Tag Archives: state governments

The unseen costs of Amazon’s HQ2 Site Selection

Earlier this year Amazon narrowed down the list of potential cities to site its second headquarters. Applicants are now waiting out the selection process. It’s unclear when Amazon will make its choice, but that hasn’t stopped many from speculating who the likely contenders are. Varying sources report Atlanta, Boston, and Washington D.C. at the top of the list. The cities that didn’t make the cut are no doubt envious of the finalists, having just missed out on the potential for a $5 billion facility and 50,000 jobs. The second HQ is supposed to be as significant for economic growth as the company’s first site, which according to Amazon’s calculations contributed an additional $38 billion to Seattle’s economy between 2010 and 2016. There is clearly a lot to be gained by the winner.  But there are also many costs. Whichever city ends up winning the bid will be changed forever. What’s left out of the discussion is how the bidding process and corporate incentives affect the country.

Although the details of the proposals are not made public, each finalist is likely offering some combination of tax breaks, subsidies, and other incentives in return for the company’s choice to locate in their city. The very bidding process necessitates a lot of time and effort by many parties. It will certainly seem “worth it” to the winning party, but the losers aren’t getting back the time and effort they spent.

This practice of offering incentives for businesses has been employed by states and localities for decades, with increased usage over time. Targeted economic development incentives can take the form of tax exemptions, abatements, regulatory relief, and taxpayer assistance. They are but one explicit cost paid by states and cities looking to secure business, and there is a growing literature that suggests these policies are more costly than meets the eye.

First, there’s the issue of economic freedom. Recent Mercatus research suggests that there may be a tradeoff to offering economic development incentives like the ones that Amazon is receiving. Economists John Dove and Daniel Sutter find that states that spend more on targeted development incentives as a percentage of gross state product also have less overall economic freedom. The theoretical reasoning behind this is not very clear, but Dove and Sutter propose that it could be because state governments that use more subsidies or tax breaks to attract businesses will also spend more or raise taxes for everyone else in their state, resulting in less equitable treatment of their citizens and reducing overall economic freedom.

The authors define an area as having more economic freedom if it has lower levels of government spending, taxation, and labor market restrictions. They use the Fraser Institute’s Economic Freedom of North America Index (EFNA) to measure this. Of the three areas within the EFNA index, labor market freedom is the most affected by targeted economic development incentives. This means that labor market regulation such as the minimum wage, government employment, and union density are all significantly related to the use of targeted incentives.

Economic freedom can be ambiguous, however, and it’s sometimes hard to really grasp its impact on our lives. It sounds nice in theory, but because of its vagueness, it may not seem as appealing as a tangible economic development incentive package and the corresponding business attached to it. Economic freedom is associated with a series of other, more tangible benefits, including higher levels of income and faster economic growth. There’s also evidence that greater economic freedom is associated with urban development.

Not only is the practice of offering targeted incentives associated with lower economic freedom, but it is also indicative of other issues. Economists Peter Calcagno and Frank Hefner have found that states with budget issues, high tax and regulatory burdens, and poorly trained labor forces are also more likely to offer targeted incentives as a way to offset costly economic conditions. Or, in other words, targeted development incentives can be – and often are – used to compensate for a less than ideal business climate. Rather than reform preexisting fiscal or regulatory issues within a state, the status quo and the use of targeted incentives is the more politically feasible option.

Perhaps the most concerning aspect of Amazon’s bidding process is the effect it has on our culture. Ideally, economic development policy should be determined by healthy economic competition between states. In practice, it has evolved into more of an unhealthy interaction between private interests and political favor. Economists Joshua Jansa and Virginia Gray refer to this as cultural capture. They find increases in business political contributions to be positively correlated with state subsidy spending. Additionally, they express concern over the types of firms that these subsidies attract. There is a selection bias for targeted incentives to systematically favor “flighty firms” or firms that will simply relocate if better subsidies are offered by another state, or potentially threaten to leave in an effort to extract more subsidies.

None of these concerns even address the question of whether targeted incentives actually achieve their intended goals.  The evidence does not look good. In a review of the literature by my colleague Matthew Mitchell, and me, we found that of the studies that evaluate the effect of targeted incentives on the broader economy, only one study found a positive effect, whereas four studies found unanimously negative effects. Thirteen studies (half of the sample) found no statistically significant effect, and the remaining papers found mixed results in which some companies or industries won, but at the expense of others.

In addition to these unseen costs on the economy, some critics are beginning to question whether being chosen by Amazon is even worth it. Amazon’s first headquarters has been considered a catalyst for the city’s tech industry, but local government and business leaders have raised concerns about other possibly related issues such as gentrification, rising housing prices, and persistent construction and traffic congestion. There is less research on this, but it is worth considering.

It is up to each city’s policymakers to decide whether these trade-offs are worth it. I would argue, however, that much of the evidence points to targeted incentives – like the ones that cities are using to attract Amazon’s business – as having more costs than benefits. Targeted economic development incentives may seem to offer a lot of tangible benefits, but their unseen costs should not be overlooked. From the perspective of how they benefit each state’s economy as a whole, targeted incentives are detrimental to economic freedom as well as our culture surrounding corporate handouts. Last but not least, they may often be an attempt to cover up other issues that are unattractive to businesses.

State tax refunds and limiting spending growth

This fall eligible Alaskans will be receiving a check of $1,100 from their state government. Although the amount of the check can vary, Alaskans receive one every fall – no strings attached. Other state residents are probably more familiar with IRS tax refunds that come every spring, but this “tax refund” that Alaskans receive is unique. It’s a feature that residents have benefited from for decades, even in times when the government has experienced fiscal stress. Considering the state’s unique and distressed budget situation that I’ve described in an earlier post, I think it warrants a discussion of the fiscal viability of their refunds.

A narrow tax base reliant on volatile revenue sources, restricted funds, and growing spending are all factors that made closing Alaska’s budget gap this year very difficult. It even contributed to pulling down Alaska from 1st in our 2016 ranking of states by fiscal condition to 17th in our 2017 edition. Given this deterioration, it will be helpful to look into how and why Alaska residents receive dividend payments each year. There is no public finance rule that says giving refunds to residents is fiscally irresponsible, but there definitely are better ways to do it, and Alaska certainly hasn’t proven to display best practices.

Another state that we can look at for comparison is Colorado, which has a similar “tax refund” for residents but is structured very differently. Colorado’s Taxpayer Bill of Rights (TABOR) requires that higher than expected tax revenues each year be refunded to taxpayers and acts as a restraint on government spending growth. In contrast, Alaska’s check comes from the state’s Permanent Fund’s earnings that are generated from oil severance taxes each year, and acts more like a dividend from oil investment earnings.

Are distributing these refunds to taxpayers fiscally responsible? I am going to take a deeper look at these mechanisms to find out.

First, Alaska’s refund.

The figure below displays Alaska’s Permanent Fund checks since 2002 overlaid with the state’s revenue and expenditure trends, all adjusted for inflation. The highest check (in 2015 dollars) was $2,279 in 2008 and the lowest was $906 in 2012, with the average over this time period being about $1,497 per person. Although the check amounts do vary, Alaska has kept on top of delivering them, even in times of steep budget gaps like in 2002, 2009, and 2015. The Permanent Fund dividend formula is based on net income from the current plus the previous four fiscal years, so it makes sense that the check sizes are also cyclical in nature, albeit in a slightly delayed fashion behind oil revenue fluctuations.

Alaska’s dividend payments often end up on the chopping block during yearly budget debates, and there is growing pressure to at least have them reduced. Despite this, Alaska’s dividends are very popular with residents (who can blame them?) and probably won’t be going away for a long time; bringing a new meaning to the Permanent Fund’s name.

The Alaska Permanent Fund was established in 1976 by constitutional amendment and was seen as an investment in future generations, who might no longer have access to oil as a resource. Although this may have been decent forward-thinking, which is rare in state budgets, it does illustrate an interesting public finance story.

Alaska is a great example of a somewhat backwards situation. They generate high amounts of cash each year, but because of the way many of their funds are restricted they are forced to hoard much of it, and give the rest to citizens in the form of dividends. If a different state were to consider a similar dividend before dealing with serious structural budget flaws would be akin to putting the cart before the horse.

Luckily for Alaskan dividend recipients, there are many other areas that the state could reform first in order to improve their budget situation while avoiding cutting payments. As my colleague Adam Millsap has recommended, a fruitful area is tax reform. Alaska doesn’t have an income or sales tax; two of the most common sources of revenue for state governments. These are two potentially more stable sources of income than what the state currently has.

How does Colorado’s “tax refund” compare?

Colorado’s Taxpayer Bill of Rights (TABOR) has a feature that requires any tax revenue growth beyond inflation and population growth be refunded to taxpayers. It was adopted by Colorado voters in 1992 and it essentially restricts revenues by prohibiting any tax or spending increases without voter approval.

A recent example of this playing out was in 2014 when the state realized higher than expected tax revenues as a result of marijuana legalization. At the point of legalization, the plan was to direct tax revenues generated from the sale of marijuana towards schools or substance abuse program funding. But because of the higher than expected revenues, TABOR was triggered and it would require voter approval to decide if the excess revenues would be sent back to taxpayers or directed to other state programs.

In November of 2015, Colorado voters approved a statewide ballot measure that gave state lawmakers permission to spend $66.1 million in taxes collected from the sale of marijuana. The first $40 million was sent to school construction, the next $12 million to youth and substance abuse programs, and the remainder $14.2 billion to discretionary spending programs. A great example that although TABOR does generally restrain spending, citizens still have power to decline refunds in the name of program spending they are passionate about.

 

The second figure here displays TABOR refunds compared with state revenues and expenditures over time. Adjusted for inflation, checks have varied from $18 in 2005 to $351 in 1999, much smaller than the Alaska dividend checks. TABOR checks have only tended to be distributed when revenues have exceeded expenses. The main reason why checks weren’t distributed between 2006 and 2009, despite a revenue surplus, was because of Referendum C which removed TABOR’s revenue limit for five years, allowing the state to keep collections exceeding the rule. The revenue limit has since been reinstated, but some question the effectiveness of TABOR given an earlier amendment in 2000 which exempts much of education spending from TABOR restrictions.

The main distinguishing factor between Colorado’s refund and Alaska’s Permanent Fund dividend is that the former also acts as a constraint on spending growth. By requiring the legislature to get voter approval before any tax increase or spending of new money, it implements automatic checks on these activities. Many states attempt to do this through what are called “Tax and Expenditure Limits” or TELs.

The worry is that left unchecked, state spending can grow to unsustainable levels.

Tax and Expenditure Limits

A review of the literature up to 2012 found that although the earliest studies were largely skeptical of the effectiveness of TELs, as time has passed more research points to the contrary. TELs can restrain spending, but only in certain circumstances.

My colleague Matt Mitchell found in 2010 that TELs are more effective when they (1) bind spending rather than revenue, (2) require a super-majority rather than a simple majority vote to be overridden, (3) immediately refund revenue collected in excess of the limit, and (4) prohibit unfunded mandates on local government.

Applying these criteria to Colorado’s TABOR we see that it does well in some areas and could improve in others. TABOR’s biggest strength is that it immediately refunds revenue collected in excess of the limit in its formula, pending voter approval to do otherwise. Automatically refunding surpluses makes it difficult for governments to use excess funds irresponsibly and also gives taxpayers an incentive to support TABOR.

Colorado’s TABOR does well to limit revenue growth according to a formula, rather than to a fixed number or no limitation at all. The formula partially meets Mitchell’s standards. It stands up well with the most stringent TELs by limiting government growth that exceeds inflation and population growth, but could actually be improved if it limited actual spending growth rather than focusing on tax revenue. When a TEL or similar law limits revenues, policymakers can respond by resorting to implementing more fees or borrowing. There’s some evidence of this occurring in Colorado, with fees becoming more popular as a way to raise revenue since TABOR’s passing. A spending-based TEL is more difficult to evade.

Despite its faults, Colorado’s TABOR structure appears to be doing better than attempts to constrain spending growth in other states. The National Conference of State Legislatures still considers it one of the strictest TELs in the nation. Other states, like Arkansas, could learn a lot from Colorado. A recent Mercatus study analyzes Arkansas’ Revenue Stabilization Law and suggests that it is missing a component similar to Colorado’s TABOR formula to refund excess revenues.

How much a state spends is ultimately up to its residents and legislature. Some states may have a preference for more spending than others, but given the tendency for government spending to grow towards an unsustainable direction, having a conversation about how to slow this is key. Implementing TEL-like checks allows for spending to be monitored and that tax dollars be spent more strategically.

Alaska’s Permanent Fund dividend is not structured as well as Colorado’s, but perhaps the state’s saving grace is that it has a relatively well structured TEL. Similarly to Colorado’s TABOR, Alaska’s TEL limits budget growth to the sum of inflation and population growth and is codified in the constitution. Alaska’s TEL doesn’t immediately refund revenue that is collected in excess of the limit to taxpayers as Colorado’s TABOR does, but it does target spending rather than revenues.

Colorado’s and Alaska’s TELs can compete when it comes to restraining spending, but Colorado’s is certainly more strict. Colorado’s expenditures have grown by about 55 percent over the last decade, while Alaska’s has grown approximately 120 percent.

The Lesson

Comparing Colorado and Alaska’s situations reveals two different ways of giving tax refunds to residents. Doing so doesn’t necessarily have to be fiscally irresponsible. Colorado has provided refunds to residents when state revenues have exceeded expenses and as a result this has acted as a restraint on over-spending higher than expected revenues. Although Colorado’s TABOR has been amended over time, its general structure illustrates the effectiveness of institutional restrains on spending. The unintended effects of TABOR, such as the increase in fees, could be well addressed by specifically targeting spending rather revenue, like in the case of Alaska’s TEL. Alaska may have had their future residents’ best intent in mind when they designed their Permanent Fund Dividend, but perhaps this goal of passing forward oil investment earnings should have been paired with preparing for the potential of cyclical budget woes.

What’s going on with Alaska’s budget?

Alaska is facing another budget deficit this year – one of $3 billion – and many are skeptical that the process of closing this gap will be without hassle. The state faces declining oil prices and thinning reserves, forcing state legislators to rethink their previous budgeting strategies and to consider checking their spending appetites. This shouldn’t be a surprise to state legislators though – the budget process during the past two years ended in gridlock because of similar problems. And these issues have translated into credit downgrades from the three major credit agencies, each reflecting concern about the state’s trajectory if no significant improvements are made.

Despite these issues, residents have not been complaining, at least not until recently. Every fall, some earnings from Alaska’s Permanent Fund get distributed out to citizens – averaging about $1,100 per year since 1982. Last summer, Governor Walker used a partial veto to reduce the next dividend from $2,052 to $1,022. Although politically unpopular, these checks may be subject to even more cuts as a result of the current budget crisis.

The careful reader might notice that Alaska topped the list of the most fiscally healthy states in a 2016 Mercatus report that ranks the states according to their fiscal condition (using fiscal year 2014 data). For a state experiencing so much budget trouble, how could it be ranked so highly?

The short answer is that Alaska’s budget is incredibly unique.

On the one hand, the state has large amounts of cash, but on the other, it has large amounts of debt. Alaska’s cash levels are what secured its position in our ranking last year. Although holding onto cash is generally a good thing for state governments, there appears to be diminishing returns to doing so, especially if there is some structural reason that makes funds hard to access for paying off debt or for improving public services. It is yet to be seen how these factors will affect Alaska’s ranking in the next edition of our report.

Another reason why Alaska appeared to be doing well in our 2016 report is that the state’s problems – primarily spending growth and unsustainable revenue sources – are still catching up to them. Alaska has relied primarily on oil tax revenues and has funneled much of this revenue into restricted permanent trusts that cannot be accessed for general spending. When the Alaska Permanent Fund was created in the 1980s, oil prices were high and production was booming, so legislators didn’t really expect for this problem to occur. The state is now starting to experience the backlash of this lack of foresight.

The first figure below shows Alaska’s revenue and expenditure trends, drawing from the state’s Comprehensive Annual Financial Reports (CAFRs). At first look, you’ll see that revenues have generally outpaced spending, but not consistently. The state broke even in 2003 and revenues steadily outpaced expenditures until peaking at $1,266 billion in 2007. Revenues fell to an all-time low of $241 billion following the recession of 2008 and then fluctuated up and down before falling drastically again in fiscal year 2015.

alaska-revenues-exp4.5.17

The ups and downs of Alaska’s revenues reflect the extremely volatile nature of tax revenues, rents, and royalties that are generated from oil production. Rents and royalties make up 21 percent of Alaska’s total revenues and oil taxes 6 percent – these two combined actually come closer to 90 percent of the actual discretionary budget. Alaska has no personal income tax or sales tax, so there isn’t much room for other sources to make up for struggling revenues when oil prices decline.

Another major revenue source for the state are federal grants, at 32 percent of total revenues. Federal transfers are not exactly “free lunches” for state governments. Not only do they get funded by taxpayers, but they come with other costs as well. There is research that finds that as a state becomes more reliant on federal revenues, they tend to become less efficient, spending more and taxing more for the same level of services. For Alaska, this is especially concerning as it receives more federal dollars than any other state in per capita terms.

Federal transfers as an income stream have been more steady for Alaska than its oil revenues, but not necessarily more accessible. Federal funds are usually restricted for use for federal programs and therefore their use for balancing the budget is limited.

A revenue structure made up of volatile income streams and hard-to-access funds is enough by itself to make balancing the budget difficult. But Alaska’s expenditures also present cause for concern as they have been growing steadily, about 10 percent on average each year since 2002, compared with private sector growth of 6 percent.

In fiscal year 2015, education was the biggest spending category, at 28% of total expenditures. This was followed by health and human services (21%), transportation (11%), general government (10%), the Alaska Permanent Fund Dividend (9%), public protection (6%), and universities (5%). Spending for natural resources, development, and law and justice were all less than 5 percent.

The next figure illustrates the state’s biggest drivers of spending growth since 2002. Education and general government spending have grown the most significantly over the past several years. Alaska Permanent Fund spending has been the most variable, reflecting the cyclical nature of underlying oil market trends. Both transportation and health and human services have increased steadily since 2002, with the latter growing more significantly the past several years as a result of Medicaid expansion.

alaska-spendinggrowth4.5.17

Alaska’s spending is significantly higher than other states relative to its resource base. Spending as a proportion of state personal income was 31 percent in fiscal year 2015, much higher than the national average of 13 percent. A high level of spending, all else equal, isn’t necessarily a bad thing if you have the revenues to support it, but as we see from this year’s budget deficit, that isn’t the case for Alaska. The state is spending beyond the capacity of residents to pay for current service levels.

What should Alaska do?

This is a complicated situation so the answer isn’t simple or easy. The Alaska government website provides a Microsoft Excel model that allows you to try and provide your own set of solutions to balance the budget. After tinkering with the state provided numbers, it becomes clear that it is impossible to balance the deficit without some combination of spending cuts and changes to revenues or the Permanent Fund dividend.

On the revenue side, Alaska could improve by diversifying their income stream and/or broadening the tax base. Primarily taxing one group – in this case the oil industry – is inequitable and economically inefficient. Broadening the base would cause taxes to fall on all citizens more evenly and be less distortive to economic growth. Doing so would also smooth revenue production, making it more predictable and reliable for legislators.

When it comes to spending, it is understandably very difficult to decide what areas of the budget to cut, but a good place to start is to at least slow its growth. The best way to do this is by changing the institutional structure surrounding the political, legislative, and budgeting processes. One example would be improving Alaska’s tax and expenditure limit (TEL), as my colleague Matthew Mitchell recommends in his recent testimony. The state could also look into item-reduction vetoes and strict balanced-budget requirements, among other institutional reforms.

Ultimately, whatever steps Alaska’s legislators take to balance the budget this year will be painful. Hopefully the solution won’t involve ignoring the role that the institutional environment has played in getting them here. A narrow tax base reliant on volatile revenue sources, restricted funds, and growing spending are all factors that have led many to think that Alaska is and always will be “different.” But what constitutes sound public financial management is the same regardless of state. Although Alaska’s situation is unique, their susceptibility to fiscal stress absent any changes is not.

New York’s Buffalo Billion initiative has been underwhelming

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

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

buffalo-population

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

buffalo-billion-projects

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

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

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

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

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

buffalo-employment

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

buffalo-county-wages

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

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

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

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

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

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

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

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

City population dynamics since 1850

The reason why some cities grow and some cities shrink is a heavily debated topic in economics, sociology, urban planning, and public administration. In truth, there is no single reason why a city declines. Often exogenous factors – new modes of transportation, increased globalization, institutional changes, and federal policies – initiate the decline while subsequent poor political management can exacerbate it. This post focuses on the population trends of America’s largest cities since 1850 and how changes in these factors affected the distribution of people within the US.

When water transportation, water power, and proximity to natural resources such as coal were the most important factors driving industrial productivity, businesses and people congregated in locations near major waterways for power and shipping purposes. The graph below shows the top 10 cities* by population in 1850 and follows them until 1900. The rank of the city is on the left axis.

top cities 1850-1900

 

* The 9th, 11th, and 12th ranked cities in 1850 were all incorporated into Philadelphia by 1860. Pittsburgh was the next highest ranked city (13th) that was not incorporated so I used it in the graph instead.

All of the largest cities were located on heavily traveled rivers (New Orleans, Cincinnati, Pittsburgh, and St. Louis) or on the coast and had busy ports (New York, Boston, Philadelphia, Brooklyn, and Baltimore). Albany, NY may seem like an outlier but it was the starting point of the Erie Canal.

As economist Ed Glaeser (2005) notes “…almost every large northern city in the US as of 1860 became an industrial powerhouse over the next 60 years as factories started in central locations where they could save transport costs and make use of large urban labor forces.”

Along with waterways, railroads were an important mode of transportation from 1850 – 1900 and many of these cities had important railroads running through them, such as the B&O through Balitmore and the Erie Railroad in New York. The increasing importance of railroads impacted the list of top 10 cities in 1900 as shown below.

top cities 1900-1950

A similar but not identical set of cities dominated the urban landscape over the next 50 years. By 1900, New Orleans, Brooklyn (merged with New York) Albany, and Pittsburgh were replaced by Chicago, Cleveland, Buffalo, and San Francisco. Chicago, Cleveland, and Buffalo are all located on the Great Lakes and thus had water access, but it was the increasing importance of railroad shipping and travel that helped their populations grow. Buffalo was on the B&O railroad and was also the terminal point of the Erie Canal. San Francisco became much more accessible after the completion of the Pacific Railroad in 1869, but the California Gold Rush in the late 1840s got its population growth started.

As rail and eventually automobile/truck transportation became more important during the early 1900s, cities that relied on strategic river locations began to decline. New Orleans was already out of the top 10 by 1900 (falling from 5th to 12th) and Cincinnati went from 10th in 1900 to 18th by 1950. Buffalo also fell out of the top 10 during this time period, declining from 8th to 15th. But despite some changes in the rankings, there was only one warm-weather city in the top 10 as late as 1950 (Los Angeles). However, as the next graphs shows there was a surge in the populations of warm-weather cities during the period from 1950 to 2010 that caused many of the older Midwestern cities to fall out of the rankings.

top cities 1950-2010

The largest shakeup in the population rankings occurred during this period. Out of the top 10 cities in 1950, only 4 (Philadelphia, Los Angeles, Chicago, and New York) were still in the top 10 in 2010 (All were in the top 5, with Houston – 4th in 2010 – being the only city not already ranked in the top 10 in 1950, when it was 14th). The cities ranked 6 – 10 fell out of the top 20 while Detroit declined from 5th to 18th. The large change in the rankings during this time period is striking when compared to the relative stability of the earlier time periods.

Economic changes due to globalization and the prevalence of right-to-work laws in the southern states, combined with preferences for warm weather and other factors have resulted in both population and economic decline in many major Midwestern and Northeastern cities. All of the new cities in the top ten in 2010 have relatively warm weather: Phoenix, San Antonio, San Diego, Dallas, and San Jose. Some large cities missing from the 2010 list – particularly San Francisco and perhaps Washington D.C. and Boston as well – would probably be ranked higher if not for restrictive land-use regulations that artificially increase housing prices and limit population growth. In those cities and other smaller cities – primarily located in Southern California – low population growth is a goal rather than a result of outside forces.

The only cold-weather cities that were in the top 15 in 2014 that were not in the top 5 in 1950 were Indianapolis, IN (14th) and Columbus, OH (15th). These two cities not only avoided the fate of nearby Detroit and Cleveland, they thrived. From 1950 to 2014 Columbus’ population grew by 122% and Indianapolis’ grew by 99%. This is striking compared to the 57% decline in Cleveland and the 63% decline in Detroit during the same time period.

So why have Columbus and Indianapolis grown since 1950 while every other large city in the Midwest has declined? There isn’t an obvious answer. One thing among many that both Columbus and Indianapolis have in common is that they are both state capitals. State spending as a percentage of Gross State Product (GSP) has been increasing since 1970 across the country as shown in the graph below.

OH, IN state spending as per GSP

In Ohio state spending growth as a percentage of GSP has outpaced the nation since 1970. It is possible that increased state spending in Ohio and Indiana is crowding out private investment in other parts of those states. And since much of the money collected by the state ends up being spent in the capital via government wages, both Columbus and Indianapolis grow relative to other cities in their respective states.

There has also been an increase in state level regulation over time. As state governments become larger players in the economy business leaders will find it more and more beneficial to be near state legislators and governors in order to lobby for regulations that help their company or for exemptions from rules that harm it. Company executives who fail to get a seat at the table when regulations are being drafted may find that their competitors have helped draft rules that put them at a competitive disadvantage. The decline of manufacturing in the Midwest may have created an urban reset that presented firms and workers with an opportunity to migrate to areas that have a relative abundance of an increasingly important factor of production – government.

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.

An interesting development in state regulation of wine shipment

Can one state enforce another state’s laws that prohibit direct-to-consumer wine shipment from out-of-state retailers while allowing it by in-state retailers?  That’s the question posed in a recent New York case.

The New York State Liquor Authority has a rule that prohibits licensees from engaging in “improper conduct.”  The liquor regulator argues that direct shipments by retailers that violate other states’ laws constitute improper conduct.  It has fined, revoked licenses, and filed charges against New York retailers that it believes have shipped wine illegally to customers in other states. One retailer, Empire Wine, refused to settle and has sued the liquor authority in state court, claiming that the “improper conduct” rule is unconstitutionally vague and that the liquor authority cannot enforce other states’ laws that discriminate against interstate commerce.

Many states continue to prohibit direct shipment from out-of-state retailers. For example, 40 states do not allow New York retailers to ship directly to consumers.  This harms consumers, because it is usually out-of state-retailers, rather than wineries, that offer significant savings compared to in-state retailers. In a 2013 article published in the Journal of Empirical Legal Studies, Alan Wiseman and I identified two different anti-consumer effects of laws that allow out-of-state wineries to ship direct to consumer but prohibit out-of-state retailers from doing so. First, these laws deprive consumers of price savings from buying many bottles online: “Online retailers consistently offered price savings on much higher percentages of the bottles in each year—between 57 and 81 percent of the bottles when shipped via ground and between 32 and 48 percent when shipped via air. Excluding retailers from direct shipment thus substantially reduces—but does not completely eliminate—the price savings available from purchasing wine online.” Second, these laws reduce competitive pressure on bricks-and-mortar wine stores, since they exclude lower-priced out-of-state retailers from the local market. Thus, the laws likely harm consumers who buy from their local wine shops, not just consumers who want to buy online. (The published version of the paper is behind a paywall, but you can read the working paper version at SSRN.)

(Photo credit: http://srxawordonhealth.com/2011/07/11/exercise-in-a-bottle/)

 

With Government Shekels Come Government Shackles

Though privileged firms may not focus on it when they obtain their favors, privilege almost always come with strings attached. And these strings can sometimes be quite debilitating. Call it one of the pathologies of government-granted privilege.

Perhaps the best statement of this comes from the man whose job it was to pull the strings on TARP recipients. In 2009, Kai Ryssdal of Marketplace interviewed Kenneth Feinberg. The Washington compensation guru had just been appointed to oversee compensation practices among the biggest TARP recipients. Here is how he described his powers:

Ryssdal: How much power do you have in your new job?

FEINBERG: Well, the law grants to the secretary who delegates to me the authority to determine compensation packages for 175 senior executives of the seven largest corporate top recipients. The law also permits me, or requires me, to design compensation programs for these recipients, governing overall compensation of every senior official. And finally, the law gives me great discretion in deciding whether I should seek to recoup funds that have already been distributed to executives by top recipients. So it’s a substantial delegation of power to one person.

Another example of shackles following shekels comes from Maryland. That state has doled out over $20 million in tax privileges to a film production company called MRC. MRC films House of Cards, a show about a remarkably corrupt politician named Frank Underwood. The goal of these privileges was to “induce” (others might call it bribe) MRC to film House of Cards in Maryland. One problem (among many) with targeted privileges like this is that there is no guarantee that the induced firm will stay induced; there’s nothing to keep it from coming back for more.

In this case, MRC executives recently sent a letter to Governor Martin O’Malley threatening to “break down our stage, sets and offices and set up in another state” if “sufficient incentives do not become available.” Chagrined, state Delegate William Frick came up with a plan to seize the company’s assets through eminent domain. It is clear that Delegate Frick’s intention was to shackle the company. He told the Washington Post:

I literally thought: What is an appropriate Frank Underwood response to a threat like this?…Eminent domain really struck me as the most dramatic response.

As George Mason University’s Ilya Somin aptly puts it:

But even if the courts would uphold this taking, it is extremely foolish policy. State governments rarely condemn mobile property, for the very good reason that if they try to do so, the owners can simply take it out of the jurisdiction – a lesson Maryland should have learned when it tried to condemn the Baltimore Colts to keep them from leaving back in 1984. Moreover, other businesses are likely to avoid bringing similar property into the state in the first place.

My colleague Chris Koopman notes that there are also a number of practical problems with this proposal. The only real property the state could seize from MRC would be its filming equipment: its cameras, its lights, maybe a set piece or two. And by the U.S. Constitution, it would have to offer MRC “just compensation” for these takings. The company’s real assets—the minds of its writers and the talents of its actors—would, of course, remain intact and free to move elsewhere. So essentially Mr. Frick is offering to buy MRC a bunch of new cameras, leaving the state with a bunch of old cameras which it will use for…well that hasn’t been determined yet.

In this case, it would seem that the shackles are more like bangles.

The Maryland State House adopted Frick’s measure without debate. It now goes to the Senate.

America’s best pension system? The case of Milwaukee

NPR reports that while many municipal and state governments’s pension systems are suffering from deep underfunding, there are some outliers. One such city is Milwaukee, Wisconsin. With a funding ratio of 90 percent, Milwaukee’s public employees’ plan would seem to have beaten the odds with a very simple (and laudable) strategy: fully fund the pension plan every year.

It is common sense. Make the full annual contribution and the plan can ensure that the benefits promised are available when retirement day arrives.

Except, thanks to government accounting guidance, it’s a little more complicated than that.

The problem is that the annual contribution the city is (prudently) making each year is calculated incorrectly. This flawed approach is why Detroit could claim a few short years ago that its plans were 100 percent funded. It is why New Jersey thought its plans were overfunded in the late 1990s.

Public plans calculate their liabilities – and thus the annual amount needed to contribute to the fund – based on how much they expect the assets to return. Milwaukee’s discount rate is 8.25%, recently lowered from 8.5%.

Unfortunately, if these liabilities are considered safe and guaranteed by the government, then they should valued as such. A better rate to use is the yield US Treasury bonds. In economist-speak: the value of liabilities and assets are independent. By way of analogy: Your monthly mortgage payment doesn’t change based on how much you think you may earn in your 401(K).

On a default-free, market valuation basis, Milwaukee’s pension plans is 40% funded and has a funding gap of $6.5 billion.

The good news – Milwaukee’s elected officials have funding discipline. They aren’t skipping, skimming, or torturing their contributions based on  the desire to avoid paying their bills. And this can be said of many other cities and states. Funding a pension shouldn’t be magic or entail lots of uncertainty for the sponsor or employee.

But that leads to the bad news. Even when governments are responsible managers, they’re being sunk by bad accounting. Public sector accounting assumptions (GASB 25) lead governments to miscalculate the bill for public sector pension contributions. Even when governments pay 100 percent of the recommended amount – as it is presently calculated – this amount is too little to fully fund pension promises.

Last week I posted the Tax Foundation’s map of what pension funding levels look like under market valuation. Almost all state plans are under the 50 percent funded level. That is, they are in far worse funding shape than their current accounts recognize.

Until plans de-link the value of the liability from the expected performance of plan assets, even the best -managed plans are going to be in danger of not having put aside enough to pay these promises. Even the best intentions cannot undo the effects of bad accounting assumptions.

 

 

Are High Taxes on Smokeless Tobacco Encouraging People to Smoke?

President Obama’s recent budget proposal to pay for pre-school programs by increasing cigarette taxes highlights the confusion both on federal and state levels over taxing tobacco products. A recent Mercatus working paper questions the efficiency and utility of sin taxes in general. But even more fundamentally, tobacco tax policy may fail in its primary goal, which is to reduce the health risks of consuming tobacco.

Since the goal of tobacco taxes is to reduce tobacco’s harms by discouraging its use, the tax rates on various tobacco products should be commensurate with their health risks. If smoking carries four times higher cancer risks than using smokeless tobacco, then the tax rates on cigarettes should be four times higher than taxes on, for example, smokeless tobacco. Yet if cigarettes are taxed at a lower rate than this ratio, the policy may in fact encourage tobacco users to smoke as opposed to using less harmful smokeless tobacco.

A health policy that does not encourage riskier tobacco products should set the ratio of smokeless tobacco and cigarette taxes similar to their health risk ratios. According to a recent review of medical studies, snus (a common type of smokeless tobacco) users face considerably lower oral cancer, gastric cancer and cardiovascular disease risks compared to smokers (see Table 1). In addition, other studies found that, unlike smoking, snus does not lead to lung cancer (the table shows the lung cancer risk for nonsmokers compared to smokers). Importantly, snus users do not expose those around them to second hand smoking, further limiting its negative health impacts. Based on the relative health risks, snus taxes should be considerably lower than cigarette taxes.

Table 1. Comparative Health Risks

Health Risk Risk Ratio (Snus users vs. Smokers)
Oral Cancer 0.43
Gastric Cancer 0.60
Cardiovascular Diseases 0.55
Lung Cancer 0.14

So how do states fare? Table 2 shows the tax rates for cigarettes and smokeless tobacco for select states, which are calculated based on the data are from Tobacco Free Kids campaign (in the source, the tax rates are per ounce of snus and per pack of cigarettes). To make sure that we compare apples to apples, I account for the varying nicotine content in these products. According to a recent study, consuming one gram of snus delivers nicotine content equal to smoking a cigarette. That works out to about a can of snus (typically 1.2 oz) replacing approximately 35 cigarettes (almost two packs). So I convert state taxes to show rates per equivalent nicotine amounts. For simplicity, I focus only on the states that tax smokeless tobacco by ounce. Other states tax smokeless tobacco based on either wholesale or manufacturing prices rather than retail, making calculations trickier.

The relative cancer and cardiovascular disease risks of snus are lower than the risks of smoking, ranging between 0.14 and 0.6 (see Table 1). States with a high snus to cigarette tax ratio are essentially pushing tobacco users towards smoking, which carries higher health risks (coded red in the table). States with a moderate tax ratio are somewhat neutral (coded yellow). Their tax ratio is commensurate with relative health risks for some but not all risk sources. Finally, states with a low tax ratio generally encourage tobacco consumers to use a safer product (coded green).

Table 2. State Tobacco Taxes for Equivalent Nicotine Content

State Snus Tax (gram) Cigarette Tax (cigarette) Tax Ratio (Snus/Cigarette)
Arizona $0.01 $0.10 7.88%
Connecticut $0.04 $0.17 20.75%
Delaware $0.02 $0.08 23.81%
District of Columbia $0.03 $0.13 21.16%
Illinois $0.01 $0.10 10.69%
Iowa $0.04 $0.07 61.73%
Maine $0.07 $0.10 71.25%
Montana $0.03 $0.09 35.27%
Nebraska $0.02 $0.03 48.50%
New Jersey $0.03 $0.14 19.60%
New York $0.07 $0.22 32.44%
North Dakota $0.02 $0.02 96.20%
Oregon $0.06 $0.06 106.42%
Rhode Island $0.04 $0.17 20.39%
Texas $0.04 $0.07 59.54%
Vermont $0.07 $0.13 50.35%
Washington $0.09 $0.15 58.91%
Wyoming $0.02 $0.03 70.55%

Note: snus and cigarette taxes are rounded to nearest cent. The tax ratio is based on actual tax values.

The picture that emerges from the table is that of a confused health policy pursued by the states. Only two states in the list set the snus and cigarette tax rates at the level that does not steer consumer towards riskier tobacco products. Most states set the tax rates at levels that are commensurate with some risks but not the others. Specifically, most states do not account for the fact that snus does not cause lung cancer, which is one of the greatest risks of smoking. Finally, a few states may be steering tobacco users towards cigarettes by setting snus taxes too high (or cigarette taxes too low).

I am not claiming that smokeless tobacco is harmless or that states should promote smokeless tobacco as a substitute for cigarettes. As the National Cancer Institute points out, smokeless tobacco is not a safe alternative to smoking. It still carries increased health risks, including certain types of cancer and cardiovascular diseases. But current policy on tobacco taxes may result in the unintended consequence of pushing tobacco users away from less risky forms of tobacco towards riskier ones.