Category Archives: New Research

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.

Does the New Markets Tax Credit Program work?

Location-based programs that provide tax credits to firms and investors that locate in particular areas are popular among politicians of both parties. Democrats tend to support them because they are meant to revitalize poorer or rural areas. In a recent speech about the economy, presumed Democratic nominee Hillary Clinton spoke favorably about two of them: the New Markets Tax Credit Program and Empowerment Zones.

Some Republicans also support such programs, which they view as being a pro-business way to help low-income communities. However, House Speaker Paul Ryan’s recent tax reform blueprint generally disapproves of tax credit programs.

Due to the volume of location-based programs and their relatively narrow objectives, many taxpayers are unfamiliar with their differences or unaware that they even exist. This is to be expected since most people are never directly affected by one. In this post I explain one that Hillary Clinton recently spoke about, the New Markets Tax Credit (NMTC) program.

The NMTC program was created in 2000 as part of the Community Renewal Tax Relief Act. It is managed by the Community Development Financial Institutions Fund, which is a division of the U.S. Treasury Department.

The NMTC program provides both new and established businesses with a tax credit that can be used to offset the costs of new capital investment or hiring new workers. The goal is to increase investment in low income communities (LIC) in order to improve the economic outcomes of residents.

Even though the program was started in 2000, no funds were issued to investors until 2003 (although some funds were allocated to the program in 2001 and 2002). Since 2001 over $43 billion has been allocated to the program. The figure below shows the allocations by year, amount issued to investors, and the total amount allocated from 2001 – 2014 (orange bar, uses right axis).

NMTC allocations

Figure 1

Practically all of the allocated funds from 2001 to 2012 have been issued to investors. A little over $250 million remains from 2013 and $1.3 billion from 2014. As the figure makes clear, this program controls a non-trivial amount of money.

The types of projects funded by the NMTC program can be seen in the figure below. The data for this figure comes from a 2013 Urban Institute report.

NMTC projects funded

Figure 2

So what have taxpayers gotten for their money? The program’s ‘fact sheet’ asserts that since 2003 the program has

“…created or retained an estimated 197,585 jobs. It has also supported the construction of 32.4 million square feet of manufacturing space, 74.8 million square feet of office space, and 57.5 million square feet of retail space.”

Like many government program administrators, those running the NMTC program seem to confuse outputs with outcomes. Presumably the goal of the NMTC program is not to build office space, which is a trivial achievement, but to improve the lives of the people living in low income communities. In fact, the program’s fact sheet also states that

“Investments made through the NMTC Program are used to finance businesses, breathing new life into neglected, underserved low-income communities.”

What really matters is whether the program has succeeded at “breathing new life” into LICs. To answer this more complicated question one needs to examine the actual economic outcomes in areas receiving the credits in order to determine whether they have improved relative to areas that haven’t received the credits. Such an exercise is not the same thing as simply reporting the amount of new office space.

That being said, even the simpler task of measuring new office space or counting new jobs is harder than it first appears. It’s important for program evaluators and the taxpayers who fund the program to be aware of the reasons that either result could be speciously assigned to the tax credit.

First, the office space or jobs might have been added regardless of the tax credit. Firms choose locations for a variety of reasons and it’s possible that a particular firm would locate in a particular low income community regardless of the availability of a tax credit. This could happen for economic reasons—the firm is attracted by the low price of space or the location is near an important supplier—or the location has sentimental value e.g. the firm owner is from the neighborhood.

A second reason is that the firms that locate or expand in the community might do so at the expense of other firms that would have located there absent the tax credit. For example, suppose the tax credit attracts a hotel owner who due to the credit finds it worthwhile to build a hotel in the neighborhood, and that this prevents a retail store owner from locating on the same plot of land, even though she would have done so without a credit.

The tax credit may also mistakenly appear to be beneficial if all it does is reallocate investment from one community to another. Not all communities are eligible for these tax credits. If a firm was going to locate in a neighboring community that wasn’t eligible but then switched to the eligible community upon finding out about the tax credit then no new investment was created in the city, it was simply shifted around. In this scenario one community benefits at the expense of another due to the availability of the tax credit.

A new study examines the NMTC program in order to determine whether it has resulted in new employment or new businesses in eligible communities. It uses census tract data from 2002 – 2006. In order to qualify for NMTCs, a census tract’s median family income must be 80% or less of its state’s median family income or the poverty rate of the tract must be over 20%. (There are two other population criteria that were added in 2004, but according to the study 98% qualify due to the income or poverty criterion.)

The authors use the median income ratio of 0.8 to separate census tracts into a qualifying and non-qualifying group, and then compare tracts that are close to and on either side of the 0.8 cutoff. The economic outcomes they examine are employment at new firms, number of new firms, and new employment at existing firms.

They find that there was less new employment at new firms in NMTC eligible tracts in the transportation and wholesale industries but more new employment in the retail industry. Figure 2 shows that retail received a relatively large portion of the tax credits. This result shows that the tax credits helped new retail firms add workers relative to firms in transportation and manufacturing in eligible census tracts.

The authors note that the magnitude of the effects are small—a 0.2% increase in new retail employment and a 0.12% and 0.41% decrease in new transportation and wholesale employment respectively. Thus the program had a limited impact during the 2002 – 2006 period according to this measure, despite the fact that nearly $8 billion was granted to investors from 2002 – 2005.

The authors find a similar result when examining new firms: Retail firms located in the NMTC eligible tracts while services and wholesale firms did not. Together these two results are evidence that the NMTC does not benefit firms in all industries equally since it causes firms in different industries to locate in different tracts. The latter result also supports the idea that firms that benefit most from the tax credit crowd out other types of firms, similar to the earlier hotel and retail store example.

Finally, the authors examined new employment at existing firms. This result is more favorable to the program—an 8.8% increase in new employment at existing manufacturing firms and a 10.4% increase at retail firms. Thus NMTCs appear to have been primarily used to expand existing operations.

But while there is evidence that the tax credit slightly increased employment, the authors note that due to the limitations of their data they are unable to conclude whether the gains in new employment or firms was due to a re-allocation of economic activity from non-eligible to eligible census tracts or to actual new economic activity that only occurred because of the program. Thus even the small effects identified by the authors cannot be conclusively considered net new economic activity generated by the NMTC program. Instead, the NMTC program may have just moved economic activity from one community to another.

The mixed results of this recent study combined with the inability to conclusively assign them to the NMTC program cast doubt on the programs overall effectiveness. Additionally, the size of the effects are quite small. Thus even if the effects are positive once crowding out and reallocation are taken into account, the benefits still may fall short of the $43.5 billion cost of the program (which doesn’t include the program’s administrative costs).

An alternative to location-based tax credit programs is to lower tax rates on businesses and investment across the board. This would remove the distortions that are inherent in location-based programs that favor some areas and businesses over others. It would also reduce the uncertainty that surrounds the renewal and management of the programs. Attempts to help specific places are often unsuccessful and give residents of such places false hope that community revitalization is right around the corner.

Tax credits, despite their good intentions, often fail to deliver the promised benefits. The alternative—low, stable tax rates that apply to all firms—helps create a business climate that is conducive to long-term planning and investment, which leads to better economic outcomes.

Municipalities in fiscal distress: state-based laws and remedies

The Great Recession of 2008 “stress tested” many policies and institutions including the effectiveness of laws meant to handle municipal fiscal crises. In new Mercatus research professor Eric Scorsone of Michigan State University assess the range and type of legal remedies offered by states to help local governments in financial trouble.

“Municipal Fiscal Emergency Laws: Background and Guide to State-Based Approaches,” begins with some brief context. Most municipal fiscal laws trace their lineage through the 1975 New York City fiscal crisis, the Great Depression and the 19th century railroad bankruptcies. Writing in 1935, attorney Edward Dimock articulated three pieces to addressing municipal insolvency:  1) oversight of the municipality’s financial management 2) stop individual creditors from undermining the distressed entity and 3) put together a plan of adjustment for meeting the creditor’s needs.

These general parameters are at work in state laws today. The details vary. Some states are passive and others much more “hands-on” in dealing with local financial troubles. Scorsone documents these approach with a focus on the “triggers” states use to identify a crisis, the remedies permitted (e.g. can a municipality amend a collective bargaining agreement?), and the exit strategies offered. Maine has the most “Spartan” of fiscal triggers. A Maine municipality that fails to redistribute state taxes, or misses a bond payment triggers the state government’s attention. Michigan also has very strong municipal distress laws which create, “almost a form of quasi-bankruptcy” allowing the state emergency manager to break existing contracts. Texas and Tennessee, by contrast, are relatively hands-off.

How well these laws work is a live issue in many places, including Pennsylvania. In 1987 the state passed Act 47 to identify distressed municipalities. While Act 47 appears to have diagnosed dozens of faltering local governments, the law has proven ineffective in helping municipalities right course. Many cities have remained on the distressed list for 20 years. Recent legislation proposes to allow a municipality that can’t “exit Act 47” the option of disincorporating. Is there a middle ground? As the PA State Association of Town Supervisors put it, “If we can’t address the labor issues, if we can’t address the mandates, if we can’t address the tax exempt properties, we go nowhere.”

Municipalities end up in distress for a complex set of reasons: self-inflicted policy and governance failures, uncontrollable social and economic shifts, and external shocks. Unwinding the effects of decades of interlocking problems isn’t a neat and easy undertaking. The purpose of the paper isn’t to evaluate the effectiveness various approaches to helping municipalities out of distress, it is instead a much-needed guide to help navigate and compare the states’ legal frameworks in which municipal leaders make decisions.

 

 

 

Is American Federalism conducive to liberty?

In new Mercatus research, Dr. Richard E. Wagner, Harris professor of Economics at George Mason University tackles a fascinating question: Is the American form of federalism supportive of liberty?

His answer is a qualified ‘yes.’ Under certain conditions, American federalism does support liberty, but that very same system can also be modified resulting in the expansion of political power relative to the liberty of citizens. The question of what results from the gradual constitutional transformation of the American federalist system is a salient one for not only students of government but also policymakers.

The important conditions that determine which form of federalism prevails (liberty-supporting or liberty-eroding) are rooted in competition among governments. Today we are experiencing a very different kind of federalism than the one instituted by the Founders. For the better part of a century, the US constitution has often been amended in a way to encourage collusion among the states thus undermining a key feature of a liberty-supporting federalism.

Restoring a liberty-supporting federalism first requires a deeper diagnosis of the American federalist system. Dr. Wagner develops that possibility through a very engaging synthesis of public choice theory, Austrian and new institutional economics.  Student of Dr. Wagner may be familiar with many of these concepts, developed in his public finance books including Deficits, Debt and Democracy (2012, Elgar). Rather than summarize the paper in today’s blog post, for now I encourage you to read the piece in full.

Embrace Change

Kaiserin_Maria_Theresia_(HRR)Whenever someone suggested a new innovation or an improvement, Empress Maria Theresa had a favorite response: “Leave everything as it is.” As the sovereign of most of central Europe during the 18th Century, the Habsburg Empress epitomized absolutist rule, claiming that her powers had no limit.

But as her statement demonstrates, she clearly understood that her powers were limited by new and disruptive innovations. Her husband, Holy Roman Emperor Francis I understood this as well. Daron Acemoglu and James Robinson relate that when an English philanthropist suggested some social reforms for the benefit of Austria’s poorest, one of Francis’s assistants replied: “We do not desire at all that the great masses shall become well off and independent….How could we otherwise rule over them?” (A&R, 224).

This is why these Habsburg rulers did everything they could to stand athwart innovation. As Acemoglu and Robinson put it:

In addition to serfdom, which completely blocked the emergence of a labor market and removed the economic incentives or initiative from the mass of the rural population, Habsburg absolutism thrived on monopolies and other restrictions on trade. The urban economy was dominated by guilds, which restricted entry into professions. (A&R, 224).

Francis went so far as to block new technologies. For instance, he banned the adoption of new industrial machinery until 1811. He also refused to permit the building of steam railroads. Acemoglu and Robinson inform us that:

[T]he first railway built in the empire had to use horse-drawn carriages. The line…was built with gradients and corners, which meant that it was impossible subsequently to convert it to steam engines. So it continued with horse power until the 1860s. (A&R, 226).

Unfortunately, history is replete with examples of despots who stood in the way of innovation. In Russia, Nicholas I enacted laws restricting the number of factories and “forbade the opening of any new cotton or woolen spinning mills and iron foundries.” (A&R, 229). And in the Ottoman Empire, sultans banned the use of printing. So stultifying was the effect that “well into the second half of the nineteenth century, book production in the Ottoman Empire was still primarily undertaken by scribes hand-copying existing books.” (A&R, 214).

The centuries and the miles that separate us from these episodes give us some objectivity and allow us to see them for what they are: the naked exercise of government force to obstruct innovation for the benefit of a few entrenched interests. But how different are these episodes, really, from the stories we read in today’s newspapers? Are they all that different from New Jersey’s refusal to allow car companies to sell directly to consumers? Are they any less silly than the anti-Uber laws cooked up by a dozen U.S. cities? We like to think that our own political process is more enlightened but right now, federal, state and city policy makers are working to block the development of promising innovations such as wearable technologies, 3D printing, smart cars, and autonomous vehicles.

book-cover-smallFor a thoughtful and forceful discussion of what might be called the anti-Maria Theresa view, everyone should read Permissionless Innovation by my colleague Adam Thierer. It is a well-researched and well-argued defense of the proposition that our default policy should be “innovation allowed.” You can find Kindle and paperback versions on Amazon. Or you can check out the free PDF version at the Mercatus Center. For a nice overview of his book, see Adam’s post (and video) here. Please read it and send (free) copies to any modern-day Maria Theresas you may know.

How are your state’s finances?

Just how well do your state’s finances compare to those of other states?

I sat down with our state policy group last week to discuss recent Mercatus research that ranks states’ fiscal condition based on the their 2012 Comprehensive Annual Financial Report (CAFR). The findings contained in State Fiscal Condition: Ranking the 50 States by Dr. Sarah Arnett are aimed at helping states apply basic financial ratios to get a general picture of fiscal health. Dr. Arnett’s paper uses four solvency criteria developed in the public finance literature – cash solvency, budgetary solvency, long-run solvency and service-level solvency. In this podcast, I discuss how legislators and policy analyst might use the study and the limitations of ratios and rankings in understanding a state’s deeper financial picture.

Markets Fail and Governments Do Too

We often hear that markets fail when it comes to preserving the environment, so government regulation is needed to protect natural resources from the ravages of capitalism. But what happens when government regulations themselves get in the way of innovative ideas that move us towards a cleaner and more environmentally sustainable future?

This is exactly what happened in Logan City, Utah when the local government built a small hydropower turbine and ran into a nightmare of regulatory red tape that led to large cost overruns and far more time committed to the project than was originally anticipated. In the end, the project was delayed four years and ended up costing twice as much as planned.

This abstract from a recent working paper from the Mercatus Center describes what happened:

In 2004 Logan, Utah, saw the opportunity to place a turbine within the city’s culinary water system. The turbine would reduce excess water pressure and would generate clean, low-cost electricity for the city’s residents. Federal funding was available, and the city qualified for a grant under the American Recovery and Reinvestment Act. Unfortunately, Logan City found that a complex and costly federal nexus of regulatory requirements must be met before any hydropower project can be licensed with the Federal Energy Regulatory Commission. This regulation drove up costs in terms of time and money and, as a result, Logan City is not planning to undertake any similar projects in the future. Other cities have had similar experiences to Logan’s, and we briefly explore these as well. We find that regulation is likely deterring the development of small hydropower potential across the United States, and that reform is warranted.

This wouldn’t be the first time that regulations have led to perverse environmental outcomes. To prevent these problems in the future, agencies need to take better account of the expected costs and benefits of their rules before finalizing them. For example, recent analysis by myself and my colleague Richard Williams shows that agencies only rarely estimate dollar values for both benefits and costs of their regulations.

Another improvement would be for agencies to consider more flexible approaches when regulating. For example, the Occupational Safety and Health Administration recently proposed a rule to reduce silica exposure for workers. The rule requires businesses to consider gas masks or other personal protection equipment only as a last resort. Other methods of controlling silica dust, like enclosing work areas or using sprays and vacuums, should be considered first. These methods are likely to be more burdensome than asking workers to wear a gas mask. The agency should consider offering more flexibility to businesses and workers if it wants to relieve some unnecessary burden in its proposed rule.

Of course it’s true that markets can fail. But it’s important to remember that governments often fail too. Only an approach that considers both market failure and government failure can illuminate the best course of action when addressing a serious social problem like environmental degradation. Furthermore, until regulators start acting more like the experts we expect them to be, government is likely to fail just as much, if not more often, than markets.

New resource: Mercatus Center’s 2013 State and Local Policy Guide

Are you interested in the practical policy applications of the kinds of research the State and Local Policy Project is producing?

For an accessible and very useful review have a look at the inaugural edition of the Mercatus Center’s 2013 State and Local Policy Guide produced by our Outreach Team.

The guide is divided into six sections outlining how to control spending, fix broken pensions systems, control healthcare cost, streamline government, evaluate regulations, and develop competitive tax policies. Each section gives an overview of our research and makes brief, specific, and practical policy proposals.

If you have any questions, please contact Michael Leland, Associate Director of State Outreach, mleland@mercatus.gmu.edu

Should Illinois be Downgraded? Credit Ratings and Mal-Investment

No one disputes that Illinois’s pension systems are in seriously bad condition with large unfunded obligations. But should this worry Illinois bondholders? New Mercatus research by Marc Joffe of Public Sector Credit Solutions finds that recent downgrades of Illinois’s bonds by credit ratings agencies aren’t merited. He models the default risk of Illinois and Indiana based on a projection of these states’ financial position. These findings are put in the context of the history of state default and the role the credit ratings agencies play in debt markets. The influence of credit ratings agencies in this market is the subject a guest blog post by Marc today at Neighborhood Effects.

Credit Ratings and Mal-Investment

by Marc Joffe

Prices play a crucial role in a market economy because they provide signals to buyers and sellers about the availability and desirability of goods. Because prices coordinate supply and demand, they enabled the market system to triumph over Communism – which lacked a price mechanism.

Interest rates are also prices. They reflect investor willingness to delay consumption and take on risk. If interest rates are manipulated, serious dislocations can occur. As both Horwitz and O’Driscoll have discussed, the Fed’s suppression of interest rates in the early 2000s contributed to the housing bubble, which eventually gave way to a crash and a serious financial crisis.

Even in the absence of Fed policy errors, interest rate mispricing is possible. For example, ahead of the financial crisis, investors assumed that subprime residential mortgage backed securities (RMBS) were less risky than they really were. As a result, subprime mortgage rates did not reflect their underlying risk and thus too many dicey borrowers received home loans. The ill effects included a wave of foreclosures and huge, unexpected losses by pension funds and other institutional investors.

The mis-pricing of subprime credit risk was not the direct result of Federal Reserve or government intervention; instead, it stemmed from investor ignorance. Since humans lack perfect foresight, some degree of investor ignorance is inevitable, but it can be minimized through reliance on expert opinion.

In many markets, buyers rely on expert opinions when making purchase decisions. For example, when choosing a car we might look at Consumer Reports. When choosing stocks, we might read investment newsletters or review reports published by securities firms – hopefully taking into account potential biases in the latter case. When choosing fixed income most large investors rely on credit rating agencies.

The rating agencies assigned what ultimately turned out to be unjustifiably high ratings to subprime RMBS. This error and the fact that investors relied so heavily on credit rating agencies resulted in the overproduction and overconsumption of these toxic securities. Subsequent investigations revealed that the incorrect rating of these instruments resulted from some combination of suboptimal analytical techniques and conflicts of interest.

While this error occurred in market context, the institutional structure of the relevant market was the unintentional consequence of government interventions over a long period of time. Rating agencies first found their way into federal rulemaking in the wake of the Depression. With the inception of the FDIC, regulators decided that expert third party evaluations were needed to ensure that banks were investing depositor funds wisely.

The third party regulators chose were the credit rating agencies. Prior to receiving this federal mandate, and for a few decades thereafter, rating agencies made their money by selling manuals to libraries and institutional investors. The manuals included not only ratings but also large volumes of facts and figures about bond issuers.

After mid-century, the business became tougher with the advent of photocopiers. Eventually, rating agencies realized (perhaps implicitly) that they could monetize their federally granted power by selling ratings to bond issuers.

Rather than revoking their regulatory mandate in the wake of this new business model, federal regulators extended the power of incumbent rating agencies – codifying their opinions into the assessments of the portfolios of non-bank financial institutions.

With the growth in fixed income markets and the inception of structured finance over the last 25 years, rating agencies became much larger and more profitable. Due to their size and due to the fact that their ratings are disseminated for free, rating agencies have been able to limit the role of alternative credit opinion providers. For example, although a few analytical firms market their insights directly to institutional investors, it is hard for these players to get much traction given the widespread availability of credit ratings at no cost.

Even with rating agencies being written out of regulations under Dodd-Frank, market structure is not likely to change quickly. Many parts of the fixed income business display substantial inertia and the sheer size of the incumbent firms will continue to make the environment challenging for new entrants.

Regulatory involvement in the market for fixed income credit analysis has undoubtedly had many unintended consequences, some of which may be hard to ascertain in the absence of unregulated markets abroad. One fairly obvious negative consequence has been the stunting of innovation in the institutional credit analysis field.

Despite the proliferation of computer technology and statistical research methods, credit rating analysis remains firmly rooted in its early 20th century origins. Rather than estimate the probability of a default or the expected loss on a credit instruments, rating agencies still provide their assessments in the form of letter grades that have imprecise definitions and can easily be misinterpreted by market participants.

Starting with the pioneering work of Beaver and Altman in the 1960s, academic models of corporate bankruptcy risk have become common, but these modeling techniques have had limited impact on rating methodology.

Worse yet, in the area of government bonds, very little academic or applied work has taken place. This is especially unfortunate because government bond ratings frame the fiscal policy debate. In the absence of credible government bond ratings, we have no reliable way of estimating the probability that any government’s revenue and expenditure policies will lead to a socially disruptive default in the future. Further, in the absence of credible research, there is great likelihood that markets inefficiently price government bond risk – sending confusing signals to policymakers and the general public.

Given these concerns, I am pleased that the Mercatus Center has provided me the opportunity to build a model for Illinois state bond credit risk (as well as a reference model for Indiana). This is an effort to apply empirical research and Monte Carlo simulation techniques to the question of how much risk Illinois bondholders actually face.

While readers may not like my conclusion – that Illinois bonds carry very little credit risk – I hope they recognize the benefits of constructing, evaluating and improving credit models for systemically important public sector entities like our largest states. Hopefully, this research will contribute to a discussion about how we can improve credit rating assessments.

 

 

Freedom in the 50 States and Migration

In last month’s publication of Freedom in the 50 StatesWill Ruger and Jason Sorens point to net domestic migration as an indicator that Americans demonstrate their preferences for more libertarian states by where they choose to live. They explain, ”

In each case, the bivariate relationship between freedom and migration is positive. However, it is strongest for fiscal freedom and weakest for personal freedom.”

The authors go on to use regression analysis to control for some of the other variables that likely cause people to move from one state to another:

We also try a regression specification including state cost of living from 2000, as estimated by political scientists William D. Berry, Richard C. Fording and Russell L. Hanson.7 This is an index variable linked to a value of 10 for the national average in 2007, the last date for which a value is available. There is some concern that this variable is endogenous to freedom. For instance, it correlates with the Wharton land-use regulation variable at r = 0.67, implying that strict land-use regulation drives up the cost of living. It also correlates with fiscal freedom at −0.35, perhaps implying that taxation can also drive up cost of living.

Finally, we also try including growth in personal income from 2000 to 2007 from the Bureau of Economic Analysis, adjusted for change in state cost of living from Berry, Fording, and Hanson. This variable is even more clearly endogenous to economic freedom, as well as to migration (more workers means more personal income). Nevertheless, we want to put the hypothesis that freedom attracts people to the strictest reasonable tests.

With this more in-depth analysis, the authors find that the three types of freedom they study — fiscal, regulatory, and personal — are all positively associated with net migration (PDF p. 97). In particular, the relationship between land use regulation and migration strikes me as an interesting one. States with the strictest land use regulations prevent in-migration by disallowing new housing development. According to Census data, New York City grew by about 2-percent between 2000 to 2010, including natural growth and foreign immigration. This is a significant slowdown from the 1990s. While the Big Apple wouldn’t be expected to attract new residents through libertarian policies, it does offer many economic and cultural opportunities that people might value. Ed Glaeser explains that by preventing new development, city- and state-level restrictions have prevented more people from being able to move to New York City:

The high prices that persist in New York City suggest that the demand for city living isn’t falling. Case-Shiller data, which captures the metropolitan area rather than the city, shows that the New York area’s prices have risen by 67 percent since 2000 (32 percent in real terms), more than any metropolitan area in the sample except Los Angeles.

But the combination of economic strength and high prices need not lead to population growth if an area doesn’t build many more units. In that case, high housing demand leads only to higher prices — not more people.

[…]

The Bloomberg administration has worked hard to allow more building, but the recent Census numbers seem to suggest that a combination of slow growth and continuing high prices implies that New York’s barriers to building, such as a complex zoning code and ever more Historic Preservation Districts, are still shutting out families that would like to move to the city.

This is just one city-level example, but New York City demonstrates that locations with the strictest land use regulations are not just discouraging in-migration with policies that limit residents’ freedom, they are also preventing people from moving to their jurisdictions by restricting growth in housing stock.