how the decoupling of setting and financing employee benefits tends to lead to these taxes, and how the use of these taxes is associated with significantly underfunded pension systems. Below I highlight Pennsylvania’s experience and caution against further usage of this mechanism for pension funding.

How it works (or doesn’t)

In 1895, Pennsylvania implemented a 2 percent tax on out-of-state fire and casualty insurance companies’ premiums on in-state property and then earmarked this for distribution to local governments to pay for pensions. Act 205 of 1984 replaced the original act in which the state of Pennsylvania allocated pension aid based on where the insured property was located and instead the new allocation was based on the number of public employees in a locality.

Calabrese explains how the funds were distributed:

“Each public employee was considered a ‘unit,’ and uniformed employees (such as police and fire) each represented two units. The pool of insurance tax revenue collected by the state was then divided by the sum of municipal units to arrive at a unit value. This distribution could subsidize local governments’ pension expenditures up to 100 percent of the annual cost. In 1985, this tax generated $62.3 million in revenues; as a result, each unit value was worth $1,146 – meaning that local governments received $1,146 for pension funding for each public employee and an additional $1,146 for pension funding for each uniformed public employee. Importantly, 75 percent of municipalities received enough funding from this revenue in 1985 to fully offset their pension costs.”

The new mechanism raised more funds, but it also unexpectedly raised costs. If a municipality had to contribute less than the $1,146 annually for a regular employee or $2,292 for a uniformed employee, for example, the municipality was essentially incentivized to increase benefits to public employees up to this limit, because local public employees would receive increased benefits at no direct budgetary cost to the municipality.

“…the tax likely increased insurance costs for residents and businesses (and then only a small fraction of the cost), but not directly for the government employer. Further, this system privileged benefits relative to other compensation, because these payments (borne at least statutorily by out-of-state companies) could only be used for financing pensions and not other forms of compensation.”

A tax originally implemented to fund pension costs statewide resulted in a system that encouraged more generous benefits.

Despite increased subsidies from the state, only 38 percent of municipalities received sufficient allocated funds from the pool to fully offset the costs of pensions. This was because annual pension contributions were growing at a faster rate than the rate at which the subsidy from the state insurance tax was growing.

To highlight a city with severely distressed pension plans, Philadelphia continued to struggle even following the implementation of the state insurance tax. The police pension plan, nonuniformed plan, and firefighter pension plan were all only 49, 47, and 45 percent funded, respectively. In 2009, the City Council passed a temporary 1 percentage point increase in their sales tax and when the temporary rate was renewed in 2014, any revenue in excess of $120 million was dedicated to the city’s pension plans. Additionally, the state permitted the city to pass a $2 per pack cigarette tax to fund a planned budget deficit for the school system; likely because its income tax capacity was largely exhausted.

Philadelphia’s new taxes technically generated new revenues, but they did little to improve the funding of the city’s pension plans.

The selective taxes implemented to fund pension liabilities in Pennsylvania were effectively a Band-Aid that was two small for the state’s pension funding problem, which in turn required the addition of more, insufficient pension Band-Aids. It merely created a public financing system that encouraged pension benefit growth which led to the passage of additional laws requiring certain pension funding levels. And when these funding levels were not met, even more laws were passed that provided temporary pension funding relief, which further grew liabilities for distressed municipalities.

Act 44 became law in 1993 and provided plan sponsors pension funding relief, but primarily by allowing sponsors to alter actuarial assumptions and thereby reduce required pension contributions. Another law delayed funding by manipulating how the required contribution was calculated, rather than providing any permanent fix.

Moving forward

Selective taxes for the purpose of funding pensions are still a relatively rare practice, but as pension liabilities grow and the landscape of reform options changes, it may become increasingly attractive to policymakers. As Calabrese has demonstrated in his book chapter, however, we should be wary of this avenue as it may only encourage the growth of pension liabilities without addressing the problem in any meaningful way. Reforming the structure of the pension plan or the level of benefits provided to current or future employees would provide the most long-term solution.

A solution with the long-term in mind and that doesn’t involve touching current beneficiaries includes moving future workers to defined contribution plans; plans that are better suited to keeping costs contained. The ballooning costs aren’t stemming solely from overly generous plan benefits, but more seriously are the result of their poor management and incentives for funding, only exacerbated by poor accounting practices. The problem is certainly complicated and moving towards the use of defined contribution plans wouldn’t eliminate all issues, but it would at least set governments on a more sustainable path.

At the very least, policymakers interested in long-term solutions should be cautioned against using selective taxes to fund pensions.

Graduate School Opportunities Available Through Mercatus

One of the great parts of working at Mercatus is getting to interact with all of the bright and ambitious students that participate in our academic programs. Mercatus offers four unique graduate programs for students interested in political economy and public policy. The training and education that Mercatus provides are one of a kind.

As part of each program students get access to funding, practical experience, and a wide network of passionate, dedicated scholars. Many graduates from each program go on to develop successful careers in academia and public policy. Ninety-two percent of MA Fellowship graduates, for example, receive a job within 9 months of graduation. Whether you’re pursuing a Master’s, PhD, or law degree, there may be something for you at Mercatus.

The four programs and their details are below.  If you’re interested in learning more and applying, check out our website. Deadlines are right around the corner, with the PhD Fellowship deadline approaching at the end of this week.

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Mercatus PhD Fellowship

The PhD Fellowship is a competitive, full-time fellowship program for students pursuing a doctoral degree in economics at George Mason University. PhD Fellows take courses in market process economics, public choice, and institutional analysis and work on projects that use these lenses to understand global prosperity and change.

Students receive an award up to $200,000 (over five years) for full tuition support and a monthly stipend, as well as experience as a research assistant working closely with Mercatus-affiliated Mason faculty. The application deadline is February 1, 2018.

Mercatus MA Fellowship

The MA Fellowship is a tw0-year, competitive, full-time fellowship program for students pursuing a master’s degree in economics at George Mason University in preparation for a career in public policy. Fellows attend readings groups and career development workshops, spend at least 20 hours per week working with Mercatus scholars and staff, and complete a Mercatus Graduate Policy essay.

Students receive an award of up to $80,000 (over two years) for full tuition support and a monthly stipend, as well as practical experience conducting and disseminating research with Mercatus scholars and staff on pertinent policy issues. The application deadline is March 1, 2018.

Mercatus Adam Smith Fellowship

The Adam Smith Fellowship is a one-year, competitive fellowship program for PhD students at any university and in any discipline. The goal of this fellowship is to introduce students to a framework of ideas they may not otherwise encounter in their studies. Fellows meet a few times out of the year to engage in discussions on key foundational texts in the Austrian, Virginia, and Bloomington schools of political economy and learn how these texts may apply to their research interests.

Students receive a stipend up to $10,000 as well as travel, lodging, and all materials to attend workshops and seminars hosted by the Mercatus Center. The application deadline is March 15, 2018.

Mercatus Frédéric Bastiat Fellowship

The Frédéric Bastiat Fellowship is a one-year, competitive fellowship program for graduate students attending master’s, juris doctoral, and doctoral programs in a variety of disciplines. The goal of this fellowship is to introduce students to the Austrian, Virginia, and Bloomington school of political economy as academic foundations for pursuing contemporary policy analysis. Fellows meet a few times out of the year to engage in discussions on key foundational texts and interact with scholars that work on the cutting edge of policy analysis.

Students receive a stipend of up to $5,000 as well as travel, lodging, and all materials to attend workshops and seminars hosted by the Mercatus Center. The application deadline is March 15, 2018.

 

 

State tax refunds and limiting spending growth

This fall eligible Alaskans will be receiving a check of $1,100 from their state government. Although the amount of the check can vary, Alaskans receive one every fall – no strings attached. Other state residents are probably more familiar with IRS tax refunds that come every spring, but this “tax refund” that Alaskans receive is unique. It’s a feature that residents have benefited from for decades, even in times when the government has experienced fiscal stress. Considering the state’s unique and distressed budget situation that I’ve described in an earlier post, I think it warrants a discussion of the fiscal viability of their refunds.

A narrow tax base reliant on volatile revenue sources, restricted funds, and growing spending are all factors that made closing Alaska’s budget gap this year very difficult. It even contributed to pulling down Alaska from 1st in our 2016 ranking of states by fiscal condition to 17th in our 2017 edition. Given this deterioration, it will be helpful to look into how and why Alaska residents receive dividend payments each year. There is no public finance rule that says giving refunds to residents is fiscally irresponsible, but there definitely are better ways to do it, and Alaska certainly hasn’t proven to display best practices.

Another state that we can look at for comparison is Colorado, which has a similar “tax refund” for residents but is structured very differently. Colorado’s Taxpayer Bill of Rights (TABOR) requires that higher than expected tax revenues each year be refunded to taxpayers and acts as a restraint on government spending growth. In contrast, Alaska’s check comes from the state’s Permanent Fund’s earnings that are generated from oil severance taxes each year, and acts more like a dividend from oil investment earnings.

Are distributing these refunds to taxpayers fiscally responsible? I am going to take a deeper look at these mechanisms to find out.

First, Alaska’s refund.

The figure below displays Alaska’s Permanent Fund checks since 2002 overlaid with the state’s revenue and expenditure trends, all adjusted for inflation. The highest check (in 2015 dollars) was $2,279 in 2008 and the lowest was $906 in 2012, with the average over this time period being about $1,497 per person. Although the check amounts do vary, Alaska has kept on top of delivering them, even in times of steep budget gaps like in 2002, 2009, and 2015. The Permanent Fund dividend formula is based on net income from the current plus the previous four fiscal years, so it makes sense that the check sizes are also cyclical in nature, albeit in a slightly delayed fashion behind oil revenue fluctuations.

Alaska’s dividend payments often end up on the chopping block during yearly budget debates, and there is growing pressure to at least have them reduced. Despite this, Alaska’s dividends are very popular with residents (who can blame them?) and probably won’t be going away for a long time; bringing a new meaning to the Permanent Fund’s name.

The Alaska Permanent Fund was established in 1976 by constitutional amendment and was seen as an investment in future generations, who might no longer have access to oil as a resource. Although this may have been decent forward-thinking, which is rare in state budgets, it does illustrate an interesting public finance story.

Alaska is a great example of a somewhat backwards situation. They generate high amounts of cash each year, but because of the way many of their funds are restricted they are forced to hoard much of it, and give the rest to citizens in the form of dividends. If a different state were to consider a similar dividend before dealing with serious structural budget flaws would be akin to putting the cart before the horse.

Luckily for Alaskan dividend recipients, there are many other areas that the state could reform first in order to improve their budget situation while avoiding cutting payments. As my colleague Adam Millsap has recommended, a fruitful area is tax reform. Alaska doesn’t have an income or sales tax; two of the most common sources of revenue for state governments. These are two potentially more stable sources of income than what the state currently has.

How does Colorado’s “tax refund” compare?

Colorado’s Taxpayer Bill of Rights (TABOR) has a feature that requires any tax revenue growth beyond inflation and population growth be refunded to taxpayers. It was adopted by Colorado voters in 1992 and it essentially restricts revenues by prohibiting any tax or spending increases without voter approval.

A recent example of this playing out was in 2014 when the state realized higher than expected tax revenues as a result of marijuana legalization. At the point of legalization, the plan was to direct tax revenues generated from the sale of marijuana towards schools or substance abuse program funding. But because of the higher than expected revenues, TABOR was triggered and it would require voter approval to decide if the excess revenues would be sent back to taxpayers or directed to other state programs.

In November of 2015, Colorado voters approved a statewide ballot measure that gave state lawmakers permission to spend $66.1 million in taxes collected from the sale of marijuana. The first $40 million was sent to school construction, the next $12 million to youth and substance abuse programs, and the remainder $14.2 billion to discretionary spending programs. A great example that although TABOR does generally restrain spending, citizens still have power to decline refunds in the name of program spending they are passionate about.

 

The second figure here displays TABOR refunds compared with state revenues and expenditures over time. Adjusted for inflation, checks have varied from $18 in 2005 to $351 in 1999, much smaller than the Alaska dividend checks. TABOR checks have only tended to be distributed when revenues have exceeded expenses. The main reason why checks weren’t distributed between 2006 and 2009, despite a revenue surplus, was because of Referendum C which removed TABOR’s revenue limit for five years, allowing the state to keep collections exceeding the rule. The revenue limit has since been reinstated, but some question the effectiveness of TABOR given an earlier amendment in 2000 which exempts much of education spending from TABOR restrictions.

The main distinguishing factor between Colorado’s refund and Alaska’s Permanent Fund dividend is that the former also acts as a constraint on spending growth. By requiring the legislature to get voter approval before any tax increase or spending of new money, it implements automatic checks on these activities. Many states attempt to do this through what are called “Tax and Expenditure Limits” or TELs.

The worry is that left unchecked, state spending can grow to unsustainable levels.

Tax and Expenditure Limits

A review of the literature up to 2012 found that although the earliest studies were largely skeptical of the effectiveness of TELs, as time has passed more research points to the contrary. TELs can restrain spending, but only in certain circumstances.

My colleague Matt Mitchell found in 2010 that TELs are more effective when they (1) bind spending rather than revenue, (2) require a super-majority rather than a simple majority vote to be overridden, (3) immediately refund revenue collected in excess of the limit, and (4) prohibit unfunded mandates on local government.

Applying these criteria to Colorado’s TABOR we see that it does well in some areas and could improve in others. TABOR’s biggest strength is that it immediately refunds revenue collected in excess of the limit in its formula, pending voter approval to do otherwise. Automatically refunding surpluses makes it difficult for governments to use excess funds irresponsibly and also gives taxpayers an incentive to support TABOR.

Colorado’s TABOR does well to limit revenue growth according to a formula, rather than to a fixed number or no limitation at all. The formula partially meets Mitchell’s standards. It stands up well with the most stringent TELs by limiting government growth that exceeds inflation and population growth, but could actually be improved if it limited actual spending growth rather than focusing on tax revenue. When a TEL or similar law limits revenues, policymakers can respond by resorting to implementing more fees or borrowing. There’s some evidence of this occurring in Colorado, with fees becoming more popular as a way to raise revenue since TABOR’s passing. A spending-based TEL is more difficult to evade.

Despite its faults, Colorado’s TABOR structure appears to be doing better than attempts to constrain spending growth in other states. The National Conference of State Legislatures still considers it one of the strictest TELs in the nation. Other states, like Arkansas, could learn a lot from Colorado. A recent Mercatus study analyzes Arkansas’ Revenue Stabilization Law and suggests that it is missing a component similar to Colorado’s TABOR formula to refund excess revenues.

How much a state spends is ultimately up to its residents and legislature. Some states may have a preference for more spending than others, but given the tendency for government spending to grow towards an unsustainable direction, having a conversation about how to slow this is key. Implementing TEL-like checks allows for spending to be monitored and that tax dollars be spent more strategically.

Alaska’s Permanent Fund dividend is not structured as well as Colorado’s, but perhaps the state’s saving grace is that it has a relatively well structured TEL. Similarly to Colorado’s TABOR, Alaska’s TEL limits budget growth to the sum of inflation and population growth and is codified in the constitution. Alaska’s TEL doesn’t immediately refund revenue that is collected in excess of the limit to taxpayers as Colorado’s TABOR does, but it does target spending rather than revenues.

Colorado’s and Alaska’s TELs can compete when it comes to restraining spending, but Colorado’s is certainly more strict. Colorado’s expenditures have grown by about 55 percent over the last decade, while Alaska’s has grown approximately 120 percent.

The Lesson

Comparing Colorado and Alaska’s situations reveals two different ways of giving tax refunds to residents. Doing so doesn’t necessarily have to be fiscally irresponsible. Colorado has provided refunds to residents when state revenues have exceeded expenses and as a result this has acted as a restraint on over-spending higher than expected revenues. Although Colorado’s TABOR has been amended over time, its general structure illustrates the effectiveness of institutional restrains on spending. The unintended effects of TABOR, such as the increase in fees, could be well addressed by specifically targeting spending rather revenue, like in the case of Alaska’s TEL. Alaska may have had their future residents’ best intent in mind when they designed their Permanent Fund Dividend, but perhaps this goal of passing forward oil investment earnings should have been paired with preparing for the potential of cyclical budget woes.

A public sector retirement plan for Millennials

According to the Center for Retirement Research, about 52 percent of households are “at risk of not having enough to maintain their living standards in retirement” and that the retirement landscape is making “the outlook for retiring Baby Boomers and Generation Xers far less sanguine than for current retirees.” This growing problem for younger generations is highlighted by the Economic Policy Institute’s finding that almost half of households headed by someone between the ages of 32 and 61 have nothing saved for retirement. A confluence of factors has led to a predicament for millennials as they try to prepare for retirement in a drastically changing job market.

The millennial generation has grown to be an integral part of the workforce, and private sector companies are increasing their efforts to understand what they value most a job. A Deloitte survey reveals that a good work/life balance, opportunities to progress/be leaders, flexibility, and a sense of meaning emerge as the most important factors when evaluating job opportunities. What’s more, millennials are not likely to stick around for a job that doesn’t meet this criteria. The same survey found that if given the choice during the next year, one in four millennials would quit his or her current employer to join a new organization or to do something different.

This flightiness appears to be a characteristic of many young people and to be happening in tandem with, if not contributing to, an increasingly transient job market. This phenomenon, corroborated by other surveys, demonstrates that more and more millennial workers are changing jobs at a higher rate than previous generations. It is not as common to stick with your first or second job until retirement, as it once was for Baby Boomers. The “loyalty challenge” facing companies, paired with changes in technology and culture, has in turn been transforming the landscape of retirement options.

As workers become more transient, companies are forced to provide more portable retirement plan options. During the past two decades, the private sector has done just that by transitioning from offering primarily defined benefit retirement plans to offering more defined contribution plans. This change is to be expected in part because of the flexibility it provides for beneficiaries. Defined contribution plans allow for workers to take their benefits more easily with them from job to job.

The public sector has not quite caught up to this trend. Public sector plans have had much more difficulty staying solvent and much of this is because of the prevalence of defined benefit plans. Mercatus scholars, along with many economists, have long criticized the poor incentive structure of these plans. If these aren’t reason enough for policymakers to offer defined contribution plans in their place, then maybe their changing workforces will.

Much of the debate over growing pension liabilities has focused on whether public sector compensation costs are fair either in comparison to other states or to the private sector. But much less has been said about what is fair across generations.

Most pension reform efforts at the state level target changes in benefits for younger employees while preserving the benefits of older workers. Although this is largely the result of legal and political constraints, such changes have the potential to force younger generations of public-sector workers to shoulder a disproportionate share of the cost of reforms, as their retirement benefits become more uncertain, thus violating a crucial criterion of “intergenerational equity” for pension reform.

Pension experts Robert Novy-Marx and Joshua Rauh reveal in a 2008 study that the intergenerational transfer of pension debt could be quite large. They predict a 50 percent chance of underfunding across the states amounting to more than $750 billion, even before adjusting for risk. In other words, if left alone, the pension bills of today are going to be handed to the generations of tomorrow.

A new Mercatus paper uncovers how similar intergenerational equity issues have developed in the state of Oregon. The author, legal scholar Scott Shepard, writes:

“…the system radically favors (generally older) workers who started before 1996 and 2003, respectively – not just in expected ways, like seniority pay bumps, but in deeply structural ways; earlier-hired employees simply get a significantly better pay-and-benefit package for every minute of their climb up the seniority ladder.”

Oregon’s pension system, along with many other states’ plans, started out offering extremely generous benefits, but as this has grown increasingly unsustainable, the state is being forced to deal with reality and reign in benefits for newer workers.

The unfair retirement landscape that this creates is largely the result of many past poor policy decisions and although this difference in benefits between age groups is far from intentional, how Oregon – and other states in similar positions – responds can be. Changing demographic trends may lend reason for public pension officials to consider moving towards defined contribution plan structures, or at least providing the option.

Shepard strongly urges Oregon to make this shift. He describes a number of benefits; from the perspective of the state, taxpayers, and future generations:

“First, payments must be made when due, rather than being shifted off to future generations. This may seem painful to present taxpayers, but the long-term effect is to ensure a more honest government, in that politicians cannot make promises that their (unrepresented) descendants end up paying for generations later, long after the promisors have reaped the political benefits of making unfunded promises, only to have retired from the scene when payment comes due. This inability to promise now and pay later has a corollary benefit of thwarting the impulse to make extravagant pension promises, as the payments come due immediately, rather than being foisted off on future generations.”

Offering defined contribution plans for workers can provide a more sustainable option that would prevent this equity issue from worsening.

In addition to the accountability and savings that offering a defined contribution option provides, like we have seen demonstrated in Utah and Michigan, this also has the potential to lead to higher worker satisfaction.

With millennials looking to save money for retirement through more portable means, policymakers will want to offer benefits packages that match these preferences. Private sector workers and some public – including Federal and public university – workers lie at the forefront of those benefiting from the defined contribution trend. Most state public plans, however, still fall behind, which has continuing implications for public plan solvency and intergenerational equity.

Smart rule-breakers make the best entrepreneurs

A new paper in the Quarterly Journal of Economics (working version here) finds that the combination of intelligence and a willingness to break the rules as a youth is associated with a greater tendency to operate a high-earning incorporated business as an adult i.e. be an entrepreneur.

Previous work examining entrepreneurship that categorizes all self-employed persons as entrepreneurs has often found that entrepreneurs earn less than similar salaried workers. But this contradicts the important role entrepreneurs are presumed to play in generating economic growth. As the authors of the new QJE paper remark:

“If the self-employed are a good proxy for risk-taking, growth-creating entrepreneurs, it is puzzling that their human capital traits are similar to those of salaried workers and that they earn less.”

So instead of looking at the self-employed as one group, the authors separate them into two groups: those who operate unincorporated businesses and those who operate incorporated businesses. They argue that incorporation is important for risk-taking entrepreneurs due to the limited liability and separate legal identity it provides, and they find that those who choose incorporation are more likely to engage in tasks that require creativity, analytical flexibility and complex interpersonal communications; all tasks that are closely identified with the concept of entrepreneurship.

People who operate unincorporated businesses, on the other hand, are more likely to engage in activities that require high levels of hand, eye and foot coordination, such as landscaping or truck driving.

Once the self-employed are separated into incorporated and unincorporated, the puzzling finding of entrepreneurs earning less than similar salaried workers disappears. The statistics in the table below taken from the paper show that on average incorporated business owners (last column) earn more, work more hours, have more years of schooling and are more likely to be a college graduate than both unincorporated business owners and salaried workers based on two different data sets (Current Population Survey (CPS) and National Longitudinal Survey of Youth (NLSY)).

(click table to enlarge)

The authors then examine the individual characteristics of incorporated and unincorporated business owners. They find that people with high self-esteem, a strong sense of controlling one’s future, high Armed Forces Qualifications Test scores (AFQT)—which is a measure of intelligence and trainability—and a greater propensity for engaging in illicit activity as a youth are more likely to be incorporated self-employed.

Moreover, it’s the combination of intelligence and risk-taking that turns a young person into a high-earning owner of an incorporated business. As the authors state, “The mixture of high learning aptitude and disruptive, “break-the-rules” behavior is tightly linked with entrepreneurship.”

These findings fit nicely with some notable recent examples of entrepreneurship—Uber and Airbnb. Both companies are regularly sued for violating state and local ordinances, but this hasn’t stopped them from becoming popular providers of transportation and short-term housing.

If the founders of Uber and Airbnb always obtained approval before operating the companies would be hindered by all sorts of special interests, including taxi commissions, hotel industry groups and nosy neighbors. Seeking everyone’s approval—including the government’s—before operating likely would have meant never getting off the ground and the companies know this. It’s interesting to see evidence that many other, less well-known entrepreneurs share a similar willingness to violate the rules if necessary in order to provide their goods and services to customers.

Manufacturing employment and the prime-age male LFP rate: What’s the relationship?

Recently I wrote about the decline in the U.S. prime-age male labor force participation (LFP) rate and discussed some of the factors that may have caused it. One of the demand-side factors that many people think played a role is the decline in manufacturing employment in the United States.

Manufacturing has typically been a male-dominated industry, especially for males with less formal education, but increases in automation and productivity have resulted in fewer manufacturing jobs in the United States over time. As manufacturing jobs disappeared, the story goes, so did a lot of economic opportunities for working-age men. The result has been men leaving the labor force.

However, the same decline in manufacturing employment occurred in other countries as well, yet many of them experienced much smaller declines in their prime-age male LFP rates. The table below shows the percent of employment in manufacturing in 1990 and 2012 for 10 OECD countries, as well as their 25 to 54 male LFP rates in 1990 and 2012. The manufacturing data come from the FRED website and the LFP data are from the OECD data site. The ten countries included here were chosen based on data availability and I think they provide a sample that can be reasonably compared to the United States.

country 25-54 LFP rate, manuf table

As shown in the table, all of the countries experienced a decline in manufacturing employment and labor force participation over this time period. Thus America was not unique in this regard.

But when changes in both variables are plotted on the same graph, the story that the decline in manufacturing employment caused the drop in male LFP rate doesn’t really hold up.

country 25-54 LFP rate, manuf scatter plot

The percentage point change in manufacturing employment is across the top on the x-axis and the percentage point change in the prime-age male LFP rate is on the y-axis. As shown in the graph the relationship between the two is negative in this sample, and the change in manufacturing employment explains almost 36% of the variation in LFP rate declines (the coefficient on the decline in manufacturing employment is -0.322 and the p-value is 0.08).

In other words, the countries that experienced the biggest drops in manufacturing employment experienced the smallest drops in their LFP rate, which is the opposite of what we would expect if the decline in manufacturing employment played a big role in the decline of the LFP rate across countries.

Of course, correlation does not mean causation and I find it hard to believe that declines in manufacturing employment actually improved LFP rates, all else equal. But I also think the less manufacturing, less labor force participation story is too simple, and this data supports that view.

America and Italy experienced similar declines in their male LFP rates but neither experienced the largest declines in manufacturing employment over this time period. What else is going on in America that caused its LFP decline to more closely resemble Italy’s than that of Canada, Australia and the UK, which are more similar to America along many dimensions?

Whatever the exact reasons are, it appears that American working-age males responded differently to the decline in manufacturing employment over the last 20 + years than similar males in similar countries. This could be due to our higher incarceration rate, the way our social safety net is constructed, differences between education systems, the strength of the economy overall or a number of other factors. But attributing the bulk of the blame to the decline of manufacturing employment doesn’t seem appropriate.

Many working-age males aren’t working: What should be done?

The steady disappearance of prime-age males (age 25-54) from the labor force has been occurring for decades and has recently become popular in policy circles. The prime-age male labor force participation rate began falling in the 1950s, and since January 1980 the percent of prime-age males not in the labor force has increased from 5.5% to 12.3%. In fact, since the economy started recovering from our latest recession in June 2009 the rate has increased by 1.3 percentage points.

The 12.3% of prime-age males not in the labor force nationwide masks substantial variation at the state level. The figure below shows the percentage of prime-age males not in the labor force—neither working nor looking for a job—by state in 2016 according to data from the Current Population Survey.

25-54 males NILF by state 2016

The lowest percentage was in Wyoming, where only 6.3% of prime males were out of the labor force. On the other end of the spectrum, over 20% of prime males were out of the labor force in West Virginia and Mississippi, a shocking number. Remember, prime-age males are generally not of school age and too young to retire, so the fact that one out of every five is not working or even looking for a job in some states is hard to fathom.

Several researchers have investigated the absence of these men from the labor force and there is some agreement on the cause. First, demand side factors play a role. The decline of manufacturing, traditionally a male dominated industry, reduced the demand for their labor. In a state like West Virginia, the decline of coal mining—another male dominated industry—has contributed as well.

Some of the most recent decline is due to less educated men dropping out as the demand for their skills continues to fall. Geographic mobility has also declined, so even when an adjacent state has a stronger labor market according to the figure above—for example West Virginia and Maryland—people aren’t moving to take advantage of it.

Of course, people lose jobs all the time yet most find another one. Moreover, if someone isn’t working, how do they support themselves? The long-term increase in female labor force participation has allowed some men to rely on their spouse for income. Other family members and friends may also help. There is also evidence that men are increasingly relying on government aid, such as disability insurance, to support themselves.

These last two reasons, relying on a family member’s income or government aid, are supply-side reasons, since they affect a person’s willingness to accept a job rather than the demand for a person’s labor. A report by Obama’s Council of Economic Advisors argued that supply-side reasons were only a small part of the decline in the prime-age male labor force participation rate and that the lack of demand was the real culprit:

“Reductions in labor supply—in other words, prime-age men choosing not to work for a given set of labor market conditions—explain relatively little of the long-run trend…In contrast, reductions in the demand for labor, especially for lower-skilled men, appear to be an important component of the decline in prime-age male labor force participation.”

Other researchers, however, are less convinced. For example, AEI’s Nicholas Eberstadt thinks that supply-side factors play a larger role than the CEA acknowledges and he discusses these in his book Men Without Work. One piece of evidence he notes is the different not-in-labor-force (NILF) rates of native born and foreign born prime-age males: Since one would think that structural demand shocks would affect both native and foreign-born alike, the difference indicates that some other factor may be at work.

In the figure below, I subtract the foreign born not-in-labor-force rate from the native born rate by state. A positive number means that native prime-age males are less likely to be in the labor force than foreign-born prime age males. (Note: Foreign born only means a person was born in a country other than the U.S.: It does not mean that the person is not a citizen at the time the data was collected.)

25-54 native, foreign NILF diff

As shown in the figure, natives are less likely to be in the labor force (positive bar) in 34 of the 51 areas (DC included). For example, in Texas the percent of native prime-age men not in the labor force is 12.9% and the percentage of foreign-born not in the labor force is 5.9%, a 7 percentage point gap, which is what’s displayed in the figure above.

The difference in the NILF rate between the two groups is also striking when broken down by education, as shown in the next figure.

25-54 native, foreign males NILF by educ

In 2016, natives with less than a high school degree were four times more likely to be out of the labor force than foreign born, while natives with a high school degree were twice as likely to be out of the labor force. The NILF rates for some college or a bachelor’s or more are similar.

Mr. Eberstadt attributes some of this difference to the increase in incarceration rates since the 1970s. The U.S. imprisons a higher percentage of its population than almost any other country and it is very difficult to find a job with an arrest record or a conviction.

There aren’t much data combining employment and criminal history so it is hard to know exactly how much of a role crime plays in the difference between the NILF rates by education. Mr. Eberstadt provides some evidence in his book that shows that men with an arrest or conviction are much more likely to be out of the labor force than similar men without, but it is not perfectly comparable to the usual BLS data. That being said, it is reasonable to think that the mass incarceration of native prime-age males, primarily those with little formal education, has created a large group of unemployable, and thus unemployed, men.

Is incarceration a supply or demand side issue? On one hand, people with a criminal record are not really in demand, so in that sense it’s a demand issue. On the other hand, crime is a choice in many instances—people may choose a life of crime over other, non-criminal professions because it pays a higher wage than other available options or it somehow provides them with a more fulfilling life (e.g. Tony Soprano). In this sense crime and any subsequent incarceration is the result of a supply-side choice. Drug use that results in incarceration could also be thought of this way. I will let the reader decide which is more relevant to the NILF rates of prime-age males.

Criminal justice reform in the sense of fewer arrests and incarcerations would likely improve the prime-age male LFP rate, but the results would take years to show up in the data since such reforms don’t help the many men who have already served their time and want to work but are unable to find a job. Reforms that make it easier for convicted felons to find work would offer more immediate help, and there has been some efforts in this area. How successful they will be remains to be seen.

Other state reforms such as less occupational licensing would make it easier for people— including those with criminal convictions—to enter certain professions. There are also several ideas floating around that would make it easier for people to move to areas with better labor markets, such as making it easier to transfer unemployment benefits across state lines.

More economic growth would alleviate much of the demand side issues, and tax reform and reducing regulation would help on this front.

But has something fundamentally changed the way some men view work? Would some, especially the younger ones, rather just live with their parents and play video games, as economist Erik Hurst argues? For those wanting to learn more about this issue, Mr. Eberstadt’s book is a good place to start.

What’s going on with Alaska’s budget?

Alaska is facing another budget deficit this year – one of $3 billion – and many are skeptical that the process of closing this gap will be without hassle. The state faces declining oil prices and thinning reserves, forcing state legislators to rethink their previous budgeting strategies and to consider checking their spending appetites. This shouldn’t be a surprise to state legislators though – the budget process during the past two years ended in gridlock because of similar problems. And these issues have translated into credit downgrades from the three major credit agencies, each reflecting concern about the state’s trajectory if no significant improvements are made.

Despite these issues, residents have not been complaining, at least not until recently. Every fall, some earnings from Alaska’s Permanent Fund get distributed out to citizens – averaging about $1,100 per year since 1982. Last summer, Governor Walker used a partial veto to reduce the next dividend from $2,052 to $1,022. Although politically unpopular, these checks may be subject to even more cuts as a result of the current budget crisis.

The careful reader might notice that Alaska topped the list of the most fiscally healthy states in a 2016 Mercatus report that ranks the states according to their fiscal condition (using fiscal year 2014 data). For a state experiencing so much budget trouble, how could it be ranked so highly?

The short answer is that Alaska’s budget is incredibly unique.

On the one hand, the state has large amounts of cash, but on the other, it has large amounts of debt. Alaska’s cash levels are what secured its position in our ranking last year. Although holding onto cash is generally a good thing for state governments, there appears to be diminishing returns to doing so, especially if there is some structural reason that makes funds hard to access for paying off debt or for improving public services. It is yet to be seen how these factors will affect Alaska’s ranking in the next edition of our report.

Another reason why Alaska appeared to be doing well in our 2016 report is that the state’s problems – primarily spending growth and unsustainable revenue sources – are still catching up to them. Alaska has relied primarily on oil tax revenues and has funneled much of this revenue into restricted permanent trusts that cannot be accessed for general spending. When the Alaska Permanent Fund was created in the 1980s, oil prices were high and production was booming, so legislators didn’t really expect for this problem to occur. The state is now starting to experience the backlash of this lack of foresight.

The first figure below shows Alaska’s revenue and expenditure trends, drawing from the state’s Comprehensive Annual Financial Reports (CAFRs). At first look, you’ll see that revenues have generally outpaced spending, but not consistently. The state broke even in 2003 and revenues steadily outpaced expenditures until peaking at $1,266 billion in 2007. Revenues fell to an all-time low of $241 billion following the recession of 2008 and then fluctuated up and down before falling drastically again in fiscal year 2015.

alaska-revenues-exp4.5.17

The ups and downs of Alaska’s revenues reflect the extremely volatile nature of tax revenues, rents, and royalties that are generated from oil production. Rents and royalties make up 21 percent of Alaska’s total revenues and oil taxes 6 percent – these two combined actually come closer to 90 percent of the actual discretionary budget. Alaska has no personal income tax or sales tax, so there isn’t much room for other sources to make up for struggling revenues when oil prices decline.

Another major revenue source for the state are federal grants, at 32 percent of total revenues. Federal transfers are not exactly “free lunches” for state governments. Not only do they get funded by taxpayers, but they come with other costs as well. There is research that finds that as a state becomes more reliant on federal revenues, they tend to become less efficient, spending more and taxing more for the same level of services. For Alaska, this is especially concerning as it receives more federal dollars than any other state in per capita terms.

Federal transfers as an income stream have been more steady for Alaska than its oil revenues, but not necessarily more accessible. Federal funds are usually restricted for use for federal programs and therefore their use for balancing the budget is limited.

A revenue structure made up of volatile income streams and hard-to-access funds is enough by itself to make balancing the budget difficult. But Alaska’s expenditures also present cause for concern as they have been growing steadily, about 10 percent on average each year since 2002, compared with private sector growth of 6 percent.

In fiscal year 2015, education was the biggest spending category, at 28% of total expenditures. This was followed by health and human services (21%), transportation (11%), general government (10%), the Alaska Permanent Fund Dividend (9%), public protection (6%), and universities (5%). Spending for natural resources, development, and law and justice were all less than 5 percent.

The next figure illustrates the state’s biggest drivers of spending growth since 2002. Education and general government spending have grown the most significantly over the past several years. Alaska Permanent Fund spending has been the most variable, reflecting the cyclical nature of underlying oil market trends. Both transportation and health and human services have increased steadily since 2002, with the latter growing more significantly the past several years as a result of Medicaid expansion.

alaska-spendinggrowth4.5.17

Alaska’s spending is significantly higher than other states relative to its resource base. Spending as a proportion of state personal income was 31 percent in fiscal year 2015, much higher than the national average of 13 percent. A high level of spending, all else equal, isn’t necessarily a bad thing if you have the revenues to support it, but as we see from this year’s budget deficit, that isn’t the case for Alaska. The state is spending beyond the capacity of residents to pay for current service levels.

What should Alaska do?

This is a complicated situation so the answer isn’t simple or easy. The Alaska government website provides a Microsoft Excel model that allows you to try and provide your own set of solutions to balance the budget. After tinkering with the state provided numbers, it becomes clear that it is impossible to balance the deficit without some combination of spending cuts and changes to revenues or the Permanent Fund dividend.

On the revenue side, Alaska could improve by diversifying their income stream and/or broadening the tax base. Primarily taxing one group – in this case the oil industry – is inequitable and economically inefficient. Broadening the base would cause taxes to fall on all citizens more evenly and be less distortive to economic growth. Doing so would also smooth revenue production, making it more predictable and reliable for legislators.

When it comes to spending, it is understandably very difficult to decide what areas of the budget to cut, but a good place to start is to at least slow its growth. The best way to do this is by changing the institutional structure surrounding the political, legislative, and budgeting processes. One example would be improving Alaska’s tax and expenditure limit (TEL), as my colleague Matthew Mitchell recommends in his recent testimony. The state could also look into item-reduction vetoes and strict balanced-budget requirements, among other institutional reforms.

Ultimately, whatever steps Alaska’s legislators take to balance the budget this year will be painful. Hopefully the solution won’t involve ignoring the role that the institutional environment has played in getting them here. A narrow tax base reliant on volatile revenue sources, restricted funds, and growing spending are all factors that have led many to think that Alaska is and always will be “different.” But what constitutes sound public financial management is the same regardless of state. Although Alaska’s situation is unique, their susceptibility to fiscal stress absent any changes is not.

Mutant Capitalism rears its ugly head in Arlington

Confectionery-giant Nestlé plans to move its U.S. headquarters from California to 1812 North Moore in the Rosslyn area of Arlington in the next few years. This should be great news for the people of Arlington—a world-famous company has decided that Arlington County is the best place to be in the U.S. This must be due to our educated workforce and high quality of life, right?

Maybe. The real attraction might also be the $6 million of state handouts to Nestlé, along with an additional $6 million from Arlington County. Government handouts like these have become a way of life in the U.S. even though the results are often underwhelming.

Federal programs such as the New Markets Tax Credit Program have had at best small effects on economic development, and there is a good chance they just reallocate economic activity from one place to another rather than generate new economic activity. Local programs like Tax Increment Financing appear to largely reallocate economic activity as well. These programs might be good for the neighborhood or city that gets the handout, but it doesn’t help the residents of nearby places who are forced to contribute via their tax dollars.

In the Nestlé case, all of Virginia’s taxpayers are paying for Nestlé to locate in Arlington, which already has a relatively strong economy and is one of the wealthiest counties in Virginia. Why should taxpayers in struggling counties such as Buchanan or Dickenson County be forced to subsidize a company in Arlington? Government handouts to firms are often regressive since companies rarely want to locate in areas with a low-skill—and thus low-income—workforce. Everyone pays, but the most economically successful areas get the benefits.

Government officials often praise the jobs that these deals create and the Nestlé deal is no different: According to the performance agreement, Nestlé must create and maintain 748 new full-time jobs. And even if we ignore the fact that jobs are an economic cost, not a benefit, a closer look reveals that projections and reality usually diverge. For example, Buffalo awarded hundreds of millions of dollars to SolarCity, which promised to create 5,000 jobs. They have since revised that number down to 1,460. There are numerous other examples where the cost per job turned out to be higher than initially projected.

The grant performance agreement also estimates that Nestlé will provide $18.2 million in taxes to the county over the next 10 years, more than enough to offset the grant expenditure. But this doesn’t take into account what would have happened absent the handout. Perhaps some other company would have relocated here for free. Or a local company, or collection of companies, would have eventually rented out the space.

Government grants may also distort the real estate market: There’s a good chance no company had occupied 1812 North Moore because the rent was too high. If so, part of this grant is a handout to the owners of the building, Monday Properties, since now it does not have to lower its rent to attract a tenant. This may lead other property companies to lobby for and expect government handouts to help them find tenants.

Government grants often distort the economy by treating out-of-state companies differently than in-state companies. They encourage relocation by subsidizing it, which discourages expansion. A better strategy is to create a simple, non-intrusive business environment that treats all businesses equally.

Government grants are a characteristic of what my colleague Chris Koopman calls Mutant Capitalism and are antithetical to real capitalism and free enterprise. Capitalism involves businesses competing for consumers on an even playing field—there is no room for government favors that tilt the playing field towards one business or another.