Tag Archives: tax

Baltimore’s misguided move to raise its minimum wage will harm its most vulnerable

Baltimore’s city council, like others around the country, is considering raising the city’s minimum wage to $15 per hour. This is an ill-advised move that will make it harder for young people and the least skilled to find employment, which is already a difficult task in Baltimore.

The figure below shows the age 16 – 19 labor force participation (LFP) rate, employment rate, and unemployment rate in Baltimore City from 2009 to 2014 (most recent data available). The data are from the American Community Survey table S2301.

baltimore 16-19 emp stats

As shown in the figure, the LFP rate declined along with the employment rate, which has caused the unemployment rate to hold steady at approximately 40% (red line). So 40% of Baltimore’s unemployed teens were searching for a job but couldn’t find one and only 20% of all teens were actually employed, a decline of 4 percentage points (blue line). How is increasing the minimum wage to $15 per hour going to help the 40% who are looking for a job find one?

The minimum wage increase may help some people who are able to keep their job at the higher wage, but for the 40% who can’t find a job at the current minimum wage of $8.25, an increase to $15 is only going to make the task harder, if not impossible. Who is standing up for these people?

The data are just as gloomy when looking at workers with less than a high school degree, which is another group that is severely impacted by a higher minimum wage. As the figure below shows, the employment rate is falling while the unemployment rate is rising.

baltimore lt hs emp stats

In 2009 over 42% of people in this skill group were employed (blue line). In 2014 only 37% were, a decline of five percentage points. Meanwhile, the unemployment rate increased from about 19% to over 25% (red line). And all of this occurred while the economy was supposedly improving.

Again we should ask; how is a higher minimum wage going to help the 25% of high school dropouts in Baltimore who are unemployed find a job? It won’t. Unemployed workers do not become more attractive as employees simply because the city council mandates a higher wage.

What’s going to happen is that more people in this skill group will become discouraged and leave the labor market entirely. Then they will earn $0 per hour indefinitely and be forced to rely entirely on family, friends, and public assistance to live. A $15 minimum wage destroys their chances of finding meaningful employment and unduly deprives them of opportunities to better their lives.

This is the unseen effect of minimum wage hikes that $15 supporters rarely acknowledge. When faced with the higher cost, firms will hire workers who can justify a $15 wage and those who cannot will be unable to find employment. Additionally, firms will start using more technology and automation instead of workers. This happens because consumers want low prices and high quality, and as the minimum wage increases technology and capital become the best way to give consumers what they want. Over time workers in states with lower minimum wages may be forced out of the labor market as well as new technologies spread from high minimum wage areas to low minimum wage areas.

Another common argument put forth by minimum wage supporters is that taxpayers subsidize firms that pay low wages. But this is not true. Firms like Wal-Mart, McDonalds, and the countless other large and small business that employ low-skill workers are doing their part by giving people an opportunity. Firm owners did not unilaterally decide that all Americans should have a minimum standard of living and they should not be required to provide it on their own. Ultimately, advocates of a higher minimum wage who worry that they are subsidizing firms will likely be forced to contribute even more tax dollars to social programs since the wage for unemployed workers is $0.

Furthermore, why $15 and not $20? The argument is that $15/ hour is the minimum necessary to maintain a basic standard of living for working Americans but that argument is subjective. In fact, it can be extended to other areas. For example, should new hires be paid more than an entry-level salary so they can pay off college debt and maintain the standard of living of their parents?

To the extent that Americans deserve a particular lifestyle, providing it is a collective burden that should be shared by everyone. Politicians, clergy, union heads and other minimum wage supporters who want to push the entire burden onto firms are abandoning the moral obligation they claim we all share.

While minimum wage supporters mean well they appear to be blind to those who are harmed by wage controls. And those who are harmed are some of the most vulnerable members of the workforce – high school drop-outs, recent immigrants and urban youth. The minimum wage is a misguided policy that consigns these vulnerable members of the labor force to the basement of the economy and prevents any escape.

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.

Fixing municipal finances in Pennsylvania

Last week I was a panelist at the Keystone Conference on Business and Policy. The panel was titled Fixing Municipal Finances and myself and the other panelists explained the current state of municipal finances in Pennsylvania, how the municipalities got into their present situation, and what they can do to turn things around. I think it was a productive discussion. To get a sense of what was discussed my opening remarks are below.

——————————————————————————–

Pennsylvania is the 6th most populous state in the US – just behind IL and in front of OH – and its population is growing.

PA population

But though Pennsylvania is growing, southern and western states are growing faster. According to the US census, from 2013 to 2014 seven of the ten fastest growing states were west of the Mississippi, and two of the remaining three were in the South (FL and SC). Only Washington D.C. at #5 was in the Northeast quadrant. Every state with the largest numeric increase was also in the west or the south. This is the latest evidence that the US population is shifting westward and southward, which has been a long term trend.

Urbanization is slowing down in the US as well. In 1950 only about 60% of the population lived in an urban area. In 2010 a little over 80% did. The 1 to 4 ratio appears to be close to the equilibrium, which means that city growth can no longer come at the expense of rural areas like it did throughout most of the 20th century.

urban, rural proportion

2012 census projections predict only 0.66% annual population growth for the US until 2043. The birth rate among white Americans is already below the replacement rate. Without immigration and the higher birth rates among recent immigrants the US population would be growing even slower, if not shrinking. This means that Pennsylvania cities that are losing population – Erie, Scranton, Altoona, Harrisburg and others – are going to have to attract residents from other cities in order to achieve any meaningful level of growth.

PA city populations

Fixing municipal finances ultimately means aligning costs with revenue. Thus a city that consistently runs a deficit has two options:

  1. Increase revenue
  2. Decrease costs

Municipalities must be vigilant in monitoring their costs since the revenue side is more difficult to control, much like with firms in the private sector. A city’s revenue base – taxpayers – is mobile. Taxpayers can leave if they feel like they are not getting value for their tax dollars, an issue that is largely endogenous to the city itself, or they can leave if another jurisdiction becomes relatively more attractive, which may be exogenous and out of the city’s control (e.g. air conditioning and the South, state policy, the decline of U.S. manufacturing/the economic growth of China, Japan, India, etc.). The aforementioned low natural population growth in the US precludes cities from increasing their tax base without significant levels of intercity migration.

What are the factors that affect location choice? Economist Ed Glaeser has stated that:

“In a service economy where transport costs are small and natural productive resources nearly irrelevant, weather and government stand as the features which should increasingly determine the location of people.” (Glaeser and Kohlhase (2004) p. 212.)

Pennsylvania’s weather is not the worst in the US, but it I don’t think anyone would argue that it’s the best either. The continued migration of people to the south and west reveal that many Americans like sunnier climates. And since PA municipalities cannot alter their weather, they will have to create an attractive fiscal and business environment in order to induce firms and residents to locate within their borders. Comparatively good government is a necessity for Pennsylvania municipalities that want to increase – or simply stabilize – their tax base. Local governments must also strictly monitor their costs, since mobile residents and firms who perceive that a government is being careless with their money can and will leave for greener – and sunnier – pastures.

Fixing municipal finances in Pennsylvania will involve more than just pension reform. Act 47 was passed by the general assembly in 1987 and created a framework for assisting distressed municipalities. Unfortunately, its effectiveness is questionable. Since 1987, 29 municipalities have been placed under Act 47, but only 10 have recovered and each took an average of 9.3 years to do so. Currently 19 municipalities are designated as distressed under Act 47 and 13 of the 19 are cities. Only one city has recovered in the history of Act 47 – the city of Nanticoke. The average duration of the municipalities currently under Act 47 is 16.5 years. The city of Aliquippa has been an Act 47 city since 1987 and is on its 6th recovery plan.

Act 47 bar graphAct 47 under pie chartAct 47 recovered pie chart

The majority of municipalities that have recovered from Act 47 status have been smaller boroughs (8 of 10). The average population of the recovered communities using the most recent data is 5,569 while the average population of the currently-under communities is 37,106. The population distribution for the under municipalities is skewed due to the presence of Pittsburgh, but even the median of the under cities is nearly double that of the recovered at 9,317 compared to 4,669.

Act 47 avg, med. population

This raises the question of whether Act 47 is an effective tool for dealing with larger municipalities that have comparatively larger problems and perhaps a more difficult time reaching a political/community consensus concerning what to do.

To attract new residents and increase revenue, local governments must give taxpayers/voters/residents a reason for choosing their city over the alternatives available. Economist Richard Wagner argues that governments are a lot like businesses. He states:

“In order to attract investors [residents, voters], politicians develop new programs and revise old programs in a continuing search to meet the competition, just as ordinary businesspeople do in ordinary commercial activity.” (American Federalism – How well does it support liberty? (2014))

Ultimately, local governments in Pennsylvania must provide exceptional long-term value for residents in order to make up for the place-specific amenities they lack. This is easier said than done, but I think it’s necessary to ensure the long-run solvency of Pennsylvania’s municipalities.

Puerto Rico’s labor market woes

Puerto Rico – a U.S. territory – has $72 billion dollars in outstanding debt, which is dangerously high in a country with a Gross Domestic Product (GDP) of only $103.1 billion. The Puerto Rican government failed to pay creditors in August and this was viewed as a default by the credit rating agency Moody’s, which had already downgraded Puerto Rico’s bonds to junk status earlier this year. The Obama administration has proposed allowing Puerto Rico to declare bankruptcy, which would allow it to negotiate with creditors and eliminate some of its debt. Currently only municipalities – not states or territories – are allowed to declare bankruptcy under U.S. law. Several former Obama administration officials have come out in favor of the plan, including former Budget Director Peter Orszag and former Director of the National Economic Council Larry Summers. Others are warning that bankruptcy is not a cure-all and that more structural reforms need to take place. Many of these pundits have pointed out that Puerto Rico’s labor market is a mess and that people are leaving the country in droves. Since 2010 over 200,000 people have migrated from Puerto Rico, decreasing its population to just over 3.5 million. This steady loss of the tax base has increased the debt burden on those remaining and has made it harder for Puerto Rico to get out of debt.

To get a sense of Puerto Rico’s situation, the figure below shows the poverty rate of Puerto Rico along with that of three US states that will be used throughout this post as a means of comparison: California (wealthy state), Ohio (medium-wealth state), and Mississippi (low-wealth state). All the data are 1-year ACS data from American FactFinder.

puerto rico poverty

The poverty rate in Puerto Rico is very high compared to these states. Mississippi’s poverty rate is high by US standards and was approximately 22% in 2014, but Puerto Rico’s dwarfed it at over 45%. Assisting Puerto Rico with their immediate debt problem will do little to fix this issue.

A government requires taxes in order to provide services, and taxes are primarily collected from people who work in the regular economy via income taxes. A small labor force with relatively few employed workers makes it difficult for a county to raises taxes to provide services and pay off debt. Puerto Rico has a very low labor force participation (LFP) rate relative to mainland US states and a very low employment rate. The graphs below plot Puerto Rico’s LFP rate and employment rate along with the rates of California, Mississippi, and Ohio.

puerto rico labor force

puerto rico employ rate

As shown in the figures, Puerto Rico’s employment rate and LFP rate are far below the rates of the US states including one of the poorest states, Mississippi. In 2014 less than 45% of Puerto Rico’s 16 and over population was in the labor force and only about 35% of the 16 and over population was employed. In Mississippi the LFP rate was 58% while the employment rate was 52%. Additionally, the employment rate fell in Puerto Rico from 2010-14 while it rose in each of the other three states. So at a time when the labor market was improving on the mainland things were getting worse in Puerto Rico.

An educated labor force is an important input in the production process and it is especially important for generating innovation and entrepreneurship. The figure below shows the percent of people 25 and over in each area that have a bachelor’s degree or higher.

puerto rico gt 24 education attain

Puerto Rico has a relatively educated labor force compared to Mississippi, though it trails Ohio and California. The percentage also increased over this time period, though it appears to have stabilized after 2012 while continuing to grow in the other states.

Puerto Rico has nice beaches and weather, so a high percentage of educated people over the age of 25 may simply be due to a high percentage of educated retirees residing in Puerto Rico to take advantage of its geographic amenities. The next figure shows the percentage of 25 to 44 year olds with a bachelor’s degree or higher. I examined this age group to see if the somewhat surprising percentage of people with a bachelor’s degree or higher in Puerto Rico is being driven by educated older workers and retirees who are less likely to help reinvigorate the Puerto Rican economy going forward.

puerto rico 25to44 educ attain

As shown in the graph, Puerto Rico actually fares better when looking at the 25 – 44 age group, especially from 2010-12. In 2012 Puerto Rico had a higher percentage of educated people in this age group than Ohio.

Since then, however, Puerto Rico’s percentage declined slightly while Ohio’s rose, along with Mississippi’s and California’s. The decline in Puerto Rico was driven by a decline in the percentage of people 35 to 44 with a bachelor’s or higher as shown in the next figure below.

puerto rico 35to44 educ attain

The percentage of 35 to 44 year olds with a bachelor’s or advanced degree fell from 32% in 2012 to 29.4% in 2014 while it rose in the other three states. This is evidence that educated people in their prime earning years left the territory during this period, most likely to work in the US where there are more opportunities and wages are higher. This “bright flight” is a bad sign for Puerto Rico’s economy.

One of the reforms that many believe will help Puerto Rico is an exemption from compliance with federal minimum wage laws. Workers in Puerto Rico are far less productive than in the US, and thus a $7.25 minimum wage has a large effect on employment. Businesses cannot afford to pay low-skill workers in Puerto Rico such a high wage because the workers simply do not produce enough value to justify it. The graph below shows the median individual yearly income in each area divided by the full time federal minimum wage income of $15,080.

puerto rico min wage ratio

As shown in the graph, Puerto Rico’s ratio was the highest by a substantial amount. The yearly income from earning the minimum wage was about 80% of the yearly median income in Puerto Rico over this period, while it was only about 40% in Mississippi and less in Ohio and California. By this measure, California’s minimum wage would need to be $23.82 – which is equal to $49,546 per year – to equal the ratio in Puerto Rico. California’s actual minimum wage is $9 and it’s scheduled to increase to $10 in 2016. I don’t think there’s a single economist who would argue that more than doubling the minimum wage in California would have no effect on employment.

The preceding figures do not paint a rosy picture of Puerto Rico: Its poverty rate is high and trending up, less than half of the people over 16 are in the labor force and only about a third are actually employed, educated people appear to be leaving the country, and the minimum wage is a severe hindrance on hiring. Any effort by the federal government to help Puerto Rico needs to take these problems into account. Ultimately the Puerto Rican government needs to be enabled and encouraged to institute reforms that will help grow Puerto Rico’s economy. Without fundamental reforms that increase economic opportunity in Puerto Rico people will continue to leave, further weakening the commonwealth’s economy and making additional defaults more likely.

 

 

Pennsylvania taxpayer’s new “boutique” apartments

Eric Blumenfeld Realty Management (EBRM) recently secured $44 million in financing to restore the Divine Lorraine Hotel in Philadelphia. According to the article:

“EBRM will renovate the 9-story property into a boutique residential community comprised of 109-rental units to sit above 20,000 s/f of restaurant and retail space.”

But Blumenfeld did not receive ordinary financing. Instead EBRM largely circumvented the private sector capital markets and received a substantial portion of its financing courtesy of the Pennsylvania taxpayer:

“The hotel’s revitalization involved coordinating with an array of state and city governmental agencies and programs, including the Philadelphia Redevelopment Authority which provided a $2,500,000 loan and $1,000,000 grant, the Pennsylvania Redevelopment Assistance Capital Program which provided a $3,500,000 RACP grant, the Philadelphia Industrial Development Corp. which provided a bridge loan for the state grant, and the parks department which is anticipated to provide $8,000,000 in historic tax credits financing.”

In total EBRM received over $15 million in government grants, loans, and tax credits, including a RACP grant, which my research shows simply shuffles economic activity around Pennsylvania and puts taxpayers on the hook for paying back the bonds that fund the program – with interest.

I appreciate the renovation of historic landmarks but I don’t think taxpayers should have to help with the financing. Boutique apartments are a private good and as such their provision is best left to the market, without assistance from public funds. Some businesses choose to pursue government grants and subsidies rather than create a business plan that private investors are willing to finance – and who can blame them? It’s often easier to work with local governments that are just waiting to throw money at any business venture that promises jobs than to go through the trouble of creating a profitable business capable of attracting investors.

If you’re a Pennsylvania taxpayer thinking about moving to Philadelphia I recommend a new unit in the remodeled Divine Lorraine. At least that way you might get something for your money.

Scranton, PA and the failures of top-down planning

City officials in Scranton, PA are concerned that a recently released U.S. census map used as a basis for distributing federal grant money doesn’t reflect reality. The map was created using 2010 census data and identifies which neighborhoods meet the U.S. government’s criteria for low-to-moderate-income classification. Such neighborhoods are eligible to receive Community Development Block grant (CDBG) funding.

Scranton Councilman Wayne Evans stated that:

“A lot of us feel that the map is inaccurate, knowing the neighborhoods like we do,”

The city is hoping to conduct their own survey of the area and then use the results to petition the federal government to change the designations of the areas city officials believe are misclassified so they can receive funding.

This situation is a great example of the importance of local knowledge. Economist F.A. Hayek wrote the seminal paper on the importance of local knowledge in 1945. In his book Doing Bad by Doing Good, economist Chris Coyne builds on Hayek’s idea and defines the “planner’s problem” as “the inability of nonmarket participants to access relevant knowledge regarding how to allocate resources in a welfare-maximizing way in the face of a variety of competing, feasible alternatives.” The primary goal of the CDBG program is to create viable urban communities. In order to accomplish this a top-down planner needs to take certain steps: 1) the place to be developed needs to be identified and the goals of the development need to be established; 2) the availability of the resources needed for the development project needs to be confirmed and the resources need to be allocated; and 3) a feedback mechanism needs to be identified that can confirm that the goals are met. If any of these steps are not taken effective economic development will not occur.

As the example from Scranton shows, sometimes the planner – in this case the Department of Housing and Urban Development – fails to carry out step 1 effectively: Scranton officials and HUD can’t even agree on the place to be developed. Instead of letting the local officials who are knowledgeable about the area allocate the CDBGs, HUD officials in Washington bypass them by identifying the areas that need help via census data. Sometimes this approach might work, but when it doesn’t resources will be given to relatively prosperous areas while poorer areas are ignored.

The misallocation of resources will be an issue as long as the ability to allocate the funds is severed from the people with local knowledge of the communities. Cities and municipalities are receiving more and more of their revenues from the state and federal government, as seen in the graph below for Pennsylvania, and this contributes to situations like the one in Scranton.

PA intergov grants

As shown in the graph, total intergovernmental revenue and state intergovernmental to local governments in Pennsylvania increased in real terms from 1992 to 2012 (measured on the left vertical axis). In 1992, total intergovernmental revenue to local governments was equal to 59% of the revenue that local governments raised on their own (the orange line measured on the right vertical axis). In 2012 it was equal to 69%, an increase of 10 percentage points. This means that local governments became more dependent on higher-level governments for funding.

Funding from higher-level governments usually comes with restrictions and conditions that must be met, which prevents local citizens from using their local knowledge to alleviate the problems in their community. The further away decisions makers are from the region, the more likely they are to misidentify the problem areas. In Scranton’s case, city officials now have to expend scarce resources conducting their own survey and petitioning the federal government to change the neighborhood classifications.

Local knowledge is important and it should be utilized by decision makers. State and federal governments should limit intergovernmental transfers and allow local communities to keep more of their own tax dollars, which they can then use to address their own local issues.

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.

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.