Category Archives: New Research

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.

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.

Innovation and economic growth in the early 20th century and lessons for today

Economic growth is vital for improving our lives and the primary long-run determinant of economic growth is innovation. More innovation means better products, more choices for consumers and a higher standard of living. Worldwide, hundreds of millions of people have been lifted out of poverty due to the economic growth that has occurred in many countries since the 1970s.

The effect of innovation on economic growth has been heavily analyzed using data from the post-WWII period, but there is considerably less work that examines the relationship between innovation and economic growth during earlier time periods. An interesting new working paper by Ufuk Akcigit, John Grigsby and Tom Nicholas that examines innovation across America during the late 19th and early 20th century helps fill in this gap.

The authors examine innovation and inventors in the U.S. during this period using U.S. patent data and census data from 1880 to 1940. The figure below shows the geographic distribution of inventiveness in 1940. Darker colors mean higher rates of inventive activity.

geography of inventiveness 1940

Most of the inventive activity in 1940 was in the industrial Midwest and Northeast, with California being the most notable western exception.

The next figure depicts the relationship between the log of the total number of patents granted to inventors in each state from 1900 to 2000 (x-axis) and annualized GDP growth (y-axis) over the same period for the 48 contiguous states.

innovation, long run growth US states

As shown there is a strong positive relationship between this measure of innovation and economic growth. The authors also conduct multi-variable regression analyses, including an instrumental variable analysis, and find the same positive relationship.

The better understand why certain states had more inventive activity than others in the early 20th century, the authors analyze several factors: 1) urbanization, 2) access to capital, 3) geographic connectedness and 4) openness to new ideas.

The figures below show the more urbanization was associated with more innovation from 1940 to 1960. The left figure plots the percent of people in each state living in an urban area in 1940 on the x-axis while the right has the percent living on a farm on the x-axis. Both figures tell the same story—rural states were less innovative.

pop density, innovation 1940-1960

Next, the authors look at the financial health of each state using deposits per capita as their measure. A stable, well-funded banking system makes it easier for inventors to get the capital they need to innovate. The figure below shows the positive relationship between deposits per capita in 1920 and patent production from 1920 to 1930.

innovation, bank deposits 1920-1940

The size of the market should also matter to inventors, since greater access to consumers means more sales and profits from successful inventions. The figures below show the relationship between a state’s transport cost advantage (x-axis) and innovation. The left figure depicts all of the states while the right omits the less populated, more geographically isolated Western states.

innovation, transport costs 1920-1940

States with a greater transport cost advantage in 1920—i.e. less economically isolated—were more innovative from 1920 to 1940, and this relationship is stronger when states in the far West are removed.

The last relationship the authors examine is that between innovation and openness to new, potentially disruptive ideas. One of their proxies for openness is the percent of families who owned slaves in a state, with more slave ownership being a sign of less openness to change and innovation.

innovation, slavery 1880-1940

The figures show that more slave ownership in 1860 was associated with less innovation at the state-level from 1880 to 1940. This negative relationship holds when all states are included (left figure) and when states with no slave ownership in 1860—which includes many Northern states—are omitted (right figure).

The authors also analyze individual-level data and find that inventors of the early 20th century were more likely to migrate across state lines than the rest of the population. Additionally, they find that conditional on moving, inventors tended to migrate to states that were more urbanized, had higher bank deposits per capita and had lower rates of historical slave ownership.

Next, the relationship between innovation and inequality is examined. Inequality has been a hot topic the last several years, with many people citing research by economists Thomas Piketty and Emmanuel Saez that argues that inequality has increased in the U.S. since the 1970s. The methods and data used to construct some of the most notable evidence of increasing inequality has been criticized, but this has not made the topic any less popular.

In theory, innovation has an ambiguous effect on inequality. If there is a lot of regulation and high barriers to entry, the profits from innovation may primarily accrue to large established companies, which would tend to increase inequality.

On the other hand, new firms that create innovative new products can erode the market share and profits of larger, richer firms, and this would tend to decrease inequality. This idea of innovation aligns with economist Joseph Schumpeter’s “creative destruction”.

So what was going on in the early 20th century? The figure below shows the relationship between innovation and two measures of state-level inequality: the ratio of the 90th percentile wage over the 10th percentile wage in 1940 and the wage income Gini coefficient in 1940. For each measure, a smaller value means less inequality.

innovation, inc inequality 1920-1940

As shown in the figures above, a higher patent rate is correlated with less inequality. However, only the result using 90-10 ratio remains statistically significant when each state’s occupation mix is controlled for in a multi-variable regression.

The authors also find that when the share of income controlled by the top 1% of earners is used as the measure of inequality, the relationship between innovation and inequality makes a U shape. That is, innovation decreases inequality up to a point, but after that point it’s associated with more inequality.

Thus when using the broader measures of inequality (90-10 ratio, Gini coeffecieint) innovation is negatively correlated with inequality, but when using a measure of top-end inequality (income controlled by top 1%) the relationship is less clear. This shows that inequality results are sensitive to the measurement of inequality used.

Social mobility is an important measure of economic opportunity within a society and the figure below shows that innovation is positively correlated with greater social mobility.

innovation, social mobility 1940

The measure of social mobility used is the percentage of people who have a high-skill occupation in 1940 given that they had a low-skill father (y-axis). States with more innovation from 1920 to 1940 had more social mobility according to this measure.

In the early 20th century it appears that innovation improved social mobility and decreased inequality, though the latter result is sensitive to the measurement of inequality. However, the two concepts are not equally important: Economic and social mobility are worthy societal ideals that require opportunity to be available to all, while static income or wealth inequality is largely a red herring that distracts us from more important issues. And once you take into account the consumer-benefits of innovation during this period—electricity, the automobile, refrigeration etc.—it is clear that innovation does far more good than harm.

This paper is interesting and useful for several reasons. First, it shows that innovation is important for economic growth over a long time period for one country. It also shows that more innovation occurred in denser, urbanized states that provided better access to capital, were more interconnected and were more open to new, disruptive ideas. These results are consistent with what economists have found using more recent data, but this research provides evidence that these relationships have existed over a much longer time period.

The positive relationships between innovation and income equality/social mobility in the early 20th century should also help alleviate the fears some people have about the negative effects of creative destruction. Innovation inevitably creates adjustment costs that harm some people, but during this period it doesn’t appear that it caused widespread harm to workers.

If we reduce regulation today in order to encourage more innovation and competition we will likely experience similar results, along with more economic growth and all of the consumer benefits.

High-speed rail: is this year different?

Many U.S. cities are racing to develop high speed rail systems that shorten commute times and develop the economy for residents. These trains are able to reach speeds over 124 mph, sometimes even as high as 374 mph as in the case of Japan’s record-breaking trains. Despite this potential, American cities haven’t quite had the success of other countries. In 2009, the Obama administration awarded almost a billion dollars of stimulus money to Wisconsin to build a high-speed rail line connection between Milwaukee and Madison, and possibly to the Twin Cities, but that project was derailed. Now, the Trump administration has plans to support a high-speed rail project in Texas. Given so many failed attempts in the U.S., it’s fair to ask if this time is different. And if it is, will high-speed rail bring the benefits that proponents claim it to have?

The argument for building high-speed rail lines usually entails promises of faster trips, better connections between major cities, and economic growth as a result. It almost seems like a no-brainer – why would any city not want to pursue something like this? The answer, like with most public policy questions, depends on the costs, and whether the benefits actually realize.

In a forthcoming paper for the Mercatus Center, transportation scholar Kenneth Button explores these questions by studying the high-speed rail experiences of Spain, Japan, and China; the countries with the three largest systems (measured by network length). Although there are benefits to these rail systems, Button cautions against focusing too narrowly on them as models, primarily because what works in one area can’t necessarily be easily replicated in another.

Most major systems in other countries have been the result of large public investment and built with each area’s unique geography and political environment kept in mind. Taking their approaches and trying to apply them to American cities not only ignores how these factors can differ, but also how much costs can differ. For example, the average infrastructure unit price of high-speed rail in Europe is between $17 and $24 million per mile and the estimated cost for proposals in California is conservatively estimated at $35 million per mile.

The cost side of the equation is often overlooked, and more attention is given to the benefit side. Button explains that the main potential benefit – generating economic growth – doesn’t always live up to expectations. The realized growth effects are usually minimal, and sometimes even negative. Despite this, proponents of high-speed rail oversell them. The process of thinking through high-speed rail as a sound public investment is often short-lived.

The goal is to generate new economic activity, not merely replace or divert it from elsewhere. In Japan, for example, only six percent of the traffic on the Sanyo Shinkansen line was newly generated, while 55 percent came from other rail lines, 23 percent from air, and 16 percent from inter-city bus. In China, after the Nanguang and Guiguang lines began operating in 2014, a World Bank survey found that many of the passengers would have made the journey along these commutes through some other form of transportation if the high-speed rail option wasn’t there. The passengers who chose this new transport method surely benefited from shorter travel times, but this should not be confused with net growth across the economy.

Even if diverted away from other transport modes, the amount of high-speed rail traffic Japan and China have generated is commendable. Spain’s system, however, has not been as successful. Its network has only generated about 5 percent of Japan’s passenger volume. A line between Perpignan, France and Figueres, Spain that began services in 2009 severely fell short of projected traffic. Originally, it was expected to run 19,000 trains per year, but has only reached 800 trains by 2015.

There is also evidence that high speed rail systems poorly re-distribute activity geographically. This is especially concerning given the fact that projects are often sold on a promise of promoting regional equity and reducing congestion in over-heating areas. You can plan a track between well-developed and less-developed regions, but this does not guarantee that growth for both will follow. The Shinkansen system delivers much of Japan’s workforce to Tokyo, for example, but does not spread much employment away from the capital. In fact, faster growth happened where it was already expected, even before the high-speed rail was planned or built. Additionally, the Tokyo-Osaka Shinkansan line in particular has strengthened the relative economic position of Tokyo and Osaka while weakening those of cities not served.

Passenger volume and line access are not – and should not be – the only metrics of success. Academics have exhibited a fair amount of skepticism regarding high-speed rail’s ability to meet other objectives. When it comes to investment value, many cases have resulted in much lower returns than expected. A recent, extreme example of this is California’s bullet train that is 50 percent over its planned budget; not to mention being seven years behind in its building schedule.

The project in California has been deemed a lost cause by many, but other projects have gained more momentum in the past year. North American High Speed Rail Group has proposed a rail line between Rochester and the Twin Cities, and if it gets approval from city officials, it plans to finance entirely with private money. The main drawback of the project is that it would require the use of eminent domain to take the property of existing businesses that are in the way of the planned line path. Private companies trying to use eminent domain to get past a roadblock like this often do so claiming that it is for the “public benefit.” Given that many residents have resisted the North American High Speed Rail Group’s plans, trying to force the use of eminent domain would likely only destroy value; reallocating property from a higher-value to a lower-value use.

Past Mercatus research has found that using eminent domain powers for redevelopment purposes – i.e. by taking from one private company and giving to another – can cause the tax base to shrink as a result of decreases in private investment. Or in other words, when entrepreneurs see that the projects that they invest in could easily be taken if another business owner makes the case to city officials, it would in turn discourage future investors from moving into the same area. This ironically discourages development and the government’s revenues suffer as a result.

Florida’s Brightline might have found a way around this. Instead of trying to take the property of other businesses and homes in its way, the company has raised money to re-purpose existing tracks already between Miami and West Palm Beach. If implemented successfully, this will be the first privately run and operated rail service launched in the U.S. in over 100 years. And it doesn’t require using eminent domain or the use of taxpayer dollars to jump-start that, like any investment, has risk of being a failure; factors that reduce the cost side of the equation from the public’s perspective.

Which brings us back to the Houston-to-Dallas line that Trump appears to be getting behind. How does that plan stack up to these other projects? For one, it would require eminent domain to take from rural landowners in order to build a line that would primarily benefit city residents. Federal intervention would require picking a winner and loser at the offset. Additionally, there is no guarantee that building of the line would bring about the economic development that many proponents promise. Button’s new paper suggests that it’s fair to be skeptical.

I’m not making the argument that high-speed rail in America should be abandoned altogether. Progress in Florida demonstrates that maybe in the right conditions and with the right timing, it could be cost-effective. The authors of a 2013 study echo this by writing:

“In the end, HSR’s effect on economic and urban development can be characterized as analogous to a fertilizer’s effect on crop growth: it is one ingredient that could stimulate economic growth, but other ingredients must be present.”

For cities that can’t seem to mix up the right ingredients, they can look to other options for reaching the same goals. In fact, a review of the economic literature finds that investing in road infrastructure is a much better investment than other transportation methods like airports, railways, or ports. Or like I’ve discussed previously, being more welcoming to new technologies like driver-less cars has the potential to both reduce congestion and generate significant economic gains.

Why the lack of labor mobility in the U.S. is a problem and how we can fix it

Many researchers have found evidence that mobility in the U.S. is declining. More specifically, it doesn’t appear that people move from places with weaker economies to places with stronger economies as consistently as they did in the past. Two sets of figures from a paper by Peter Ganong and Daniel Shoag succinctly show this decline over time.

The first, shown below, has log income per capita by state on the x-axis for two different years, 1940 (left) and 1990 (right). On the vertical axis of each graph is the annual population growth rate by state for two periods, 1940 – 1960 (left) and 1990 – 2010 (right).

directed migration ganong, shoag

In the 1940 – 1960 period, the graph depicts a strong positive relationship: States with higher per capita incomes in 1940 experienced more population growth over the next 20 years than states with lower per capita incomes. This relationship disappears and actually reverses in the 1990 – 2010 period: States with higher per capita incomes actually grew slower on average. So in general people became less likely to move to states with higher incomes between the middle and end of the 20th century. Other researchers have also found that people are not moving to areas with better economies.

This had an effect on income convergence, as shown in the next set of figures. In the 1940 – 1960 period (left), states with higher per capita incomes experienced less income growth than states with lower per capita incomes, as shown by the negative relationship. This negative relationship existed in the 1990 – 2010 period as well, but it was much weaker.

income convergence ganong, shoag

We would expect income convergence when workers leave low income states for high income states, since that increases the labor supply in high-income states and pushes down wages. Meanwhile, the labor supply decreases in low-income states which increases wages. Overall, this leads to per capita incomes converging across states.

Why labor mobility matters

As law professor David Schleicher points out in a recent paper, the current lack of labor mobility can reduce the ability of the federal government to manage the U.S. economy. In the U.S. we have a common currency—every state uses the U.S. dollar. This means that if a state is hit by an economic shock, e.g. low energy prices harm Texas, Alaska and North Dakota but help other states, that state’s currency cannot adjust to cushion the blow.

For example, if the UK goes into a recession, the Bank of England can print more money so that the pound will depreciate relative to other currencies, making goods produced in the UK relatively cheap. This will decrease the UK’s imports and increase economic activity and exports, which will help it emerge from the recession. If the U.S. as a whole suffered a negative economic shock, a similar process would take place.

However, within a country this adjustment mechanism is unavailable: Texas can’t devalue its dollar relative to Ohio’s dollar. There is no within-country monetary policy that can help particular states or regions. Instead, the movement of capital and labor from weak areas to strong areas is the primary mechanism available for restoring full employment within the U.S. If capital and labor mobility are low it will take longer for the U.S. to recover from area-specific negative economic shocks.

State or area-specific economic shocks are more likely in large countries like the U.S. that have very diverse local economies. This makes labor and capital mobility more important in the U.S. than in smaller, less economically diverse countries such as Denmark or Switzerland, since those countries are less susceptible to area-specific economic shocks.

Why labor mobility is low

There is some consensus about policies that can increase labor mobility. Many people, including former President Barack Obama, my colleagues at the Mercatus Center and others, have pointed out that state occupational licensing makes it harder for workers in licensed professions to move across state borders. There is similar agreement that land-use regulations increase housing prices which makes it harder for people to move to areas with the strongest economies.

Reducing occupational licensing and land-use regulations would increase labor mobility, but actually doing these things is not easy. Occupational licensing and land-use regulations are controlled at the state and local level, so currently there is little that the federal government can do.

Moreover, as Mr. Schleicher points out in his paper, state and local governments created these regulations for a reason and it’s not clear that they have any incentive to change them. Like all politicians, state and local ones care about being re-elected and that means, at least to some extent, listening to their constituents. These residents usually value stability, so politicians who advocate too strongly for growth may find themselves out of office. Mr. Schleicher also notes that incumbent politicians often prefer a stable, immobile electorate because it means that the voters who elected them in the first place will be there next election cycle.

Occupational licensing and land-use regulations make it harder for people to enter thriving local economies, but other policies make it harder to leave areas with poor economies. Nearly 13% of Americans work for state and local governments and 92% of them have a defined-benefit pension plan. Defined-benefit plans have long vesting periods and benefits can be significantly smaller if employees split their career between multiple employers rather than remain at one employer. Thus over 10% of the workforce has a strong retirement-based incentive to stay where they are.

Eligibility standards for public benefits and their amounts also vary by state, and this discourages people who receive benefits such as Temporary Assistance for Needy Families (TANF) from moving to states that may have a stronger economy but less benefits. Even when eligibility standards and benefits are similar, the paperwork and time burden of enrolling in a new state can discourage mobility.

The federal government subsidizes home ownership as well, and homeownership is correlated with less labor mobility over time. Place-based subsidies to declining cities also artificially support areas that should have less people. As long as state and federal governments subsidize government services in cities like Atlantic City and Detroit people will be less inclined to leave them. People-based subsidies that incentivize people to move to thriving areas are an alternative that is likely better for the taxpayer, the recipient and the country in the long run.

How to increase labor mobility

Since state and local governments are unlikely to directly address the impediments to labor mobility that they have created, Mr. Schleicher argues for more federal involvement. Some of his suggestions don’t interfere with local control, such as a federal clearinghouse for coordinated occupational-licensing rules across states. This is not a bad idea but I am not sure how effective it would be.

Other suggestions are more intrusive and range from complete federal preemption of state and local rules to federal grants that encourage more housing construction or suspension of the mortgage-interest deduction in places that restrict housing construction.

Local control is important due to the presence of local knowledge and the beneficial effects that arise from interjurisdictional competition, so I don’t support complete federal preemption of local rules. Economist William Fischel also thinks the mortgage interest deduction is largely responsible for excessive local land-use regulation, so eliminating it altogether or suspending it in places that don’t allow enough new housing seems like a good idea.

I also support more people-based subsidies that incentivize moving to areas with better economies and less place-based subsidies. These subsidies could target people living in specific places and the amounts could be based on the economic characteristics of the destination, with larger amounts given to people who are willing to move to areas with the most employment opportunities and/or highest wages.

Making it easier for people to retain any state-based government benefits across state lines would also help improve labor mobility. I support reforms that reduce the paperwork and time requirements for transferring benefits or for simply understanding what steps need to be taken to do so.

Several policy changes will need to occur before we can expect to see significant changes in labor mobility. There is broad agreement around some of them, such as occupational licensing and land-use regulation reform, but bringing them to fruition will take time. As for the less popular ideas, it will be interesting to see which, if any, are tried.

Decreasing congestion with driverless cars

Traffic is aggravating. Especially for San Francisco residents. According to Texas A&M Transportation Institute, traffic congestion in the San Francisco-Oakland CA area costs the average auto commuter 78 hours per year in extra travel time, $1,675 for their travel time delays, and an extra 33 gallons of gas compared to free-flow traffic conditions. That means the average commuter spends more than three full days stuck in traffic each year. Unfortunately for these commuters, a potential solution to their problems just left town.

Last month, after California officials told Uber to stop its pilot self-driving car program because it lacked the necessary state permits for autonomous driving, Uber decided to relocate the program from San Francisco to Phoenix, Arizona. In an attempt to alleviate safety concerns, these self-driving cars are not yet driverless, but they do have the potential to reduce the number of cars on the road. Other companies like Google, Tesla, and Ford have expressed plans to develop similar technologies, and some experts predict that completely driverless cars will be on the road by 2021.

Until then, however, cities like San Francisco will continue to suffer from the most severe congestion in the country. Commuters in these cities experience serious delays, higher gasoline usage, and lost time behind the wheel. If you live in any of these areas, you are probably very familiar with the mind-numbing effect of sitting through sluggish traffic.

It shouldn’t be surprising then that these costs could culminate into a larger problem for economic growth. New Mercatus research finds that traffic congestion can significantly harm economic growth and concludes with optimistic predictions for how autonomous vehicle usage could help.

Brookings Senior Fellow Clifford Winston and Yale JD candidate Quentin Karpilow find significant negative effects of traffic congestion on the growth rates of California counties’ gross domestic product (GDP), employment, wages, and commodity freight flows. They find that a 10% reduction in congestion in a California urban area increases both job and GDP growth by roughly 0.25% and wage growth to increase by approximately 0.18%.

This is the first comprehensive model built to understand how traffic harms the economy, and it builds on past research that has found that highway congestion leads to slower job growth. Similarly, congestion in West Coast ports, which occurs while dockworkers and marine terminal employers negotiate contracts, has caused perishable commodities to go bad, resulting in a 0.2 percentage point reduction in GDP during the first quarter of 2015.

There are two main ways to solve the congestion problem; either by reducing the number of cars on the road or by increasing road capacity. Economists have found that the “build more roads” method in application has actually been quite wasteful and usually only induces additional highway traffic that quickly fills the new road capacity.

A common proposal for the alternative method of reducing the number of cars on the road is to implement congestion pricing, or highway tolls that change based on the number of drivers using the road. Increasing the cost of travel during peak travel times incentivizes drivers to think more strategically about when they plan their trips; usually shifting less essential trips to a different time or by carpooling. Another Mercatus study finds that different forms of congestion pricing have been effective at reducing traffic congestion internationally in London and Stockholm as well as for cities in Southern California.

The main drawback of this proposal, however, is the political difficulty of implementation, especially with interstate highways that involve more than one jurisdiction to approve it. Even though surveys show that drivers generally change their mind towards supporting congestion pricing after they experience the lower congestion that results from tolling, getting them on board in the first place can be difficult.

Those skeptical of congestion pricing, or merely looking for a less challenging policy to implement, should look forward to the new growing technology of driverless cars. The authors of the recent Mercatus study, Winston and Karpilow, find that the adoption of autonomous vehicles could have large macroeconomic stimulative effects.

For California specifically, even if just half of vehicles became driverless, this would create nearly 350,000 additional jobs, increase the state’s GDP by $35 billion, and raise workers’ earnings nearly $15 billion. Extrapolating this to the whole country, this could add at least 3 million jobs, raise the nation’s annual growth rate 1.8 percentage points, and raise annual labor earnings more than $100 billion.

What would this mean for the most congested cities? Using Winston and Karpilow’s estimates, I calculated how reduced congestion from increased autonomous car usage could affect Metropolitan Statistical Areas (MSAs) that include New York City, Los Angeles, Boston, San Francisco, and the DC area. The first chart shows the number of jobs that would have been added in 2011 if 50% of motor vehicles had been driverless. The second chart shows how this would affect real GDP per capita, revealing that the San Francisco MSA would have the most to gain, but with the others following close behind.

jobsadd_autonomousvehicles realgdp_autonomousvehicles

As with any new technology, there is uncertainty with how exactly autonomous cars will be fully developed and integrated into cities. But with pilot programs already being implemented by Uber in Pittsburgh and nuTonomy in Singapore, it is becoming clear that the technology’s efficacy is growing.

With approximately $1,332 GDP per capita and 45,318 potential jobs on the table for the San Francisco Metropolitan Statistical Area, it is a shame that San Francisco just missed a chance to realize some of these gains and to be at the forefront of driving progress in autonomous vehicle implementation.

Solving the Public Pension Crisis

Last week I had the pleasure of attending a public policy conference that brought together many scholars who study public pensions to share what they have learned from their research. The crisis – growing unfunded pension liabilities and resulting fiscal distress for states and municipalities – laid as the foundation of the day. Hosted by GMU’s Law & Economics Center, the conference featured several panel discussions framed around different aspects of how to both diagnose the cause of this growing problem and hopefully find solutions to address the problem.

Professor Robert Inman of the University of Pennsylvania presented a helpful categorization of the different avenues to address the public pension crisis. He explained that as a reformer, you can either put stock in (1) courts, (2) markets, or (3) politics to solve the public policy problem. The next question is, which avenue is most effective at making pensions solvent while also keeping promises to beneficiaries?

First, take the courts. In municipal bankruptcy cases like that of Central Falls, Rhode Island; Stockton, California; and Detroit, Michigan, courts have ruled that reductions in benefits of current public workers and retirees are legally allowed. Until these rulings, however, it was thought to be almost impossible do such a thing. These cities employed reforms ranging from cutting payments to reducing current benefit formulas. By contrast, the state supreme court of Illinois has ruled similar cuts unconstitutional. It will be interesting to see how these conflicting legal precedents will affect future cases and what it will mean for the benefits of public workers.

However this legal discussion unfolds, it will certainly affect the courts as an avenue for solving the pension crisis. Strict rulings prevent states from cutting pension benefits of current workers, but they also require states to keep their promises, especially when it is politically hardest – during times of fiscal stress.

Times of fiscal stress are often prompted by a combination of factors. Growing unfunded liabilities, not enough cash in reserves, and poorly structured tax systems can all come together to really put policymakers in a tough spot and often leaves a large bill for taxpayers. A struggling economy on top of all of this can really exacerbate the situation. The main difference between the first three things and a struggling economy is that the latter is largely out of a policymaker’s control.

Despite this, many policymakers rely on the market to get them out of tough times. From the policymaker’s perspective “relying on the market” to solve the pension crisis usually means something different than what it means for an economist. This phrase for the policymaker usually entails reaping the benefits of more taxes generated from an economic boom or relying on high investment returns to improve the performance of pension funds.

Not only are the timing of economic booms fairly unpredictable, but they also don’t guarantee to solve all of your problems when they do occur. The growing city of Austin, Texas, for example, is facing budgetary pressures and only has enough money to pay for about two-thirds of the benefits workers have already earned, demonstrating that even good economic times don’t exempt you from pension problems.

The good news is that what we learn from market interactions can be transferred to the political sphere in order to increase our understanding. One lesson we learn from markets is that individuals respond to incentives and that the institutional structure in which they act influences how this occurs. The importance of incentives and rules doesn’t change when going from markets to politics, but the way they manifest does.

At the Law and Economics conference, Anthony Randazzo of the Reason Foundation explained how there is a tangled web of factors causing inappropriate pension funding behavior. These factors create misaligned incentives between fiduciaries and taxpayers. One way this has manifested is that the pension funding policy process has been captured by elected officials who are more concerned with near-term budget allocation than long-term solvency.

My colleague Eileen Norcross and her co-author Sheila Weinberg expanded more on the type of behavior that Randazzo spoke of. In their paper titled “A Judge in their Own Cause: GASB 67/68 and the continued mis-measurement of public sector liabilities” they review how policymakers are incentivized by state and local accounting guidelines to underreport the true value of their pension liabilities. Two new accounting rules were implemented in fiscal year 2015 in an attempt to improve this, but as Norcross and Weinberg’s findings suggest, they have not had their intended effects.

For example, there is evidence that one of the rules, GASB 67, is creating incentives for pension actuaries to project robust funding levels far into the future in order to avoid calculating and reporting large unfunded liabilities in the present.

They sum up the effects of both rules in their conclusion:

“Though these measures are justified in providing flexibility and practicality for governments, they only contribute to an artificial picture of state’s true fiscal results and thus affect important decisions on how states use resources.”

Their analysis demonstrates just how important it is to study the incentives present in both the measurement of and the governance of public pension funds. Luckily, there is also work being done that attempts to understand exactly what type of rules can improve incentives facing policymakers.

Another paper, presented by Professor Odd Stalebrink of Penn State, touched upon this by examining how governance structures affect the investment performance of public pension funds. He found that pension systems are more likely to meet their performance targets if they are governed by an institutional structure that (1) extends plan autonomy, (2) places emphasis on transparency, and (3) limits inefficient investment practices. In states that exhibit more corruption, however, Stalebrink noted that plans might actually be better off with less autonomy, while still focusing on transparency and improving efficiency.

The discussion of these papers along with many others at the conference underscored that pension problem in the states multifaceted one. The question of what avenue to employ reform efforts through does not have a simple answer. Growing unfunded pension liabilities are a result of many factors across market, political, and legal spheres. It only makes sense that effective solutions will revolve around an understanding of all three areas.

Proceedings of the conference will be published in a special symposium issue of Scalia Law School’s Journal of Law, Economics & Policy.

Eight years after the financial crisis: lessons from the most fiscally distressed cities

You’d think that eight years after the financial crisis, cities would have recovered. Instead, declining tax revenues following the economic downturn paired with growing liabilities have slowed recovery. Some cities exacerbated their situations with poor policy choices. Much could be learned by studying how city officials manage their finances in response to fiscal crises.

Detroit made history in 2013 when it became the largest city to declare bankruptcy after decades of financial struggle. Other cities like Stockton and San Bernardino in California had their own financial battles that also resulted in bankruptcy. Their policy decisions reflect the most extreme responses to fiscal crises.

You could probably count on both hands how many cities file for bankruptcy each year, but this is not an extremely telling statistic as cities often take many other steps to alleviate budget problems and view bankruptcy as a last resort. When times get tough, city officials often reduce payments into their pension systems, raise taxes – or when that doesn’t seem adequate – find themselves cutting services or laying off public workers.

It turns out that many municipalities weathered the 2008 recession without needing to take such extreme actions. Studying how these cities managed to recover more quickly than cities like Stockton provides interesting insight on what courses of action can help city officials better respond to fiscal distress.

A new Mercatus study examines the types of actions that public officials have taken under fiscal distress and then concludes with recommendations that could help future crises from occurring. Their empirical model finds that increased reserves, lower debt, and better tax structures all significantly improve a city’s fiscal health.

The authors, researchers Evgenia Gorina and Craig Maher, define fiscal distress as:

“the condition of local finances that does not permit the government to provide public services and meet its own operating needs to the extent to which these have been provided and met previously.”

In order to determine whether a city or county government is under fiscal distress, the authors study the actual actions taken by city officials between 2007 and 2012. Their approach is unique because it stands in contrast with previous literature that primarily looks to poorly performing financial indicators to measure fiscal distress. An example of such an indicator would be how much cash a government has on hand relative to its liabilities.

Although financial indicators can tell someone a lot about the fiscal condition of their locality, they are only a snapshot of financial resources on hand and don’t provide information on how previous policy choices got them to their current state. A robust analysis of a city’s financial health would require a deeper look. Looking at policy decisions as well as financial indicators can paint a more complete picture of just how financial resources are being managed.

The figure here displays the types of actions, or “fiscal distress episodes”, that the authors of the study found were the most common among cities in California, Michigan, and Pennsylvania. As expected, you’ll see that bankruptcy occurs much less frequently than other courses of action. The top three most common attempts to meet fundamental operating needs and service requirements during times of fiscal distress include (1) large across-the-board budget cuts or cuts in services, (2) blanket reduction in employee salaries, and (3) unusual tax rate or fee increases.

fiscal-distress-episodes

Another thing that becomes clear from this figure is that public workers and taxpayers appear to be adversely affected by the most common fiscal episodes. Cuts in services, reductions in employee salaries, large tax increases, and layoffs all place much of the distress on these groups. By contrast, actions like fund transfers, deferring capital projects, or late budget enactment don’t directly affect public workers or taxpayers (at least in the short term).

I decided to break down how episodes affected public workers and taxpayers for each state examined in the sample. 91% of California’s municipal fiscal distress episodes directly affected public employees or the provision of public services, while the remaining 9% indirectly affected them. Michigan and Pennsylvania followed with 85% and 66% of episodes, respectively, directly affecting public workers or taxpayers through cuts in services, tax increases, or layoffs.

Many of these actions surely happen in tandem with each other in more distressed cities, but it seems that more often than not, the burden falls heavily on public workers and taxpayers.

The city officials who had to make these hard decisions obviously did so under financially and politically intense circumstances; what many, including researchers like Gorina and Maher, consider to be a fiscal crisis. In fact, 32 percent of the communities across the three states in their sample experienced fiscal distress which, on its own, sheds light on the magnitude of the 2007-2009 recession. A large motivator of Gorina and Maher’s research is to understand what characteristics of the cities who more quickly rebounded from the Great Recession allowed them to prevent hitting fiscal crisis stage in the first place.

They do so by testing the effect of a city’s pre-existing fiscal condition on their likelihood to undergo fiscal distress. After controlling for things like government type, size, and local economic factors, they found that cities that had larger reserves and lower debt tended to weather the recession better relative to other cities. More specifically, declining general revenue balance as a percent of general expenditures and increases in debt as a share of total revenue both increase the odds of fiscal distress for a city.

Additionally, the authors found that cities with a greater reliance on property taxes managed to weather the recession better than governments reliant on other revenue sources. This suggests that revenue structure, not just the amount of revenue raised, is an important determinant of fiscal health.

No city wants to end up like Detroit or Scranton. Policymakers in these cities were forced to make hard choices that were politically unpopular; often harming public employees and taxpayers. Officials can look to Gorina and Maher’s research to understand how they can prevent ending up in such dire situations.

When approaching municipal finances, each city’s unique situation should of course be taken into consideration. This requires looking at each city’s economic history and financial practices, similar to what my colleagues have done for Scranton. Combining each city’s financial context with principles of sound financial management can surely help more cities find and maintain a healthy fiscal path.