Author Archives: Ben VanMetre

About Ben VanMetre

Ben VanMetre is an MA Fellow at the Mercatus Center at George Mason University. Before joining Mercatus, Ben earned his Bachelor of Arts degree from Beloit College where he double majored in Economics and Management and Psychology. His research interests include international and state-based development issues, entrepreneurship, institutional arrangements, and economic freedom. His work has appeared in Forbes, Economic Affairs, the Cato Journal, the Journal of Business and Economic Perspectives, the Journal of the James Madison Institute, the Free Market Foundation, and the second volume of the Wealth and Wellbeing of Nations.

New Research on Freedom and Entrepreneurship

Here are a few findings from my recent paper with Joshua Hall and John Pulito titled “Freedom and Entrepreneurship: New Evidence from the 50 States”

  • Humans are entrepreneurial by nature. We desire to improve our material well-being, which drives us to innovate, often through new business creation. Despite the ever-present tendency toward entrepreneurship, public policy can have a significant impact on the incentives for entrepreneurial activity. Economists often call these incentives the “rules of the game.”
  • When making the decision to take on a new business, entrepreneurs must weigh the risks against the potential payout. Policy makers have the power to raise the cost of starting a new business by raising taxes or increasing regulatory costs, and they have the power to lower the cost by pursuing stable and consistent public policy initiatives consistent with economic freedom, such as low, broad-based taxes and prudent regulation.
  • Previous research has demonstrated that “rules of the game” favoring lower taxes and limited regulation—as measured by economic freedom indices—encourage entrepreneurship. Studies have found similar results both in comparisons across the states and in comparisons across countries. “Freedom and Entrepreneurship: New Evidence from the 50 States” uses an index of freedom, the Mercatus Center at George Mason University’s Freedom in the 50 States by Will Ruger and Jason Sorens. The study confirms earlier results: economic freedom permits higher levels of entrepreneurship, as measured by the creation of new businesses.
  • Freedom in the 50 States includes measures of both economic and personal freedom. Personal freedom had not previously been studied as a factor in the entrepreneurship level, and this study found that it did not in fact have a significant impact on business creation. Only economic freedom appears to have a positive impact on entrepreneurship, although personal freedom is of course important for other reasons.
  • This additional evidence that economic freedom is correlated with entrepreneurship should encourage policy makers to pursue changes that increase their states’ economic freedom. The evidence suggests that by increasing economic freedom, policy makers have significant power to improve their states’ climate for new business creation. For example, if policy makers in Ohio— which currently ranks 32nd in the Freedom in the 50 States’ Economic Freedom index—increased the state’s ranking to the level of Nevada, which ranks 23rd, Ohio residents could expect to see a 33 percent increase in new business creation. Lower tax rates, lower regulatory burdens, and lower barriers to trade can all encourage citizens to pursue their drive toward entrepreneurship.

Click here to read the paper in its entirety.

Potential Pension Cuts for Retired Teachers in Illinois

There was an interesting op-ed in the Chicago Tribune recently that points to the severity of Illinois’s pension mess. According to the Teachers’ Retirement System (TRS) in Illinois, if new revenues are not generated then benefits for current retirees may need to be cut via COLA reductions. This statement should not come as a surprise considering the state’s pension system is slated to run out of assets within the next decade.

As expected, however, teacher unions are unhappy with this discussion and have already deemed it unconstitutional. Unfortunately, because current benefits are protected in Illinois’s state constitution, this is a common fall back for nearly every argument against changes to the pension system.

Reducing COLA benefits may sound extreme but, as we already know, this type of reform was celebrated as a bipartisan success in Rhode Island last year. Unfortunately, during the same time, the Illinois TRS was releasing statements like this one:

The Tribune’s July 5 editorial ‘Rescuing public pensions’ is centered on the false premise that Illinois’ current pension plans for public employees are ‘doomed’ and unsustainable. The truth is that the state’s pension plans are sustainable.

One word comes to mind after reading that… scary. Illinois’s pension system is surely not sustainable. If the state continues to tell people that it is then the possibility for serious structural reform will become less likely. Reducing or suspending the COLA is one of many important steps that Illinois needs to consider.

Don’t Bailout the States

Last week the Illinois House adopted HR 0720 which was part of a growing effort to remove the possibility of a federal bailout for the states. The synopsis of the House Resolution reads:

Urges the federal government to take no action to redeem, assume, or guarantee State debt; and the Secretary of the Treasury should report to Congress negotiations to engage in actions that would result in an outlay of Federal funds on behalf of creditors to a State.

Senior Director of Government Affairs at the Illinois Policy Institute, Collin Hitt, offered committee testimony on the resolution. While writing about his testimony, Collin correctly argues that

Illinois’ problems are its own. Illinois has the tools to fix its finances. The state is seeing record reviews. Pension reform and Medicaid reform are possible, and there are concrete ideas to fix these debt-ridden programs. The prospect of a federal bailout only forestalls those solutions. If a federal bailout is considered imminent – or even possible – then the urgency to actually solve our problems ourselves is diminished. This resolution sends a message throughout state government that a bailout is not a solution that the State of Illinois can plan on.

That last part is absolutely essential, as it gets at a serious issue currently taking place in Illinois and other troubled states across the U.S. When politicians and law makers are dealing with a state that is on the brink of fiscal collapse they have two options: 1) make lasting intuitional and structural reform or 2) avoid significant reform and hope that most of the issues fix themselves. As a federal bailout becomes more likely, however, avoiding reform becomes politically easier. This, therefore, becomes a race to the bottom scenario where the states that end up in the worst fiscal shape are “rewarded” with a federal bailout… A very bad incentive structure and a scary road to head down.

Hopefully HR 0720 gains more traction and Illinois and begins to change the growing federal bailout expectations. If it is successful, other states should surely follow.

Reforming State and Local Pension Plans

The Government Accountability Office recently issued a report that provides a nice analysis on the changes that have been taking place in state and local pension plans over the past few years. According to the GAO’s tabulations, the following reforms have been implemented since 2008:

 • Reducing benefits: 35 states have reduced pension benefits, mostly for future employees due to legal provisions protecting benefits for current employees and retirees. A few states, like Colorado, have reduced post-retirement benefit increases for all members and beneficiaries of their pension plans.

• Increasing member contributions: Half of the states have increased member contributions, thereby shifting a larger share of pension costs to employees.

• Switching to a hybrid approach: Georgia, Michigan, and Utah recently implemented hybrid approaches, which incorporate a defined contribution plan component, shifting some investment risk to employees.

The reforms listed in this report seem to indicate that some states and localities are taking a step in the right direction in regards to pension reform. There is, however, a lot more work that needs to be done. One reform, for example, that we need to see more of is shifting public sector pensions from defined benefit to defined contribution plans (see Scott Beaulier’s recent paper for more on this topic). As the GAO report points out, roughly 78 percent of state and local employees participated in defined benefit plans in 2011 – compared to 18 percent of private sector employees.

Another important topic that this report touches on is the discount rate debate. That is, whether or not states should base the discount rate on the expected return of plan assets or on relevant interest rates in the bond market (Eileen Norcross has done some valuable research on this topic here and here).

 

Hamilton’s Paradox

I recently finished reading Jonathan Rodden’s 2006 book Hamilton’s Paradox: The Promise and Peril of Fiscal Federalism. The book provides a fascinating analysis of fiscal federalism that combines theory, qualitative and quantitative analysis, and contemporary case studies.

Rodden begins by detailing the potential promises and perils of fiscal federalism. He states that the promise of federalism is straightforward: “decentralized, multitiered systems of government are likely to give citizens more of what they want from government at lower cost than more centralized alternatives.” The perils of federalism, although less examined in the literature, are rooted in the idea that “In decentralized federations, politically fragmented central governments may find it difficult to solve coordination problems and provide federation-wide collective goods. As in the private sector, public institutions only produce desirable outcomes when incentives are properly structured” (p. 5).

In Chapter 3 Rodden provides a very interesting history of federalism and federal bailouts in the U.S. Specifically, he discusses the federal assumption of state debt that took place in 1790, the rapid growth in state borrowing in the early 1800s, the nine states that defaulted in 1841 and 1842 (Maryland, Pennsylvania, Arkansas, Florida, Illinois, Indiana, Louisiana, Michigan, and Mississippi), and the constitutional debt limitations that many states adopted in the 1840s and 1850s.

Most interesting is the game theory model Rodden develops in the second half of Chapter 3. Specifically, it’s a dynamic game of incomplete information that takes place between the central government and a single subnational government. Information is incomplete because subnational governments don’t know exactly how the central government will behave in the event of fiscal crisis. That is, the central government will either allow the subnational government to default (resolute type) or will provide a bailout (irresolute type).

The fist move of the game occurs when a subnational government experiences a fiscal shock with lasting effects (i.e. recession). In response to the fiscal shock it can either adjust immediately or refuse to deal with the shock by borrowing, with the long term hope of receiving a bailout. The path that the subnational government takes is a function of, among other things, the expected probability of the central government being resolute or irresolute (the complete game is much more detailed than the brief description provided here).

Rodden utilizes this game as he develops each of the case studies provided later in the book. The case studies involve comparing and contrasting the events that have taken place in Germany and Brazil. In the 1990’s two states in Germany received formal bailouts by the federal government (the Bund). During the same time, however, bailouts were distributed to virtually every state in Brazil. In Chapters 7 and 8 Rodden carefully details the structures of government in these two countries and outlines the reasons their outcomes were so different.

Two of the many important conclusions that Rodden makes in this book are (1)

when free to borrow, growing transfer dependence is associated with increasing deficits, both among federated units and local governments (p. 116)

and (2)

The central government must not only allow subnational governments significant tax autonomy and disentangle its books from those of the subnational governments, but it must demonstrate through costly action that it will not assume subnational liabilities when times get tough (p. 267)

This brief review of Hamilton’s Paradox only covered a few of the many important topics that the Rodden details in the book. I strongly recommend this book for anyone interested in fiscal federalism.

Limiting Eminent Domain Authority for the States

In June 2005, the Supreme Court’s decision in Kelo vs. City of New London extended the power of eminent domain by allowing governments to condemn private property and transfer it to others for private economic development. This decision sparked a great deal of controversy and its repercussions and implications have been widely studied (see for example, the work by Ed Lopez and Bruce Benson).

Last week, the House Judiciary Committee approved a measure that would limit government’s use of eminent domain. Specifically, the Private Property Rights Protection Act Act (H.R. 1433) would prohibit:

States and localities that receive Federal economic development funds from using eminent domain to take private property for economic development purposes. States and localities that use eminent domain for private economic development are ineligible under the bill to receive Federal economic development funds for 2 fiscal years.

When the bill was first introduced in 2011, the Honorable Trent Franks outlined its importance with the following statement:

We must restore the property rights protections that were erased from the Constitution by the Kelo decision. Fortunately, they are not permanently erased. Let us hope. John Adams wrote over 200 years ago that, ‘‘Property must be secured or liberty cannot exist.’’ As long as the specter of condemnation hangs over all property, arbitrary condemnation hanging over all property, our liberty is threatened.

There were many testimonies given throughout the hearing that pointed to the strengths and the weaknesses of H.R. 1433. Much of the economic literature suggests, however, that in general placing strong limits on eminent domain authority has substantial benefits for economic growth development, and prosperity. I think Ed Lopez, Carrie Kerekes and George Johnson (2007) sum up the importance of limiting this authority particularly well, as they write:

High taxes, excessive regulation, and loosely limited eminent domain powers are all tools of central planning and government control of the economy. Under these policies property rights are insecure, which distorts incentives for making good resource use decisions, discourages using assets as collateral for beneficial investments, and forfeits the dynamic benefits that emerge out of capitalism…Taxes, regulation, and takings through eminent domain decrease the security of property rights; therefore, these government infringements should be limited.

New Education Funding in Illinois Goes to Pensions

Neighborhood Effects readers know that Illinois’s pension problems are much worse than reported. According to the state’s numbers, Illinois’s unfunded pension liabilities amount to roughly $85 billion but as Eileen Norcross and I have argued, the amount is actually closer to $173 billion.

There have been many discussions regarding pension reform in Illinois during the past few months and, unsurprisingly, little has been accomplished. In fact, an article in Statehouse News earlier this week provided evidence that Illinois is continuing to deliberately avoid dealing with the problem by providing temporary quick fixes and banking on the idea that the state’s pension problems will simply disappear when the economy recovers.

According to the article in Statehouse, Illinois’s

12 percent increase in higher education spending this year isn’t going to benefit students. Instead, the additional funding for fiscal 2012 is going into the State Universities Retirement System, or SURS, to address its underfunded pension program…. The dramatic increase in the amount of money being given to SURS, and the other state pension systems, seeks to make up for decades of chronic underfunding by governors and legislators, and shrinking returns on investments because of the stagnant economy.

Education costs are increasing across the country. Students in Illinois paid 30 percent more for a year of college education at a university in 2011 than they did in 2007. Instead of using the additional 12 percent in higher education funds to curb these increasing costs, the state put the money towards its SURS system. This fiscal year students in Illinois are dealing with the consequences of the state’s failure to properly manage its pension system. As pension costs continue to grow in Illinois, the state will likely continue putting more money into the system – which means less money will be available for other areas of the budget.

In related pension news in Illinois, the Daily Herald provided the following quote from Hanover Park Village President Rodney Craig:

We have a fear that at the end of the day the pensions won’t be there

Without serious structural pension reform, Mr. Craig’s fear will most certainly become a reality. Labeling Illinois’s recent pension quick fix as a disappointment would be an understatement. This is nowhere near the type of reform that needs to happen in Illinois. If the state legislature wants to ensure fiscal stability in the future of Illinois’s pension system then they must start by removing the constitutional protection of pension benefits, reducing the rate of accrual for current employees, increasing current employee contributions, closing the current defined benefit plans and moving all employees to a defined contribution plan.

 

Maryland’s New Budget Proposal

Maryland’s fiscal challenges did not occur over night and, in fact, the state has been running structural deficits for the past several years. The Governor’s recent proposal to balance the state’s budget consists of two major components: (1) having the state share the costs of the teachers’ pension system with county level governments and (2) modifying the state’s tax code.

Cost Sharing:

As the system currently stands, local governments in Maryland determine teacher salaries but the state, however, picks up the entire cost of teacher pensions. The Governor’s proposal would essentially split these costs – the state would continue to pay for a portion of the teachers’ pension costs but county governments would also pick up a portion of the cost. Although some consider this to be an extreme reform, the principle behind the reform is really not that severe.

When the average family in the U.S. makes their budget for the week or the month they must include everything they spend money on – groceries, gas, health insurance, and etc. Governor O’Malley is essentially asking county governments to do the same. He is asking units of local government to budget for what they spend money on, which includes teacher pensions.

This proposal is definitely a step in the right direction. Splitting the cost of pensions with the county governments introduces more transparency and accountability into the teachers’ pension system. More importantly, cost-sharing introduces a better sense of fiscal discipline for county level budgeting.

Tax Code:

The second component of the Governor’s proposal consists of modifying the state’s tax code – increasing the tobacco tax, getting rid of tax loopholes in the mining industry, implementing a tax on internet sales, and changing the tax structure for high income earners. There seems to be some confusion on this final point. To be clear, as I understand it, this is not an increase in the tax rate but rather it’s a decrease in the number of tax exemptions for high income earners.

Some of these ideas are certainly better than others, but what’s important about these tax reforms is that Governor O’Malley is seemingly trying to introduce neutrality into the tax code. If this is in fact what he is trying to do, then it’s a step in the right direction. State’s that introduce neutrality and generality in their tax code by getting rid of tax loopholes, reducing the number of exemptions, and broadening their tax base have been able to lower tax rates while increasing revenues.

Taking Reform a Step Further:

The Governor is taking Maryland in the right direction by introducing structural reform into the state’s budgeting process. This budget proposal, however, is only one of many steps that need to be taken. If Maryland really wants to get its fiscal house in order it needs to continue focusing on institutional reform. One reform, for example, that the Governor should consider is implementing an effective spending limit – specifically, one that ties spending growth to the sum of population growth and inflation.

For more on this topic, watch my recent interview with Fox-5 news:

Gov. O’Malley Outlines $311 Million in New Revenue for Maryland: MyFoxDC.com

New Research on Immigration Policy

Immigration reform is something that has already surfaced in the recent GOP debates and will certainly receive more attention in the coming months as we make our way further into another presidential election year. The Cato Institute recently released a special edition of the Cato Journal titled “Is Immigration Good for America” in order to influence this debate and help individuals better understand the possibilities for reform.

Each of the 13 articles in this edition of the journal provides a unique insight into a wide variety of issues concerning current immigration policy. Here are a few summaries of some of the arguments I found particularly interesting.

In his article titled “Why Should We Restrict Immigration?” Bryan Caplan explores many of the prominent objectives to the liberalization of immigration policy through a moral lens. He concludes his argument with the following:

there are cheaper and more humane solutions for each and every complaint [against liberalization]. If immigrants hurt American workers, we can charge immigrants higher taxes or admission fees, and use the revenue to compensate the losers. If immigrants burden American taxpayers, we can make immigrants ineligible for benefits. If immigrants hurt American culture, we can impose tests of English fluency and cultural literacy. If immigrants hurt American liberty, we can refuse to give them the right to vote. Whatever your complaint happens to be, immigration restrictions are a needlessly draconian remedy.

In his article titled “Immigration and the Welfare State” Daniel T. Griswold, the editor of this edition of the journal, provides an interesting argument concerning the assertion that immigrants impose extreme long term fiscal burdens on U.S. taxpayers. He concludes with the following:

For those concerned about the fiscal impact of immigration, the goal should be to wall off the welfare state, not our country. As far as constitutionally possible, Congress and the states should deny welfare payments to non-citizen immigrants. This would be good for the immigrants because they could more easily avoid the disincentives to work and family formation caused by welfare payments. It would be good for U.S. taxpayers because it would reduce demand for welfare spending. And it would be good for the U.S. economy because it would remove one of the more potent political arguments against expanded legal immigration.

In our article titled “U.S. Immigration Policy in the 21st Century: A Market-Based Approach,” Joshua Hall, Richard Vedder, and I argue that visas should not be allocated based on arbitrary political criteria but instead through the price system. Our proposal has several components but consists largely of creating an NASDAQ-style international market for visas. From our paper:

The United States is the light of the world, a beacon of freedom and opportunity. Immigration is both a cause and a consequence of this reality. It is obvious that high volumes of immigration can lead to cultural clashes and can challenge our infrastructure. Thus realistically the body politic will insist that limits be placed on it. Let’s allocate access to our great country on the basis of supply and demand, reflecting the intensity of preferences of immigrants themselves and potential employers, rather than on a political process that is simply not as good as the market in allocating resources.

I think these articles, along with the other articles in this edition of the Cato Journal, are definitely worth a read and hopefully we will see these ideas influence the coming debates.

What Illinois’s Credit Rating Downgrade Really Means

Last week Moody’s Investment Service downgraded Illinois’s credit rating from A2 to A1, thus labeling the state’s debt as the riskiest in the nation. There seems to be some confusion, however, on what this downgrade means for state borrowing, how it will affect taxpayers, and how it will impact the state’s fiscal future.

To put this downgrade into perspective, it’s important to consider that it came just a few days before the state had planned to borrow $800 million to pay for roads, schools, and bridges. Many individuals predicted that this downgrade would make it more expensive for the state to follow through with its planned bonds sale. Illinois Treasure Dan Rutherford estimated that the downgrade would likely cost the state an additional $65 million in order to issue the $800 million in bonds. Bloomberg predicted that Illinois would face borrowing costs more than quadruple the average that it has paid over the past ten years.

But if the rating downgrade was supposed to make borrowing more expensive, how then was Illinois able to secure historically low interest rates in its bond sale this week?

This is precisely the source of much of the confusion and there are a few things that need to be considered. First and foremost, it’s important to point out that a credit downgrade does not necessarily increase the cost of borrowing (as we saw when the cost of borrowing decreased after the U.S treasury was downgraded). A downgrade is just that, a grade. It’s an assessment by a credit rating agency.  A downgrade will generally only change lending terms if it teaches the lenders something new. For example, if lenders (i.e. bond buyers) know that Illinois is flunking math, then they have already built that into their lending habits – the information is “baked into the price.” It’s well known that Illinois is in poor fiscal shape and thus this downgrade did not surprise lenders.

Another thing that needs to be considered is the fact that interest rates on all bonds are currently very low which certainly helped the state obtain the low rate. Additionally, as the Wall Street Journal points out, the relative scarcity of new bonds in the municipal bond market this year aided the reception of Illinois’s $800 million bond sale. And finally, it’s true that Illinois secured historically low rates on its recent bond sale but, more importantly, it’s also true that the state may have secured even lower rates if its credit rating would have been higher. In other words, even though the state was able to borrow at relatively low rates, the borrowing may have been more expensive than it would have otherwise been in the absence of a rating downgrade.

Adding to the confusion, Governor Quinn described the state’s downgrade as an “outlier decision.” It’s difficult to label this downgrade as an outlier, however, considering that Illinois has had its credit rating downgraded nine times in three years.

Not only was the downgrade not an outlier but there is simply no reason to believe that the state’s credit is going to improve in the near future. Given Illinois’s habitual utilization of budgetary gimmicks, its customary practice of issuing debt to avoid making necessary budget cuts and its vastly underfunded pension system – it’s likely that the state’s credit rating will continue to decrease unless Quinn and the state legislature start making serious institutional reform.

Most importantly, this downgrade could mean that Illinois taxpayers will now get less bang for their buck. As legislators continue to push off significant reform, borrowing costs will likely continue to increase and more taxpayer dollars will be going towards interest payments instead of building schools and roads. Paying more money for fewer services is something Illinoisans can simply not afford – especially in the wake of last year’s tax hike which increased the average family’s state tax bill by $1,594.

So to clear up any confusion, what Illinois’s recent credit downgrade really means is that the state’s long run borrowing costs may be higher than they would have otherwise been, Illinois taxpayers are now paying more for less, and Illinois’s fiscal future will suffer if the state continues to hold the riskiest debt in the nation.