Category Archives: Economic Growth

Fixing decades of fiscal distress in Scranton, PA

In new Mercatus research, Adam Millsap and I and unpack the causes for almost a quarter of a century of fiscal distress in Scranton, Pennsylvania and offer some recommendations for how the city might go forward.

Since 1992, Scranton has been designated as a distressed municipality under Act 47, a law intended to help financially struggling towns and cities implement reforms. Scranton is now on its fifth Recovery plan, and while there are signs that the city is making improvements, it still has to contend with a legacy of structural, fiscal and economic problems.

We begin by putting Scranton in historical context. The city, located in northeastern Pennsylvania was once a thriving industrial hub, manufacturing coal, iron and providing T-rails for railroad tracks. By 1930, Scranton’s population peaked and the city’s economy began to change. Gas and oil replaced coal. The spread of the automobile and trucking diminished demand for railroad transport. By the 1960s Scranton was a smaller service-based economy with a declining population. Perhaps most relevant to its current fiscal situation is that the number of government workers increased as both the city’s population and tax base declined between 1969 and 1980.

An unrelenting increase in spending and weak revenues prompted the city to seek Act 47 designation kicking off two decades of attempts to reign in spending and change the city’s economic fortunes.

Our paper documents the various recovery plans and the reasons the measures they recommended either proved temporary, ineffective, or simply “didn’t stick.” A major obstacle to cost controls in the city are the hurdle of collective bargaining agreements with city police and firefighters, protected under Act 111, that proved to be more binding than Act 47 recovery plans.

The end result is that Scranton is facing rapidly rising employee costs for compensation, health care and pension benefits in addition to a $20 million back-pay award. These bills have led the city to pursue short-term fiscal relief in the form of debt issuance, sale-leaseback agreements and reduced pension contributions. The city’s tax structure has been described as antiquated relying mainly on Act 511 local taxes (business privilege and mercantile business tax, Local Services Tax (i.e. commuter tax)), property taxes and miscellaneous revenues and fees.

Tackling these problems requires structural reforms including 1) tax reform that does not penalize workers or businesses for locating in the city, 2) pension reform that includes allowing workers to move to a defined contribution plan and 3) removing any barrier to entrepreneurship that might prevent new businesses from locating in Scranton. In addition we recommend several state-level reforms to laws that have made it harder to Scranton to control its finances namely collective bargaining reform that removes benefits from negotiation; and eliminating “budget-helping” band-aids that mask the true cost of pensions. Such band-aids include state aid for municipal pension and allowing localities to temporarily reduce payments during tough economic times. Each of these has only helped to sustain fiscal illusion – giving the city an incomplete picture of the true cost of pensions.

To date Scranton has made some progress including planned asset monetizations to bring in revenues to cover the city’s bills. Paying down debts and closing deficits is crucial but not enough. For Pennsylvania’s distressed municipalities to thrive again reforms must replace poor fiscal institutions with ones that promote transparency, stability and prudence. This is the main way in which Scranton (and other Pennsylvania cities) can compete for businesses and residents: by offering government services at lower cost and eliminating penalties and barriers to locating, working and living in Scranton.

New York’s Buffalo Billion initiative has been underwhelming

New York’s Buffalo Billion plan has come under fire amidst an ongoing corruption probe looking into whether some contracts were inappropriately awarded to political donors. The investigation has led to funding delays and there are reports of some contractors and companies rethinking their investments. But even without these legal problems, it is unlikely that the Buffalo Billion initiative will remake Buffalo’s economy.

Buffalo, NY has been one of America’s struggling cities since the 1950s, but before then it had a long history of growth. After it became the terminal point of the Erie Canal in 1825 it grew rapidly; over the next 100 years the city’s population went from just under 9,000 to over 570,000. Growth slowed down from 1930 to 1950, and between 1950 and 1960 the city lost nearly 50,000 people. It has been losing population ever since. The Metropolitan Area (MSA), which is the economic city, continued to grow until the 1970s as people left the central city for the surrounding suburbs, but it has also been losing population since then. (click to enlarge figure)

buffalo-population

Buffalo’s population decline has not escaped the notice of local, state and federal officials, and billions of dollars in government aid have been given to the area in an effort to halt or reverse its population and economic slide. The newest attempt is Governor Andrew Cuomo’s Buffalo Billion, which promises to give $1 billion of state funds to the region. The investment began in 2013 and as of January 2016, $870.5 million worth of projects have been announced. The table below lists some of the projects, the amount of the investment, and the number of jobs each investment is supposed to create, retain, or induce (includes indirect jobs due to construction and jobs created by subsequent private investment). This information is from the Buffalo Billion Process and Implementation plan (henceforth Buffalo Billion Plan).

buffalo-billion-projects

The projects listed have been awarded $727 million in direct investment, $150 million in tax breaks and $250 million in other state funds. The total number of jobs related to these investments is 9,900 according to the documentation, for an average cost of $113,859 per job (last column).

However, these jobs numbers are projections, not actual counts. This is one of the main criticisms of investment efforts like Buffalo Billion—a lot of money is spent and a lot of jobs are promised, but rarely does anyone follow up to see if the jobs were actually created. In this case it remains to be seen whether reality will match the promises, but the early signs are not encouraging.

Executives of the first project, SolarCity, which received $750 million of benefits and promised 5,000 jobs in western New York, appear to have already scaled back their promise. One company official recently said that 1,460 jobs will be created in Buffalo, including 500 manufacturing jobs. This is down from 2,000 in the Buffalo Billion Plan, a 27% decrease.

The SolarCity factory is not scheduled to open until June 2017 so there is still time for hiring plans to change. But even if the company eventually creates 5,000 jobs in the area, it is hard to see how that will drastically improve the economy of an MSA of over 1.1 million people. Moreover, page eight of the Buffalo Billion Plan reports that the entire $1 billion is only projected to create 14,000 jobs over the course of 5 years, which is again a relatively small amount for such a large area.

Contrary to the local anecdotes that say otherwise, so far there is little evidence that Buffalo Billion has significantly impacted the local economy. Since the recession, employment in Buffalo and its MSA has barely improved, as shown below (data are from the BLS). There has also been little improvement since 2013 when the Buffalo Billion development plan was released. (City data plotted on the right axis, MSA on the left axis.)

buffalo-employment

Real wages in both Erie and Niagara County, the two counties that make up the Buffalo MSA, have also been fairly stagnant since the recession, though there is evidence of some improvement since 2013, particularly in Erie County (data are from the BLS). Still, it is hard to separate these small increases in employment and wages from the general recovery that typically occurs after a deep recession.

buffalo-county-wages

The goal of the Buffalo Billion is to create a “Big Push” that leads to new industry clusters, such as a green energy cluster anchored by SolarCity and an advanced manufacturing cluster. Unfortunately, grandiose plans to artificially create clusters in older manufacturing cities rarely succeed.

As economist Enrico Moretti notes in his book, The New Geography of Jobs, in order for Big Push policies to succeed they need to attract both workers and firms at the same time. This is hard to do since either workers or firms need to be convinced that the other group will eventually arrive if they make the first move.

If firms relocate but high-skill workers stay away, then the firm has spent scarce resources locating in an area that doesn’t have the workforce it needs. If workers move but firms stay away, then the high-skill workers are left with few employment opportunities. Neither situation is sustainable in the long-run.

The use of targeted incentives to attract firms, as in the aforementioned SolarCity project, has been shown to be an ineffective way to grow a regional economy. While such incentives often help some firms at the expense of others, they do not provide broader benefits to the economy as a whole. The mobile firms attracted by such incentives, called footloose firms, are also likely to leave once the incentives expire, meaning that even if there is a short term boost it will be expensive to maintain since the incentives will have to be renewed.

Also, in order for any business to succeed state and local policies need to support, rather than inhibit, economic growth. New York has one of the worst economic environments according to several different measures: It’s 50th in overall state freedom, 50th in economic freedom, and 49th in state business tax climate. New York does well on some other measures, such as Kauffman’s entrepreneurship rankings, but such results are usually driven by the New York City area, which is an economically vibrant area largely due to historical path dependencies and agglomeration economies. Buffalo, and western New York in general, lacks the same innate and historical advantages and thus has a harder time overcoming the burdensome tax and regulatory policies of state government, which are particularly harmful to the local economies located near state borders.

Buffalo officials can control some things at the local level that will improve their economic environment, such as zoning, business licensing, and local taxes, but in order to achieve robust economic growth the city will likely need better cooperation from state officials.

State and local policy makers often refuse to acknowledge the harm that relatively high-tax, high-regulation environments have on economic growth, and this prevents them from making policy changes that would foster more economic activity. Instead, politicians invest billions of dollars of taxpayer money, often in the form of ineffective targeted incentives to favored firms or industries, with the hope that this time will be different.

Discovering an areas comparative advantage and creating a sustainable industry cluster or clusters requires experimentation, which will likely result in some failures. Local and state governments should create an environment that encourages entrepreneurs to experiment with new products and services in their region, but they shouldn’t be risking taxpayer money picking winners and losers. Creating a low-tax, low-regulation environment that treats all businesses—established and start-up, large and small—the same is a better way to grow an economy than government subsidies to favored firms. Unfortunately the Buffalo Billion project looks like another example of the latter futile strategy.

Economic Freedom, Growth, and What Might Have Been

Economists are obsessed with growth. And for good reason. Greater wealth doesn’t just buy us nicer vacations and fancier gadgets. It also buys longer life spans, better nutrition, and lower infant mortality. It buys more time with family, and less time at work. It buys greater self-reported happiness. And as Harvard economist Benjamin Friedman has argued, wealth even seems to make us better people:

Economic growth—meaning a rising standard of living for the clear majority of citizens—more often than not fosters greater opportunity, tolerance of diversity, social mobility, commitment to fairness, and dedication to democracy.

For much of my lifetime, brisk economic growth was the norm in the United States. From 1983 to 2000, annual growth in real (that is, inflation-adjusted) GDP averaged 3.67 percent. During this period, the U.S. experienced only one (short and mild) recession in the early ‘90s. The era was known among macroeconomists as the “great moderation.”

But starting around the turn of the millennium, things changed. Instead of averaging 3.67 percent growth, the U.S. economy grew at less than half that rate, 1.78 percent on average. To see the effect of this deceleration, consider the chart below (data are from the BEA). The blue line shows actual GDP growth (as measured in billions of chained 2009 dollars).

The red line shows what might have happened if we’d continued to grow at the 3.67 percent rate which prevailed for the two previous decades. At this rate, the economy would have been 30 percent larger in 2015 than it actually was.

This assumes that the Great Recession never happened. So to see what would have happened to GDP if the Great Recession had still occurred but if growth had resumed (as it has in every other post-WWII recession), I calculated a second hypothetical growth path. The green line shows the hypothetical path of GDP had the economy still gone through the Great Recession but then resumed its normal 3.67 percent rate of growth from 2010 onward. Under this scenario, the economy would have been fully 8 percent larger in 2015 than it actually was.

screen-shot-2016-09-16-at-11-31-02-am

(Click to enlarge)

So what happened to growth? One answer is economic freedom—or a lack thereof. Just yesterday, the Fraser Institute released its annual Economic Freedom of the World report. Authored by Professors James Gwartney of Florida State University, Robert Lawson of Southern Methodist University, and Joshua Hall of West Virginia University, the report assesses the degree to which people are free to exchange goods and services with one another without interference. As Adam Smith might have put it, it measures the degree to which we live under “a system of natural liberty.”

As the chart below shows, economic freedom was on the steady rise before 2000. This coincided with modest deregulation of a few industries under Carter and Reagan, tax cuts under Reagan and Clinton, free trade deals, and restrained growth in the size of government. But from 2000 onward, U.S. economic freedom has been in precipitous decline. This coincides with major new financial regulations under both Bush II and Obama, significant growth in government spending, and a steady erosion in measures of the rule of law.

screen-shot-2016-09-16-at-11-33-15-am

(Click to enlarge)

As I’ve noted before, the research on economic freedom is quite extensive (nearly 200 peer-reviewed academic studies use economic freedom as an explanatory variable). Moreover, meta-studies of that literature find “there is a solid finding of a direct positive association between economic freedom and economic growth.”

Perhaps the two charts have something to do with one another?

 

 

More competition can lead to less inequality

Wealth inequality in the United States and many European countries, especially between the richest and the rest, has been a popular topic since Thomas Piketty’s Capital in the 21st Century was published. Piketty and others argue that tax data shows that wealth inequality has increased in the U.S. since the late 1970s, as seen in the figure below from a paper by Emmanuel Saez—Picketty’s frequent co-author— and Gabriel Zucman.

top-0-1-income-inequ

The figure shows the percentage of all U.S. household wealth that is owned by the top 0.1% of households, which as the note explains consists of about 160,000 families. The percentage fell from 25% in the late 1920s to about 7% in the late 1970s and then began to rise. Many people have used this and similar data to argue for higher marginal taxes on the rich and more income redistribution in order to close the wealth gap between the richest and the rest.

While politicians and pundits continue debating what should be done, if anything, about taxes and redistribution, many economists are trying to understand what factors can affect wealth and thus the wealth distribution over time. An important one that is not talked about enough is competition, specifically Joseph Schumpeter’s idea of creative destruction.

Charles Jones, a professor at Stanford, has discussed the connection between profits and creative destruction and their link with inequality. To help illustrate the connection, Mr. Jones uses the example of an entrepreneur who creates a new phone app. The app’s creator will earn profits over time as the app’s popularity and sales increase. However, her profits will eventually decline due to the process of creative destruction: a newer, better app will hit the market that pulls her customers away from her product, erodes her sales and forces her to adapt or fail. The longer she is able to differentiate her product from others, the longer she will be in business and the more money she will earn. This process is stylized in the figure below.

firm-life-and-profit2

If the app maintains its popularity for the duration of firm life 1, the entrepreneur will earn profits P1. After that the firm is replaced by a new firm that also exists for firm life 1 and earns profit P1. The longer a firm is able to maintain its product’s uniqueness, the more profit it will earn, as shown by firm life 2: In this case the firm earns profit P2. A lack of competition stretches out a firm’s life cycle since the paucity of substitutes makes it costlier for consumers to switch products if the value of the firm’s product declines.

Higher profits can translate into greater inequality as well, especially if we broaden the discussion to include wages and sole-proprietor income. Maintaining market power for a long period of time by restricting entry not only increases corporate profits, it also allows doctors, lawyers, opticians, and a host of other workers who operate under a licensing regime that restricts entry to earn higher wages than they otherwise would. The higher wages obtained due to state restrictions on healthcare provision, restrictions on providing legal services and state-level occupational licensing can exacerbate inequality at the lower levels of the income distribution as well as the higher levels.

Workers and sole proprietors in the U.S. have been using government to restrict entry into occupations since the country was founded. In the past such restrictions were often drawn on racial or ethnic lines. In their Pulitzer Prize-winning history of New York City, Gotham, historians Edwin G. Burrows and Mike Wallace write about New York City cartmen in the 1820s:

American-born carters complained to the city fathers that Irish immigrants, who had been licensed during the war [of 1812] while Anglo-Dutchmen were off soldiering, were undercutting established rates and stealing customers. Mayor Colden limited future alien licensing to dirt carting, a field the Irish quickly dominated. When they continued to challenge the Anglo-Americans in other areas, the Society of Cartmen petitioned the Common Council to reaffirm their “ancient privileges”. The municipal government agreed, rejecting calls for the decontrol of carting, as the business and trade of the city depended on in it, and in 1826 the council banned aliens from carting, pawnbroking, and hackney-coach driving; soon all licensed trades were closed to them.

Modern occupational licensing is the legacy of these earlier, successful efforts to protect profits by limiting entry, often of “undesirables”. Today’s occupational licensing is no longer a response to racial or ethnic prejudices, but it has similar results: It protects the earning power of established providers.

Throughout America’s history the economy has been relatively dynamic, and this dynamism has made it difficult for businesses to earn profits for long periods of time; only 12% of the companies on the Fortune 500 in 1955 were still on the list in 2015. In a properly functioning capitalist economy, newer, poorer firms will regularly supplant older, richer firms and this economic churn tempers inequality.

The same churn occurs among the highest echelon of individuals as well. An increasing number of the Forbes 400 are self-made, often from humble beginnings. In 1984, 99 people on the list inherited their fortune and were not actively growing it. By 2014 only 28 people were in the same position. Meanwhile, the percentage of the Forbes 400 who are largely self-made increased from 43% to 69% over the same period.

But this dynamism may be abating and excessive regulation is likely a factor. For example, the rate of new-bank formation from 1990 – 2010 was about 100 banks per year. Since 2010, the rate has fallen to about three per year. Researchers have attributed some of the decline of small banks to the Dodd-Frank Wall Street Reform Act, which increased compliance costs that disproportionately harm small banks. Fewer banks means less competition and higher prices.

Another recent example of how a lack of competition can increase profits and inequality is EpiPen. The price of EpiPen—a medicine used to treat severe allergic reactions to things like peanuts—has increased dramatically since 2011. This price increase was possible because there are almost no good substitutes for EpiPen, and the lack of substitutes can be attributed to the FDA and other government policies that have insulated EpiPen’s maker, Mylan, from market competition. Meanwhile, the compensation of Mylan’s CEO Heather Bresch increased by 671% from 2007 to 2015. I doubt that Bresch’s compensation would have increased by such a large amount without the profits of EpiPen.

Letting firms and workers compete in the marketplace fosters economic growth and can help dampen inequality. To the extent that wealth inequality is an issue we don’t need more regulation and redistribution to fix it: We need more competition.

Pokémon Go Represents the Best of Capitalism

An article uploaded to Vox.com by Timothy Lee earlier this week, “Pokémon Go is everything that is wrong with late capitalism,”has caused quite a stir, since it was fairly critical of the “Pokémon Go economy.” Given the popularity of the game though (and our concern that some players would be alarmed that their lighthearted entertainment was somehow destroying the economy) we wanted to offer a different perspective to some of the points made in the article.

In fact, we think that Pokémon Go actually represents the best of capitalism. In less than a week the game has topped 15 million downloads and the 21 million active daily users spend an average of 33 minutes a day playing. That amounts to over 11.5 million hours of playing per day, and those numbers only look to increase. The app doesn’t cost anything to download and play, which means that Nintendo and Niantic (the game developer) are essentially giving away tens of millions of dollars of value to the eager players.

We know that’s a bold statement. But this is why it’s true: A person’s time is scarce and valuable. Every moment they spend playing Pokémon Go they could instead be doing something else. The fact that they’re voluntarily choosing to play means that the benefit of playing is more than the cost.

Economists call this “consumer surplus” – the difference between a customer’s willingness to pay for a good or service and the price that it actually costs. It’s a measurement of the dollar value gained by the consumer in the exchange. If a person was to buy a game of bowling for $5 that they value at $7, instead of playing an hour of Pokémon that they value at $3 for free, that person would lose out on value that would have made their life better.

So even if the average consumer surplus is only a measly dollar an hour, consumers are getting $11.5 million dollars of value each day. The fact that customers are buying special items to use in the game, spending upwards of $1.6 million each day, implies that the value players receive from the game is actually higher.

The article laments that local economies are harmed because people are turning toward forms of entertainment that don’t have high production costs, like movie theaters or bowling alleys that need expensive buildings or numerous employees selling buckets of popcorn. What the article misses is that the economic activity associated with traditional entertainment options represent the costs of providing the entertainment. The reality we have now is much better, since we not only gain the value of the entertainment, but we have the money we would have paid for it to purchase other things as well. It’s almost like getting something for nothing, and our lives – and the economy in general – are better as result.

This is the core of economic growth – decreasing the scarcity of goods and services that limits our lives. The article makes it seem as if economic growth comes from simply spending money. This view can lead us astray because it ignores the importance of entrepreneurs, whose role is critical in the creation of new products and services that improve everyone’s well-being.

Pokémon Go is actually a great example of this. The game developers and their investors thought that they could make something that customers might like and they took the entrepreneurial risk to create the game without the certainty that it was going to be a success. Obviously, it was a good gamble, but I’m sure that even they are amazed at the results. Imagine if the game development funds had been used to build a couple of bowling alleys instead. Wow. What fun.

Think of what would have been lost to society if entrepreneurs didn’t have the funds and the freedom to take that gamble. And their success has spawned a sub-industry of “Poképreneurs” who are selling drinks and providing rides to Pokémon players. Economic growth – and our increased social well-being – depends on this kind of permissionless innovation.

In short, Pokémon Go represents the very best of capitalism because it’s premised on voluntary exchange – no one is forced to download the game, players can stop playing at any time they like, and if they value the special items available in the game store they can buy them to enhance their fun. Furthermore, the entrepreneurs who had the foresight and the guts to dare to make the world a better place are being rewarded for their accomplishment. Most importantly, that success only comes about because they have made people’s lives better in the process. That’s something Team Rocket could never learn to do.

About the Authors:

Michael Farren is a Research Fellow in the Study of American Capitalism at the Mercatus Center at George Mason University. He’s a proud member of Team Instinct, because he likes a challenge.

Adam A. Millsap is a Research Fellow in the State and Local Policy Project at the Mercatus Center at George Mason University. No team will allow him to join, because all he can catch is Pidgeys.

*The title and opening sentence of this article has changed since it was originally published.

Does Tax Increment Financing (TIF) generate economic development?

Tax increment financing, or TIF, is a method of financing economic development projects first used in California in 1952. Since then, 48 other states have enacted TIF legislation with Arizona being the lone holdout. It was originally conceived as a method for combating urban blight, but over time it has become the go-to tool for local politicians pushing economic development in general. For example, Baltimore is considering using TIF to raise $535 million to help Under Armor founder Kevin Plank develop Port Covington.

So how does TIF work? Though the particulars can vary by state, the basic mechanism is usually similar. First, an area is designated as a TIF district. TIF districts are mostly industrial or commercial areas rather than residential areas since the goal is to encourage economic development.

Usually, in an effort to ensure that TIF is used appropriately, the municipal government that designates the area as a TIF has to assert that economic development would not take place absent the TIF designation and subsequent investment. This is known as the ‘but-for’ test, since the argument is that development would not occur but for the TIF. Though the ‘but-for’ test is still applied, some argue that it is largely pro forma.

Once an area has been designated as a TIF district, the property values in the area are assessed in order to create a baseline value. The current property tax rate is applied to the baseline assessed value to determine the amount of revenue that is used for the provision of local government goods and services (roads, police, fire, water etc.). This value will then be frozen for a set period of time (e.g. up to 30 years in North Carolina), and any increase in assessed property values that occurs after this time and the subsequent revenue generated will be used to pay for the economic development project(s) in the TIF district.

The key idea is that municipalities can borrow against the projected property value increases in order to pay for current economic development projects. A simple numerical example will help clarify how TIF works.

In the table below there are five years. In year 1 the assessed value of the property in the TIF district is $20 million and it is determined that it takes $1 million per year to provide the government goods and services needed in the area (road maintenance, sewage lines, police/fire protection, etc.). A tax rate of 5% is applied to the $20 million of assessed value to raise the necessary $1 million (Tax revenue column).

TIF example table

The municipality issues bonds totaling $1 million to invest in an economic development project in the TIF district. As an example, let’s say the project is renovating an old business park in order to make it more attractive to 21st century startups. The plan is that improving the business park will make the area more desirable and increase the property values in the TIF district. As the assessed value increases the extra tax revenue raised by applying the 5% rate to the incremental value of the property will be used to pay off the bonds (incremental revenue column).

Meanwhile, the $1 million required for providing the government goods and services will remain intact, since only the incremental increase in assessed value is used to pay for the business park improvements. Hence the term Tax Increment Financing.

As shown in the table, if the assessed value of the property increases by $2 million per year for 4 years the municipality will recoup the $1 million required to amortize the bond (I’m omitting interest to keep it simple). Each $1 million dollars of increased value increase tax revenue by $50,000 without increasing the tax rate, which is what allows the municipality to pay for the economic development without raising property tax rates. For many city officials this is an attractive feature since property owners usually don’t like tax rate increases.

City officials may also prefer TIF to the issuance of general obligation bonds since the latter often require voter approval while TIF does not. This is the case in North Carolina. TIF supporters claim that this gives city officials more flexibility in dealing with the particular needs of development projects. However, it also allows influential individuals to push TIF through for projects that a majority of voters may not support.

While TIF can be used for traditional government goods like roads, sewer systems, water systems, and public transportation, it can also be used for private goods like business parks and sports facilities. The former arguably provide direct benefits to all firms in the TIF district since better roads, streetscapes and water systems can be used by any firm in the area. The latter projects, though they may provide indirect benefits to nearby firms in the form of more attractive surroundings and increased property values, mostly benefit the owners of entity receiving the development funding. Like other development incentives, TIF can be used to subsidize private businesses with taxpayer dollars.

Projects that use TIF are often described as ‘self-financing’ since the project itself is supposedly what creates the higher property values that pay for it. Additionally, TIF is often sold to voters as a way to create jobs or spur additional private investment in blighted areas. But there is no guarantee that the development project will lead to increased private sector investment, more jobs or higher property values. Researchers at the UNC School of Government explain the risks of TIF in a 2008 Economic Bulletin:

“Tax increment financing is not a silver bullet solution to development problems. There is no guarantee that the initial public investment will spur sufficient private investment, over time, that creates enough increment to pay back the bonds. Moreover, even if the investment succeeds on paper, it may do so by “capturing” growth that would have occurred even without the investment. Successful TIF districts can place an additional strain on existing public resources like schools and parks, whose funding is frozen at base valuation levels while growth in the district increases demand for their services.”

The researchers also note that it’s often larger corporations that municipalities are trying to attract with TIF dollars, and any subsidies via TIF that the municipality provides to the larger firm gives it an advantage over its already-established, local competitors. This is even more unfair when the local competitor is a small, mom-and-pop business that already faces a difficult challenge due to economies of scale.

There is also little evidence that TIF regularly provides the job or private sector investment that its supporters promise. Chicago is one of the largest users of TIF for economic development and its program has been one of the most widely studied. Research on Chicago’s TIF program found that “Overall, TIF failed to produce the promise of jobs, business development or real estate activity at the neighborhood level beyond what would have occurred without TIF.”

If economic development projects that rely on TIF do not generate additional development above and beyond what would have occurred anyway, then the additional tax revenue due to the higher assessed values is used to pay for an economic development project that didn’t really add anything. Without TIF, that revenue could have been used for providing other government goods and services such as infrastructure or better police and fire protection. Once TIF is used, the additional revenue must be used to pay for the economic development project: it cannot be spent on other services that residents might prefer.

Another study, also looking at the Chicago metro area, found that cities that adopt TIF experience slower property value growth than those that do not. The authors suggest that this is due to a reallocation of resources to TIF districts from other areas of the city. The result is that the TIF districts grow at the expense of the municipality as a whole. This is an example of the TIF working on paper, but only because it is pilfering growth that would have occurred in other areas of the city.

Local politicians often like tax increment financing because it is relatively flexible and enables them to be entrepreneurial in some sense: local officials as venture capitalists. It’s also an easier sell than a tax rate increase or general obligation bonds that require a voter referendum.

But politicians tend to make bad venture capitalists for several reasons. First, it’s usually not their area of expertise and it’s hard: even the professionals occasionally lose money. Second, as Milton Friedman pointed out, people tend to be more careless when spending other people’s money. Local officials aren’t investing their own money in these projects, and when people invest or spend other people’s money they tend to emphasize the positive outcomes and downplay the negative ones since they aren’t directly affected. Third, pecuniary factors don’t always drive the decision. Different politicians like different industries and businesses – green energy, biotech, advanced manufacturing, etc. – for various reasons and their subjective, non-pecuniary preferences may cause them to ignore the underlying financials of a project and support a bad investment.

If TIF is going to be used it should be used on things like public infrastructure – roads, sewer/water lines, sidewalks – rather than specific private businesses. This makes it harder to get distracted by non-pecuniary factors and does a better – though not perfect – job of directly helping development in general rather than a specific company or private developer. But taxpayers should be aware of the dangers of TIF and politicians and developers should not tout it as a panacea for jump-starting an area’s economy.

Northern Cities Need To Be Bold If They Want To Grow

Geography and climate have played a significant role in U.S. population growth since 1970 (see here, here, here, and here). The figure below shows the correlation between county-level natural amenities and county population growth from 1970 – 2013 controlling for other factors including the population of the county in 1970, the average wage of the county in 1970 (a measure of labor productivity), the proportion of adults in the county with a bachelor’s degree or higher in 1970 and region of the country. The county-level natural amenities index is from the U.S. Department of Agriculture and scores the counties in the continental U.S. according to their climate and geographic features. The county with the worst score is Red Lake, MN and the county with the best score is Ventura, CA.

1970-13 pop growth, amenities

As shown in the figure the slope of the best fit line is positive. The coefficient from the regression is also given at the bottom of the figure and is equal to 0.16, meaning a one point increase in the score increased population growth by 16 percentage points on average.

The effect of natural amenities on population growth is much larger than the effect of the proportion of adults with a bachelor’s degree or higher, which is another strong predictor of population growth at the metropolitan (MSA) and city level (see here, here, here, and here). The relationship between county population growth from 1970 – 2013 and human capital is depicted below.

1970-13 pop growth, bachelors or more

Again, the relationship is positive but the effect is smaller. The coefficient is 0.026 which means a 1 percentage point increase in the proportion of adults with a bachelor’s degree or higher in 1970 increased population growth by 2.6 percentage points on average.

An example using some specific counties can help us see the difference between the climate and education effects. In the table below the county where I grew up, Greene County, OH, is the baseline county. I also include five other urban counties from around the country: Charleston County, SC; Dallas County, TX; Eau Claire County, WI; San Diego County, CA; and Sedgwick County, TX.

1970-13 pop chg, amenities table

The first column lists the amenities score for each county. The highest score belongs to San Diego. The second column lists the difference between Green County’s score and the other counties, e.g. 9.78 – (-1.97) = 11.75 which is the difference between Greene County’s score and San Diego’s score. The third column is the difference column multiplied by the 0.16 coefficient from the natural amenity figure e.g. 11.75 x 0.16 = 188% in the San Diego row. What this means is that according to this model, if Greene County had San Diego’s climate and geography it would have grown by an additional 188 percentage points from 1970 – 2013 all else equal.

Finally, the last column is the actual population growth of the county from 1970 – 2013. As shown, San Diego County grew by 135% while Greene County only grew by 30% over this 43 year period. Improving Greene County’s climate to that of any of the other counties except for Eau Claire would have increased its population growth by a substantial yet realistic amount.

Table 2 below is similar to the natural amenities table above only it shows the different effects on Greene County’s population growth due to a change in the proportion of adults with a bachelor’s degree or higher.

1970-13 pop chg, bachelor's table

As shown in the first column, Greene County actually had the largest proportion of adults with bachelor’s degree or higher in 1970 – 14.7% – of the counties listed.

The third column shows how Greene County’s population growth would have changed if it had the same proportion of adults with a bachelor’s degree or higher as the other counties did in 1970. If Greene County had the proportion of Charleston (11.2%) instead of 14.7% in 1970, its population growth is predicted to have been 9 percentage points lower from 1970 – 2013, all else equal. All of the effects in the table are negative since all of the counties had a lower proportion than Greene and population education has a positive effect on population growth.

Several studies have demonstrated the positive impact of an educated population on overall city population growth – often through its impact on entrepreneurial activity – but as shown here the education effect tends to be swamped by geographic and climate features. What this means is that city officials in less desirable areas need to be bold in order to compensate for the poor geography and climate that are out of their control.

A highly educated population combined with a business environment that fosters innovation can create the conditions for city growth. Burdensome land-use regulations, lengthy, confusing permitting processes, and unpredictable rules coupled with inconsistent enforcement increase the costs of doing business and stifle entrepreneurship. When these harmful business-climate factors are coupled with a generally bad climate the result is something like Cleveland, OH.

The reality is that the tax and regulatory environments of declining manufacturing cities remain too similar to those of cities in the Sunbelt while their weather and geography differ dramatically, and not in a good way. Since only relative differences cause people and firms to relocate, the similarity across tax and regulatory environments ensures that weather and climate remain the primary drivers of population change.

To overcome the persistent disadvantage of geography and climate officials in cold-weather cities need to be aggressive in implementing reforms. Fiddling around the edges of tax and regulatory policy in a half-hearted attempt to attract educated people, entrepreneurs and large, high-skill employers is a waste of time and residents’ resources – Florida’s cities have nicer weather and they’re in a state with no income tax. Northern cities like Flint, Cleveland, and Milwaukee that simply match the tax and regulatory environment of Houston, San Diego, or Tampa have done nothing to differentiate themselves along those dimensions and still have far worse weather.

Location choices reveal that people are willing to put up with a lot of negatives to live in places with good weather. California has one of the worst tax and regulatory environments of any state in the country and terrible congestion problems yet its large cities continue to grow. A marginally better business environment is not going to overcome the allure of the sun and beaches.

While a better business environment that is attractive to high-skilled workers and encourages entrepreneurship is unlikely to completely close the gap between a place like San Diego and Dayton when it comes to being a nice place to live and work, it’s a start. And more importantly it’s the only option cities like Dayton, Buffalo, Cleveland, St. Louis and Detroit have.

Exit, voice, and loyalty in cities

Economist Albert Hirschman’s 1970 book Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States presents a theory of how consumers express their dissatisfaction to firms and other organizations after a decline in product or service quality. In terms of interjurisdictional competition exit is demonstrated by migration: dissatisfied residents migrate to a community that better matches their preferences for local government services, externality mitigation, and fiscal policy. Voice, on the other hand, requires staying in place and is usually manifested through voting. Other methods such as protests, letters, and public comments directed at officials may also be effective ways to create change.

Loyalty plays a role in whether voice or exit is employed. Someone who is loyal to a city will be less likely to exit due to a given deterioration in quality. Hirschman argues that loyalty serves an important function by limiting the use of exit and activating voice. If exit is too easy, the quality-conscious people most capable of using voice to elicit change at the local level will tend to leave early, sparking a “brain drain” and generating cumulative deterioration. If some of the most quality-conscious residents are loyal they will remain in place, at least initially, and try to fix a city’s problems from within i.e. they will use some method of voice.

The presence of loyalty within a city’s population has implications for city population decline and growth. The diagram below, based on one from Hirschman’s book on p. 90, shows the relationship between city quality and population.

Exit and loyalty diagram

Quality deteriorates as one moves up the y-axis and population increases along the x-axis, which enables a depiction of the relationship between quality and population similar to that of a traditional demand curve.

The example begins at point A. If quality declines from Q1 to Q2, the population will decline from Pa to Pb. The relatively small population decline relative to the decline in quality is due to the presence of loyalty. Loyalty can be conscious, meaning that the loyal residents are aware of the quality decline and are staying to try to improve the situation, or it can be unconscious, meaning that some residents are unaware that quality is deteriorating. These unaware residents appear loyal to outsiders, but in reality they have just not perceived the decline in quality. Perhaps the decline has not impacted their particular neighborhood or is so gradual that many people don’t realize it is happening. Hirschman notes that unconscious loyalty will not spark voice since by definition the resident is unaware that decline is occurring.

As quality continues to decline from Q2 to Q3 it becomes more observable and even the most loyal residents accept the fact that voice will not save their city. Additionally, the unconscious “loyal” residents will finally notice the decline. Both groups of people will then exit the city in order to reside somewhere else. This leads to a larger drop in population and is shown in the diagram as a movement from Pb to Pc.

This pattern is repeated as a city recovers. An initial quality improvement from Q3 to Q2 induces a relatively small amount of migration back to the city (Pc to Pd), since most people will need confirmation that the city has actually started down a path of sustainable improvement before they will return. Further improvement from Q2 to Q1 will generate a larger increase in population, represented by a movement from point D to point A (Pd to Pa).

What is interesting about this theoretical analysis is that it generates two different populations for the same level of quality. At quality Q2 the city’s population will be relatively large (Pb) if the city is declining in quality and it will be relatively small (point Pd) if the city’s quality is improving. This means that a declining city such as Detroit, Baltimore, Cleveland, Buffalo, etc. will have to make substantial quality improvements before they will see a large influx of people. So even if a city such as Cleveland returns to its 1970 level of relative quality we shouldn’t expect a drastic increase in population, as this model predicts that its population will be less than its actual 1970 population since it will be on the returning curve (CDA) rather than the exiting curve (ABC).

A city that is consistently losing population over a long period of time faces a variety of problems such as increased crime, declining housing values, a decline in the quality of public services, and higher costs in the provision of public services. Fixing these problems is often expensive and this model implies that the costs required for increasing quality from Q1 to Q2 will not result in substantial population gain, which means per capita costs to taxpayers are unlikely to decline by much and may even increase as the city begins to improve. This model predicts that revitalizing America’s struggling cities is a more difficult task than many politicians and policy makers are acknowledging.