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Are state lotteries good sources of revenue?

By Olivia Gonzalez and Adam A. Millsap

With all the hype about the Powerball jackpot, we decided to look at the benefits and costs of state lotteries from the taxpayer’s perspective. The excitement around yesterday’s drawing is for good reason, with the jackpot reaching $1.5 billion – the largest thus far. But most taxpayers will never benefit from the actual prize money, with odds of winning as low as one in 292.2 million for the jackpot. So if few people will ever hit it big, there must be other benefits for taxpayers to justify the implementation of lotteries, right?

Of the 43 states that implement lotteries, the majority of lottery revenues – about 58% on average – go to awarding prizes. A relatively small proportion (7%) is used to pay for administration costs, such as salaries of government workers and advertising. The remaining category, and the primary purpose of implementing state lotteries, is revenue for government services. On average, about one third of state lottery revenues is directed to state funds for this purpose. The chart below displays the state-level breakdown of lottery revenue for the most recent year that data are available (2013).

lottery sales breakdown

It is surprising that such a small portion of state lottery sales actually make it to state funds, especially considering how much politicians advertise the benefits of state lotteries. A handful of states direct more than 50% of lottery revenues towards state funds: Rhode Island, Delaware, West Virginia, Oregon, and South Dakota. The other 38 states allocate significantly less with Arkansas and Massachusetts contributing the smallest percentage, only 21%.

Many states direct their lottery revenues towards education programs. The largest lottery system, New York’s, usually directs about 30% of their lottery sales to this area. Similarly, Florida’s lottery system transferred about one third of their funds, totaling $1.50 billion, to their Educational Enhancement Trust Fund (EETF) in 2013.

The data presented here are from 2013, so it will be interesting to see how the recent Powerball jackpot revenues will affect lottery revenues more broadly in the future, especially since the Multi-State Lottery Association reduced the odds of winning in October of 2015 in the hope of boosting revenues. State officials argue that reducing the chances of winning allows the prize to grow larger, which increases the demand for tickets and revenue.

The revenue-generating function of state lotteries makes them implicit taxes. The portion of revenue generated from a state lottery that is not used to operate the lottery is just like tax revenue generated from a regular sales or excise tax. So even if lotteries are effective at raising revenue, are they effective tax policy?

Effective tax policy should take into account the tax’s ability to generate revenue as well as its efficiency, equity, transparency, and collectability. Research shows that state lotteries fall short in most of these categories.

The practice of dedicating portions of tax revenue to specific expenditure categories, also known as earmarking, can be detrimental to state budgets. Research that looks specifically at the earmarking of lottery revenues finds that educational expenditures remain unaffected, and sometimes even decline, following the implementation of a state lottery.

This result is due to how earmarking changes the incentives facing politicians. A 1999 study compares the results of lottery revenues directed specifically to fund education with revenues going to a state’s general fund. Patrick Pierce, one of the co-authors, explains that when funds are earmarked for education they go to the intended program but, “instead of adding to the funds for those programs, legislators factor in the lottery revenue and allocate less government money to the program budgets.”

Earmarking also affects total government expenditures, even though from a theoretical perspective it should have little effect since one source of funding is just as good as another. Nevertheless, many empirical studies find the opposite. Mercatus research corroborates this by demonstrating that earmarking tends to result in an increase in total government spending while having little effect on the program expenditures to which the funds are tied. This raises serious transparency concerns because it obscures increases in total government spending that voters may not want.

Last but not least, about four decades of studies have examined lottery tax equity and the majority of them find that lottery sales disproportionately draw from lower-income groups, making them regressive taxes. This only adds to the aforementioned concerns about the transparency, collectability, and revenue raising capabilities of lottery taxes.

Perhaps the effectiveness of lottery taxes can be best summed up by the authors of a 1993 study who wrote that “lotteries as a source of funding are neither efficient nor equitable substitutes for more traditional tax sources.”

Although at least three people walked away with millions of dollars yesterday, many taxpayers are not getting any benefits from their state’s lottery system.

How effective are HUD programs? No one knows.

The Department of Housing and Urban Development, or HUD, has been in the news lately due to its policy proposal to ban smoking in public housing. HUD usually flys under the radar as far as federal agencies are concerned so many people are probably hearing about if for the first time and are unsure about what it does.

HUD was created as a cabinet-level agency in 1965. From its website, HUD’s mission:

“…is to create strong, sustainable, inclusive communities and quality affordable homes for all.” 

HUD carries out its mission through numerous programs. On the HUD website over 100 programs and sub-programs are listed. Running that many programs is not cheap, and the graph below depicts the outlays for HUD and three other federal agencies for reference purposes from 1965 – 2014 in inflation adjusted dollars. The other agencies are the Dept. of Energy (DOE), the Dept. of Justice (DOJ), and the Environmental Protection Agency (EPA).

HUD outlays graph

HUD was the second largest agency by outlays in 2014 and for many years was consistently as large as the Department of Energy. It was larger than both the DOJ and the EPA over this period, yet those two agencies are much better known than HUD. Google searches for the DOJ, EPA and HUD return 566 million, 58.3 million, and 25.7 million results respectively.

For such a large agency HUD has managed to stay relatively anonymous outside of policy circles. This lack of public scrutiny has contributed to HUD being able to distribute billions of dollars through its numerous programs despite little examination into their effectiveness. To be fair HUD does make a lot of reports about their programs available, but these reports are often just stories about how much money was spent and what it was spent on rather than evaluations of a program’s effectiveness.

As an example, in 2009 the Partnership for Sustainable Communities program was started. It is an interagency program run by HUD, the EPA, and the Dept. of Transportation. The website for the program provides a collection of case studies about the various projects the program has supported. The case studies for the Euclid corridor project in Cleveland, the South Lake Union neighborhood in Seattle, and the Central Corridor Light Rail project in Minneapolis are basically descriptions of the projects themselves and all of the federal and state money that was spent. The others contain similar content. Other than a few anecdotal data points the evidence for the success of the projects consists of quotes and assertions. In the summary of the Seattle project, for example, the last line is “Indeed, reflecting on early skepticism about the city’s initial investments in SLU, in 2011 a prominent local journalist concluded, “It’s hard not to revisit those debates…and acknowledge that the investment has paid off”. Yet there is no benchmarking in the report that can be used to compare the area before and after redevelopment along any metric of interest such as employment, median wage, resident satisfaction, tax revenue, etc.

The lack of rigorous program analysis is not unique to the Sustainable Communities program. The Community Development Block Grant Program (CDBG) is probably the best known HUD program. It distributes grants to municipalities and states that can be used on a variety of projects that benefit low and moderate income households. The program was started in 1975 yet relatively few studies have been done to measure its efficacy. The lack of informative evaluation of CDBG projects has even been recognized by HUD officials. Raphael Bostic, the Assistant Secretary of the Office of Policy Development and Research for HUD from 2009 – 2012, has stated “For a program with the longevity of the CDBG, remarkably few evaluations have been conducted, so relatively little is known about what works” (Bostic, 2014). Other government entities have also taken notice. During the Bush administration (2001 – 08) the Office of Management and Budget created the Program Assessment Rating Tool (PART). Several HUD programs were rated as “ineffective” – including CDBG – or “moderately effective”. The assessments noted that “CDBG is unable to demonstrate its effectiveness” in developing viable urban communities and that the program’s performance measures “have a weak connection to the program purpose and do not focus on outcomes”.

Two related reasons for the limited evaluation of CDBG and other HUD programs are the lack of data and the high cost of obtaining what data are available. For example, Brooks and Sinitsyn (2014) had to submit a Freedom of Information Act request to obtain the data necessary for their study. Furthermore, after obtaining the data, significant time and effort were needed to manipulate the data into a usable format since they “…received data in multiple different tables that required linking with little documentation” (p. 154).

HUD has significant effects on state and local policy even though it largely works behind the scenes. Regional economic and transportation plans are frequently funded by HUD grants and municipal planning agencies allocate scarce resources to the pursuit of additional grants that can be used for a variety of purposes. For those that win a grant the amount of the grant likely exceeds the cost of obtaining it. For the others, however, the resources spent pursuing the grant are largely wasted since they could have been used to advance the agency’s core mission. The larger the grant the more applicants there will be which will lead to greater amounts of resources being diverted from core activities to pursuing grants. Pursuing government grants is an example of rent-seeking and wastes resources.

Like other federal agencies, HUD needs to do a better job of evaluating its abundant programs. Or better yet, it needs to make more data available to the public so that individual researchers can conduct and duplicate studies that measure the net benefits of its programs. Currently much of the data that are available are usually only weakly related to the relevant outcomes and often are outdated or missing.

HUD also needs to specify what results it expects from the various grants it awards. Effective program evaluation starts with specifying measurable goals for each program. Without this first step there is no way to tell if a program is succeeding. Many of the goals of HUD programs are broad qualitative statements like “enhance economic competitiveness” which are difficult to measure. This allows grant recipients and HUD to declare every program a success since ex post they can use whatever measure best matches their desired result. Implementing measurable goals for all of its programs would help HUD identify ineffective programs and allow it to allocate more scarce resources to the programs that are working.

Berkeley, CA and the $15 – oops – $19 living wage

Berkeley, CA’s labor commission – in what should be an unsurprising move at this point in Berkeley’s history – has proposed raising the city’s minimum wage to an astounding $19 per hour by 2020! The labor commission’s argument in a nutshell is that Berkeley is an expensive place to live so worker’s need more money. And while Berkeley may be an expensive place to live, mandating that employers pay a certain wage doesn’t necessarily mean that the workers will get that money. As one Berkeley restaurant owner noted:

“We can raise our prices. But you can’t charge $25 for a sandwich,” said Dorothee Mitrani, who owns La Note. “A lot of mom-and-pop delis and cafes may disappear.”

The article states that Ms. Mitrani’s

…. full-service restaurant now subsidizes her take-out shop, which she said is running in the red as a result of the increases already in place. If the minimum rose to $19, she expects she would have to shut it down.

Of course, there are some politicians – and unfortunately some economists – who insist that raising the minimum wage doesn’t have adverse effects on employment, despite sound theoretical reasoning and empirical evidence to the contrary. My Mercatus center colleague Don Boudreaux has compiled an extensive collection of blog posts at Café Hayek debunking and refuting every pro-minimum wage argument out there, and I encourage interested readers to check them out.

The minimum wage most adversely effects low-skill, inexperienced workers, such as those without a high school degree, below the poverty level, between the ages of 16 – 19, and with some type of disability. So how do the people who fit into those categories currently fare in Berkeley’s labor market?

The table below shows the labor force rate and percentage employed for people 16 and over in each of those categories in the city of Berkeley in 2013 and 2014. The data is from the ACS 1-year survey. (American FactFinder table S2301)

berkely min wage employment 2013-14

As the table shows the labor force rate and the employment rate for each of those categories is already low compared to the overall labor force rate in Berkeley of 67% and employment rate of 62%. From 2013 to 2014 both the labor force rate and the employment rate declined for people without a high school degree, while the employment rate increased in the other categories. Nothing in this table leads me to believe that it would be a good idea to make the workers in these categories more expensive to hire, as it seems it is already difficult for them to find employment and it’s getting more difficult for some.

The table below compares Berkeley to the surrounding San Francisco MSA using only 2014 data.

berkeley min wage emp vs SF MSA

This table reveals that compared to the surrounding area, workers in these categories fare worse in Berkeley. The percentage of people with less than a high school degree who are employed was 11 percentage points lower in Berkeley, while the percentage with a disability was 0.8 points lower and the percentage below the poverty level was 1.5 points lower. Out of the four categories only 16 – 19 year olds had a better chance of being employed in Berkeley than in the surrounding MSA.

Hopefully Berkeley’s city council reviews the labor market reality in their city and thinks about actual consequences vs. intentions before deciding to increase the price that low-skill workers are allowed to charge for their labor. It’s already difficult for low-skill, inexperienced workers to find a job in Berkeley and making it harder won’t help them.

The cost disease and the privatization of government services

Many US municipalities are facing budget problems (see here, here, and here). The real cost of providing traditional public services like police, fire protection, and education is increasing, often at a rate that exceeds revenue growth. The graph below shows the real per-capita expenditure increase in five US cities from 1951 to 2006. (Data are from the census file IndFin_1967-2012.zip and are adjusted for inflation using the US GDP chained price index.)

real per cap spend

In 1951 none of the cities were spending more than $1,000 per person. In 2006 every city was spending well over that amount, with Buffalo spending almost $5,000 per person. Even Fresno, which had the smallest increase, increased per capita spending from $480 to $1,461 – an increase of 204%. Expenditure growth that exceeds revenue growth leads to budget deficits and can eventually result in cuts in services. Economist William Baumol attributes city spending growth to what is known as the “cost disease”.

In his 1967 paper, Baumol argues that municipalities will face rising costs of providing “public” goods and services over time as the relative productivity of labor declines in the industries controlled by local governments versus those of the private sector. As labor in the private sector becomes more productive over time due to increases in capital, wages will increase. Goods and services traditionally supplied by local governments such as police, fire protection, and education have not experienced similar increases in capital or productivity. K-12 education is a particularly good example of stagnation – a teacher from the 1950s would not confront much of a learning curve if they had to teach in a 21st century classroom. However, in order to attract competent and productive teachers, for example, local governments must increase wages to levels that are competitive with the wages that teachers could earn in the private sector. When this occurs, teacher’s wages increase even though their productivity does not. As a result, cities end up paying more money for the same amount of work. Baumol sums up the effect:

“The bulk of municipal services is, in fact, of this general stamp [non-progressive] and our model tells us clearly what can be expected as a result…inexorably and cumulatively, whether or not there is inflation, administrative mismanagement or malfeasance, municipal budgets will almost certainly continue to mount in the future, just as they have been doing in the past. This is a trend for which no man and no group should be blamed, for there is nothing than can be done to stop it.” (Baumol, 1967 p.423)

But is there really nothing than can be done to cure the cost disease? Baumol himself later acknowledged that innovation may yet occur in the relatively stagnant sectors of the economy such as education:

“…an activity which is, say, relatively stagnant need not stay so forever. It may be replaced by a more progressive substitute, or it may undergo an outburst of innovation previous thought very unlikely.” (Baumol et al. 1985, p.807).

The cure for the cost disease is that the stagnant, increasing-cost sectors need to undergo “an outburst of innovation”. But this raises the question; what has prevented this innovation from occurring thus far?

One thing that Baumol’s story ignores is public choice. Specifically, is the lack of labor-augmenting technology in the public-sector industries a characteristic of the public sector? The primary public sector industries have high rates of unionization and the primary goal of a labor union is to protect its dues-paying members. The chart below provides the union affiliation of workers for several occupations in 2013 and 2014.

union membership chart

In 2014, the protective service occupations and education, training, and library occupations, e.g. police officers and teachers, had relatively high union membership rates of 35%. Conversely, other high-skilled occupations such as management, computer and mathematical occupations, architecture and engineering occupations, and sales and office occupations had relatively low rates, ranging from 4.2% to 6.5% in 2014. Installation, maintenance, and repair occupations were in the middle at 14.6%, down from 16.1% in 2013.

The bottom part of the table shows the union membership rate of the public sector in general and of each level of government: federal, state, and local. The highest rate of unionization was at the local level, where approximately 42% of workers were members of a union in 2014, up from 41% in 2013. This is about 14 percentage points higher than the federal level and 12 percentage points higher than the state level. The union membership rate of the private sector in 2014 was only 6.6%.

In addition to the apathetic and sometimes hostile view unions have towards technological advancement and competition, union membership is also associated with higher wages, particularly at the local-government level. Economists Maury Gittleman and Brooks Piece of the Bureau of Labor statistics found that local-government workers have compensation costs 10 – 19% larger than similar private sector workers.

The table below shows the median weekly earnings in 2013 and 2014 for workers in the two most heavily unionized occupational categories; education, training, and library occupations and protective service occupations. In both occupation groups there is a substantial difference between the union and non-union weekly earnings. From the taxpayer’s perspective, higher earnings mean higher costs.

union median wage chart

There needs to be an incentive to expend resources in labor-saving technology for it to occur and it is not clear that this incentive exists in the public sector. In the public sector, taxpayers ultimately pay for the services they receive but these services are provided by an agent – the local politician(s) – who is expected to act on the taxpayer’s behalf when it comes to spending tax dollars. But in the public sector the agent/politician is accountable to both his employees and the general taxpayer since both groups vote on his performance. The general taxpayer wants the politician to cut costs and invest in labor-augmenting technology while the public-employee taxpayer wants to keep his job and earn more income. Since the public-employee unions are well organized compared to the general taxpayers it is easier for them to lobby their politicians/bosses in order to get their desired outcome, which ultimately means higher costs for the general taxpayer.

If Baumol’s cost disease is the primary factor responsible for the increasing cost of municipal government then there is not an easy remedy in the current environment. If the policing, firefighting, and education industries are unreceptive to labor-augmenting technology due to their high levels of unionization and near-monopoly status, one potential way to cure municipalities of the cost disease is privatization. In their 1996 paper, The Cost Disease and Government Growth: Qualifications to Baumol, economists J. Ferris and Edwin West state “Privatization could lead to significant changes in the structure of supply that result in “genuine” reductions in real costs” (p. 48).

Schools, police, and fire services are not true public goods and thus economic efficiency does not dictate that they are provided by a government entity. Schools in particular have been successfully built and operated by private funds for thousands of years. While there are fewer modern examples of privately operated police and fire departments, in theory both could be successfully privatized and historically fire departments were, though not always with great success. However, the failures of past private fire departments in places like New York City in the 19th century appear to be largely due to political corruption, an increase in political patronage, poorly designed incentives, and the failure of the rule of law rather than an inherent flaw in privatization. And today, many volunteer fire departments still exist. In 2013 69% of all firefighters were volunteers and 66% of all fire departments were all-volunteer.

The near-monopoly status of government provided education in many places and the actual monopoly of government provided police and fire protection makes these industries less susceptible to innovation. The government providers face little to no competition from private-sector alternatives, they are highly unionized and thus have little incentive to invest in labor-saving technology, and the importance of their output along with the aforementioned lack of competition allows them to pass cost increases on to taxpayers.

Market competition, limited union membership, and the profit-incentive are features of the private sector that are lacking in the public sector. Together these features encourage the use of labor-augmenting technology, which ultimately lowers costs and frees up resources, most notably labor, that can then be used on producing other goods and services. The higher productivity and lower costs that result from investments in productive capital also free up consumer dollars that can then be used to purchase additional goods and services from other industries.

Privatization of basic city services may be a little unnerving to some people, but ultimately it may be the only way to significantly bring down costs without cutting services. There are over 19,000 municipal governments in the US, which means there are over 19,000 groups of citizens that are capable of looking for new and innovative ways to provide the goods and services they rely on. In the private sector entrepreneurs continue to invent new things and find ways to make old things better and cheaper. I believe that if we allow entrepreneurs to apply their creativity to the public sector we will get similar outcomes.

State government spending hits new heights

There is a large literature in macroeconomics that examines the extent to which federal spending “crowds out” investment in the private sector. Basic theory and common sense lead to the conclusion that government spending must replace some private sector spending. After all, dollars are scarce – if the government taxes Paul and uses his money to build a road Paul necessarily has less money to invest in his landscaping business. In theory government spending on public goods like roads could be a net gain. This would occur if the additional value produced by spending one more dollar on roads was greater than the additional value produced by investing one more dollar in Paul’s landscaping business. But even in this scenario, Paul himself may be worse off – he’s one dollar poorer and he may not use the new road – and there is still a dead-weight loss due to the tax.

In reality, the federal government does a lot more than build roads, especially productive ones. In 2014, only 1.9% of federal income tax revenue was spent on transportation. And most of the other stuff that the government does is way less productive, like shuffling money around via entitlement programs – Medicare, Medicaid, and Social Security – and investing in businesses that later go bankrupt like Solyndra. So while it is possible that a dollar spent by the government is more productive than a dollar spent by a guy like Paul, in a country with America’s spending habits it’s unlikely to be the case.

The same crowding out that occurs at the federal level can occur at the state level. In fact, in many states state spending as a percentage of gross state product (GSP) exceeds federal spending as a percentage of GDP. The graph below shows state spending as a percentage of GSP for all 50 states and Washington D.C. in 1970, 1990, and 2012 (data). The red, dashed line is federal spending as a percentage of GDP in 2012 (21.9%).

state spending gsp graph

As shown in the graph, nearly every state increased their spending relative to GSP from 1970 – 2012 (triangles are above the X’s). Only one state, South Dakota, had lower spending relative to GSP in 2012 than in 1970. In 2012, 15 of the 50 states spent more as a percentage of GSP than the federal government spent as a percentage of GDP (states where the triangle is above the red, dashed line). In 1990 only two states, Arizona and Montana, spent at that level.

It used to be the case that state and local spending was primarily focused on classic government services like roads, water/sewer systems, police officers, firemen, and K-12 education. But state spending is increasingly looking similar to federal spending. Redistributive public welfare expenditures and pension expenditures have increased substantially since 1992. As an example, the tables below provide a breakdown of some key spending areas for two states, Ohio and Pennsylvania, in 1992 and 2012 (1992 data here, 2012 data here). The dollar per capita amounts are adjusted for inflation and are in 2009 dollars.

ohio spending table

penn spending table

As the tables show, spending on public welfare, hospitals, and health increased by 120% in Ohio and 86% in Pennsylvania from 1992 to 2012. Pension expenditures increased by 83% and 125% respectively. And contrary to what many politicians and media types say, funding for higher education – the large majority of state education spending is on higher education – increased dramatically during this time period; up 250% in Ohio and 199% in Pennsylvania. Meanwhile, funding for highways – the classic public good that politicians everywhere insist wouldn’t exist without them – has increased by a much smaller amount in both states.

The state spending increases of the recent past are being driven in large part by public welfare programs that redistribute money, pensions for government employees, and higher education. While one could argue that higher education spending is a productive public investment (Milton Friedman didn’t think so and I agree) it is hard to make a case that public welfare and pension payments are good investments. This alone doesn’t mean that society shouldn’t provide those things. Other factors like equity and economic security might be more important to some people than economic productivity. But this does make it unlikely that the marginal dollar spent by a state government today is as economically productive as that dollar spent in the private sector. Like federal spending, state spending is likely crowding out productive private investment, which will ultimately lower output and economic growth in the long run.

Education, Innovation, and Urban Growth

One of the strongest predictors of urban growth since the start of the 20th century is the skill level of a city’s population. Cities that have a highly skilled population, usually measured as the share of the population with a bachelor’s degree or more, tend to grow faster than similar cities with less educated populations. This is true at both the metropolitan level and the city level. The figure below plots the population growth of 30 large U.S. cities from 1970 – 2013 on the vertical axis and the share of the city’s 25 and over population that had at least a bachelor’s degree in 1967 on the horizontal axis. (The education data for the cities are here. I am using the political city’s population growth and the share of the central city population with a bachelor’s degree or more from the census data linked to above.)

BA, city growth 1

As shown in the figure there is a strong, positive relationship between the two variables: The correlation coefficient is 0.61. It is well known that over the last 50 years cities in warmer areas have been growing while cities in colder areas have been shrinking, but in this sample the cities in warmer areas also tended to have a better educated population in 1967. Many of the cities known today for their highly educated populations, such as Seattle, San Francisco, and Washington D.C., also had highly educated populations in 1967. Colder manufacturing cities such as Detroit, Buffalo, and Newark had less educated workforces in 1967 and subsequently less population growth.

The above figure uses data on both warm and cold cities, but the relationship holds for only cold cities as well. Below is the same graph but only depicts cities that have a January mean temperature below 40°F. Twenty out of the 30 cities fit this criteria.

BA, city growth 2

Again, there is a strong, positive relationship. In fact it is even stronger; the correlation coefficient is 0.68. Most of the cities in the graph lost population from 1970 – 2013, but the cities that did grow, such as Columbus, Seattle, and Denver, all had relatively educated populations in 1967.

There are several reasons why an educated population and urban population growth are correlated. One is that a faster accumulation of skills and human capital spillovers in cities increase wages which attracts workers. Also, the large number of specialized employers located in cities makes it easier for workers, especially high-skill workers, to find employment. Cities are also home to a range of consumption amenities that attract educated people, such as a wide variety of shops, restaurants, museums, and sporting events.

Another reason why an educated workforce may actually cause city growth has to do with its ability to adjust and innovate. On average, educated workers tend to be more innovative and better able to learn new skills. When there is an negative, exogenous shock to an industry, such as the decline of the automobile industry or the steel industry, educated workers can learn new skills and create new industries to replace the old ones. Many of the mid-20th century workers in Detroit and other Midwestern cities decided to forego higher education because good paying factory jobs were plentiful. When manufacturing declined those workers had a difficult time learning new skills. Also, the large firms that dominated the economic landscape, such as Ford, did not support entrepreneurial thinking. This meant that even the educated workers were not prepared to create new businesses.

Local politicians often want to protect local firms in certain industries through favorable treatment and regulation. But often this protection harms newer, innovative firms since they are forced to compete with the older firms on an uneven playing field. Political favoritism fosters a stagnant economy since in the short-run established firms thrive at the expense of newer, more innovative startups. Famous political statements such as “What’s good for General Motors is good for the country” helped mislead workers into thinking that government was willing and able to protect their employers. But governments at all levels were unable to stop the economic forces that battered U.S. manufacturing.

To thrive in the 21st century local politicians need to foster economic environments that encourage innovation and ingenuity. The successful cities of the future will be those that are best able to innovate and to adapt in an increasingly complex world. History has shown us that an educated and entrepreneurial workforce is capable of overcoming economic challenges, but to do this people need to be free to innovate and create. Stringent land-use regulations, overly-burdensome occupational licensing, certificate-of-need laws, and other unnecessary regulations create barriers to innovation and make it more difficult for entrepreneurs to create the firms and industries of the future.

Grants to Puerto Rico haven’t helped much

Greece’s monetary and fiscal issues have overshadowed a similar situation right in America’s own back yard: Puerto Rico. Puerto Rico’s governor recently called the commonwealth’s $72 billion in debt “unpayable” and this has made Puerto Rico’s bondholders more nervous than they already were. Puerto Rico’s bonds were previously downgraded to junk by the credit rating agencies and there is a lot of uncertainty surrounding Puerto Rico’s ability to honor its obligations to both bond holders and its own workers, as the commonwealth’s pension system is drastically underfunded.   A major default would likely impact residents of the mainland U.S., since according to Morningstar most of the debt is owned by U.S. mutual funds, hedge funds, and mainland Americans.

So how did Puerto Rico get into this situation? Like many other places, including Greece and several U.S. cities, the government of Puerto Rico routinely spent more than it collected in revenue and then borrowed to fill the gap as shown in the graph below from Puerto Rico’s Office of Management and Budget. Over a recent 13 year period (2000 – 2012) Puerto Rico ran a deficit each year and accrued $23 billion in debt.

Puerto rico govt spending

Puerto Rico has a lot in common with many struggling cities in the U.S. that followed a similar fiscal path, such as a high unemployment rate of 12.4%, a shrinking labor force, stagnant or declining median household income, population flight, and falling house prices. Only 46.1% of the population 16 and over was in the labor force in 2012 (compared to an average of nearly 64% in the US in 2012) and the population declined by 4.8% from 2010 to 2014. It is difficult to raise enough revenue to fund basic government services when less than half the population is employed and the most able-bodied workers are leaving the country.

Like other U.S. cities and states, Puerto Rico receives intergovernmental grants from the federal government. As I have explained before, these grants reduce the incentives for a local government to get its fiscal house in order and misallocate resources from relatively responsible, growing areas to less responsible, shrinking areas. As an example, since 1975 Puerto Rico has received nearly $2.7 billion in Community Development Block Grants (CDBG). San Juan, the capital of Puerto Rico, has received over $900 million. The graph below shows the total amount of CDBGs awarded to the major cities of Puerto Rico from 1975 – 2014.

Total CDBGs Puerto Rico

As shown in the graph San Juan has received the bulk of the grant dollars. The graph below shows the amount by year for various years between 1980 and 2014 for San Juan and Puerto Rico as a whole plotted on the left vertical axis (bar graphs). On the right vertical axis is the amount of CDBG dollars per capita (line graphs). San Juan is in orange and Puerto Rico is in blue.

CDBGs per capita, yr Puerto Rico

San Juan has consistently received more dollars per capita than the other areas of Puerto Rico. Both total dollars and dollars per capita have been declining since 1980, which is when the CDBG program was near its peak funding level. As part of the 2009 Recovery Act, San Juan received an additional $2.8 million dollars and Puerto Rico as a country received another $5.9 million on top of the $32 million already provided by the program (not shown on the graph).

It’s hard to look at all of this redistribution and not consider whether it did any good. After all, $2.7 billion later Puerto Rico’s economy is struggling and their fiscal situation looks grim. Grant dollars from programs like the CDBG program consistently fail to make a lasting impact on the recipient’s economy. There are structural problems holding Puerto Rico’s economy back, such as the Jones Act, which increases the costs of goods on the island by restricting intra-U.S.-shipping to U.S. ships, and the enforcement of the U.S. minimum wage, which is a significant cost to employers in a place where the median wage is much lower than on the mainland. Intergovernmental grants and transfers do nothing to solve these underlying structural problems. But despite this reality, millions of dollars are spent every year with no lasting benefit.

More reasons why intergovernmental grants are harmful

In a recent blog post I explained how intergovernmental grants subsidize some businesses at the expense of others. But that is just one of several negative features of intergovernmental grants. They also make local governments less accountable for their fiscal decisions by allowing them to increase spending without increasing taxes. The Community Development Blog Grant (CDBG) money that local governments spend on city services or use to subsidize private businesses is provided by taxpayers from all over the country. Unlike locally raised money, when cities spend CDBG money they don’t have to first convince local voters to provide them with the funds. This lack of accountability often results in wasteful spending.

These grants also erode fiscal competition between cities and reduce the incentive to pursue policies that create economic growth. If local governments can receive funds for projects meant to bolster their tax base regardless of their fiscal policies, they have less of an incentive to create a fiscal environment that is conducive to economic growth. The feedback loop between growth promoting policies and actual economic growth is impaired when revenue can be generated independently of such policies e.g. by successfully applying for intergovernmental grants.

Some of the largest recipients of CDBG money are cities that have been declining since the 1950s. The graph below shows the total amount of CDBG dollars given to nine cities that were in the top 15 of the largest cities in the US by population in 1950. (Click on graphs to enlarge. Data used in the graphs are here.)

CDBGs 9 cities 1950

None of these cities were in the top 15 cities in 2014 and most of them have lost a substantial amount of people since 1950. In Detroit, Cleveland, St. Louis, and Buffalo the CDBG money has not reversed or even slowed their decline and yet the federal government continues to give these cities millions of dollars each year. The purpose of these grants is to create sustainable economic development in the recipient cities but it is difficult to argue that such development has occurred.

Contrast the amount of money given to the cities above with that of the cities below:

CDBGs 9 cities 2014

By 2014 the nine cities in the second graph had replaced the other cities in the top 15 largest US cities by population. Out of the nine cities in the second graph only one, San Antonio, has received $1 billion or more in CDBG funds. In comparison, every city in the first graph has received at least that much.

While there are a lot of factors that contribute to the decline of some cities and the rise of others (such as the general movement of the population towards warmer weather), these graphs are evidence that the CDBG program is incapable of saving Detroit, Buffalo, St. Louis, Cleveland, etc. from population and economic decline. Detroit alone has received nearly $3 billion in CDBG grants over the last 40 years yet still had to declare bankruptcy in 2013. St. Louis, Cleveland, Baltimore, Buffalo, and Milwaukee are other examples of cities that have received a relatively large amount of CDBG funding yet are still struggling with population decline and budget issues. Place-based, redistributive policies like the CDBG program misallocate resources from growing cities to declining cities and reduce the incentive for local governments to implement policies that encourage economic growth.

Moreover, if place-based subsidies, such as the CDBG program, do create some temporary local economic growth, there is evidence that this growth is merely shifted from other areas. In a study on the Tennessee Valley Authority, perhaps the most ambitious place-based program in the country’s history, economists Patrick Kline and Enrico Moretti (2014) found that the economic gains that accrued to the area covered by the TVA were completely offset by losses in other parts of the country. As they state, “Thus, we estimate that the spillovers in the TVA region were fully offset by the losses in the rest of the country…Notably, this finding casts doubt on the traditional big push rationale for spatially progressive subsidies.” This study is further evidence for what other economists have been saying for a long time: Subsidized economic growth in one area, if it occurs, comes at the expense of growth in other areas and does not grow the US economy as a whole.

Intergovernmental grant to gelato maker distorts market competition

Intergovernmental grants are grants that are given to one level of government by another e.g. federal to state/local or state to local. In addition to being used on public works and services they also subsidize the development of private goods. The Community Development Block Grant Program (CDBG) is a federally funded grant program that distributes grants and subsidized loans to local and state governments which then use them or award them to other businesses and non-profits. The grants can be used on a variety of projects. Since 1975 the CDBG program has given over $143 billion ($215 billion adjusted for inflation) to state and local governments. The graph below (click to enlarge) shows the total dollars by year adjusted for inflation (2009 dollars) and the number of entitlement grantees by year. While the total amount of funding has declined over time, it was still $2.8 billion in 2014.

cdbg dollars, grantees

Intergovernmental grant programs like CDBG are based on the incorrect idea that moving money around produces economic development and creates a net-positive amount of jobs. But only productive entrepreneurs who create value for consumers can create jobs. The CDBG program and others like it distort the entrepreneurial process and within-industry competition by giving an artificial advantage to the companies that receive grants. This results in more workers and capital flowing into the grant-receiving business rather than their unsubsidized competitors. For example, Brunswick, ME is giving a $350,000 CDBG to Gelato Fiasco to help the company buy new equipment. Meanwhile, nearby competitors Bohemian Coffeehouse, Little Dog Coffee Shop, and Dairy Queen are not receiving any grant money. Governments at all levels, such as Brunswick’s, should not pick winners and losers via a grant process that ultimately favors some constituents over others.

Some other projects that the CDBG program has helped fund are: a soybean processing plant in Arkansas, a new facility for a farmer’s market in Oregon, solar panels for houses in San Diego, and waterfront housing in Burlington, VT. Like the Gelato Fiasco example, these are all examples of private goods, not public, and the production of such goods is best left to the market. If private investors who are subject to market forces are unwilling to produce a private good then it is probably not a worthwhile venture, as the lack of private investment implies that the expected cost exceeds the expected revenue. Private investors and entrepreneurs want to make a profit and the profit incentive promotes wise investments. Governments don’t confront the same profit incentive and this often leads to wasteful spending.

At its best, a government can create the conditions that encourage economic development and job creation: the enforcement of private property rights, a court system to adjudicate disputes, a police force to maintain law and order, and perhaps some basic infrastructure. The scope of a local government should be limited to these tasks.

Local land-use restrictions harm everyone

In a recent NBER working paper, authors Enrico Moretti and Chang-Tai Hsieh analyze how the growth of cities determines the growth of nations. They use data on 220 MSAs from 1964 – 2009 to estimate the contribution of each city to US national GDP growth. They compare what they call the accounting estimate to the model-driven estimate. The accounting estimate is the simple way of attributing city nominal GDP growth to national GDP growth in that it doesn’t account for whether the increase in city GDP is due to higher nominal wages or increased output caused by an increase in local employment. The model-driven estimate that they compare it to distinguishes between these two factors.

Before I go any further it is important to explain the theory behind the author’s empirical findings. Suppose there is a productivity shock to City A such that workers in City A are more productive than they were previously. This productivity shock could be the result of a new method of production or a newly invented piece of equipment (capital) that helps workers make more stuff with a given amount of labor. This productivity shock will increase the local demand for labor which will increase the wage.

Now one of two things can happen and the diagram below depicts the two scenarios. The supply and demand lines are those for workers, with the wage on the Y-axis and the amount of workers on the X-axis. Since more workers lead to more output I also labeled labor as L = αY, where α is some fraction less than 1 to signify that each additional unit of labor doesn’t lead to a one unit increase in output, but rather some fraction of 1 unit (capital is needed too).

moretti, land use pic

City A can have a highly elastic supply of housing, meaning that it is easy to expand the number of housing units in that city and thus it is relatively easy for people to move there. This would mean that the supply of labor is like S-elastic in the diagram. Thus the number of workers that are able to migrate to City A after labor demand increases (D1 to D2) is large, local employment increases (Le > L*), and total output (GDP) increases. Wages only increase a little bit (We > W*). In this situation the productivity shock would have a relatively large effect on national GDP since it resulted in a large increase in local output as workers moved from relatively low-productivity cities to the relatively high-productivity City A.

Alternatively, the supply of housing in City A could be very inelastic; this would be like S-inelastic. If that is the case, then the productivity shock would still increase the wage in City A (Wi > W*), but it will be more difficult for new workers to move in since new housing cannot be built to shelter them. In this case wages increase but since total local employment stays fairly constant due to the restriction on available housing the increase in output is not as large (Li > L* but < Le). If City A output stays relatively constant and instead the productivity shock is expressed in higher nominal wages, then the resulting growth in City A nominal GDP will not have as large of an effect on national output growth.

As an example, Moretti and Hsieh calculate that the growth of New York City’s GDP was 12% of national GDP growth from 1964-2009. But when accounting for the change in wages, New York’s contribution to national output growth was only 5%: Most of New York’s GDP growth was manifested in higher nominal wages. This is not surprising as it is well known that New York has strict housing regulations that make it difficult to build new housing units (the recent extension of NYC rent-control laws won’t help). This makes it difficult for people to relocate from relatively low-productivity places to a high-productivity New York.

In three of the most intensely land-regulated cities: New York, San Francisco, and San Jose, the accounting contribution to national GDP growth was 19.3%. But these cities actual contribution to national output as estimated by the authors was only 6.1%. Contrast that with the Rust Belt cities (e.g. Detroit, Pittsburgh, Cleveland, etc.) which contributed -28.5% according to the accounting method but +6.1% according to the author’s model.

The authors conclude that less onerous land-use restrictions in high-productivity cities New York, Washington D.C., Boston, San Francisco, San Jose, and the rest of Silicon Valley could increase the nation’s output growth rate by making it easier for workers to migrate from low to high-productivity areas. In an extreme migration scenario where 52% of American workers in 2009 lived in a different city than they actually did, the author’s calculate that GDP per worker would have been $8,775 higher in 2009, or $6,345 per person. In a more realistic scenario (only 20% of workers lived in a different city) it would have been $3,055 more per person: That is a substantial increase.

While I agree with the author’s conclusion that less land-use restrictions would result in a more productive allocation of labor and thus more stuff for all of us, the author’s policy prescriptions at the end of the paper leave much to be desired.  They propose that the federal government constrain the ability of municipalities to set land-use restrictions since these restrictions impose negative externalities on the rest of the country if the form of lowering national output growth. They also support the use of government funded high-speed rail to link  low-productivity labor markets to high-productivity labor markets e.g. the current high-speed rail construction project taking place in California could help workers get form low productivity areas like Stockton, Fresno, and Modesto, to high productivity areas in Silicon Valley.

Land-use restrictions are a problem in many areas, but not a problem that warrants arbitrary federal involvement. If federal involvement simply meant the Supreme Court ruling that land-use regulations (or at least most of them) are unconstitutional then I think that would be beneficial; a broad removal of land-use restrictions would go a long way towards reinstituting the institution of private property. Unfortunately, I don’t think that is what Moretti and Hsieh had in mind.

Arbitrary federal involvement in striking down local land-use regulations would further infringe on federalism and create opportunities for political cronyism. Whatever federal bureaucracy was put in charge of monitoring land-use restrictions would have little local knowledge of the situation. The Environmental Protection Agency (EPA) already monitors some local land use and faulty information along with an expensive appeals process creates problems for residents simply trying to use their own property. Creating a whole federal bureaucracy tasked with picking and choosing which land-use restrictions are acceptable and which aren’t would no doubt lead to more of these types of situations as well as increase the opportunities for regulatory activism. Also, federal land-use regulators may target certain areas that have governors or mayors who don’t agree with them on other issues.

As for more public transportation spending, I think the record speaks for itself – see here, here, and here.