Tag Archives: US

Where’s the growth?

In a famous Wendy’s commercial from 1984, three elderly women are examining a hamburger with a rather large bun when one of them asks “Where’s the beef?” in order to express her disappointment that the burger is all bun and no meat. When it comes to the economy growth is like the beef of a burger – without it all you’re left with is fluff and filler.

For the last 8 years the US economy has been mostly fluff and filler. Sure unemployment is down, but that is largely due to a lower labor force participation rate. Wage growth has been anemic and total GDP growth remains below the pre-recession long-run average of 3%.  GDP per capita growth is weak too.

Within a country as large as the US different regions are going to have different levels of GDP per capita and different growth rates for a variety of reasons including labor force characteristics, industry composition, weather, and geography. In order to examine the differences across the US, the graph below depicts the natural log of real GDP per capita in 2009 dollars for the 9 census divisions from 2001 to 2014. Because the natural log is on the y-axis the slope of the line corresponds to the growth rate between years. The black line is the US Metropolitan Area average and does not include rural areas.

ln real per cap gdp by cen div 2001-14

I created the census division average by generating a population weighted average of the real per capita GDP of the Metropolitan Statistical Areas located in each division. The weights are adjusted for each year in the data. Also, since the averages discussed in this post do not include rural areas one can think of them as the urban average in each census division. The population data for the weights and the real GDP per capita data are from the BEA.

As shown in the graph, the highest average real GDP per capita is in the New England division (orange) while the lowest is in the East South Central (purple), although as of 2014 the Mountain is not far ahead.

The slopes of the lines are steeper on average prior to the recession, indicating that the regions were growing faster during the pre-recession period. This is particularly noticeable in the Mountain and South Atlantic division, where real GDP per capita growth has essentially been zero (flat line) since 2009. Growth has also slowed considerably in the Pacific division (dark blue). Only in the East North Central (yellow) and West South Central (brown) does it appear that growth has reached or eclipsed its pre-recession rate.

The next graph below shows the average real per capita GDP by census division in three separate years – 2001, 2007, and 2014. This makes it easier to see the changes in levels over time.

real per cap gdp by cen div 2001,07,14

Real GDP per capita was higher in 2014 than in 2007 (year prior to the recession) in only three divisions – the Mid Atlantic, West North Central, and West South Central. The rest of the country has experienced either no gain or a decrease in the case of the South Atlantic and Mountain divisions. Together these graphs are hardly evidence of a strong economy.

High per capita GDP is not a perfect measure of economic prosperity but it is strongly correlated with many of the other things people care about. Countries with a higher level of per capita GDP are healthier, freer, and happier. The data presented here show that the US economy is struggling when it comes to growth, especially in the South Atlantic and Mountain divisions where people have become worse off on average. Whoever the next president is, he or she needs to come up with an answer to the question – Where’s the growth?

 

Economic freedom matters at the local level too

Since 1996 the Fraser Institute has published an annual economic freedom of the world index that ranks countries according to their level of economic freedom. They also publish an economic freedom of North America Index that ranks the US states, Canadian provinces, and Mexican provinces using similar data.

Both of these studies have been used to show that countries and states/provinces with relatively high levels of economic freedom tend to be better off in several ways, including higher GDP per capita, longer life expectancy, and greater economic growth. Countries with higher levels of economic freedom tend to have higher quality democracies as well.

A quick google search reveals that there has been a lot of other research that looks at the relationship between economic freedom and various outcomes at the country and state level. However, substantially less research has been done at the local level and there are two main reasons for this.

First, it’s hard to gather data at the local level. There are thousands of municipalities in the US and not all of them make their data easily available. This makes gathering data very costly in terms of time and resources. Second, a lot of policies that impact economic freedom are enacted at the federal and state level. Because of this many people probably don’t think about the considerable effects that local policy can have on local economies.

There has been one study that I know of that attempts to create an economic freedom index for metropolitan areas (MSAs). This study is by Dr. Dean Stansel of SMU, a coauthor of the economic freedom of North America index. The MSA economic freedom index runs from 0 (not free) to 10 (very free) and was created with 2002 data. I am currently working on a paper with Dean that uses this index, but I was recently inspired to use the index in a different way. I wanted to see if economic freedom at the MSA level impacted subsequent employment and population growth, so I gathered BEA data on employment and population and ran a few simple regressions. The dependent variables are at the top of each column in the table below and are private, non-farm employment growth from 2003 – 2014, proprietor employment growth from 2003 – 2014, and population growth from 2003 – 2014.

MSA econ freedom regressions

I also included a quality of life index independent variable from another study in order to control for the place-specific amenities of each MSA like weather and location. This variable measures how much people would be willing to pay to live in a particular MSA; a positive number means a person would pay to live in an area, while a negative number means a person would have to be paid to live in an area. Thus larger, positive numbers indicate more attractive areas. The index is constructed with 2000 data.

As shown in the table, economic freedom has a positive and significant effect on both measures of employment and population growth. The quality of life index is also positive and significant for private employment growth (column 1) and population growth (column 3, only at the 10% level). We can calculate the magnitude of the effects using the standard deviations from the table below.

MSA econ freedom sum stats

Using the standard deviation from column 1 (0.84) we can calculate that a one standard deviation increase in economic freedom would generate a 2 percentage point increase in private employment growth from 2003 – 2014 (0.84 x 0.024), a 4.5 percentage point increase in proprietor employment growth, and a 2.9 percentage point increase in population growth.  A one standard deviation change would be like increasing San Francisco’s level of economic freedom (6.70) to that of San Antonio’s (7.53).

Similarly, a one standard deviation increase in the quality of life index would lead to a 2.1 percentage point increase in private employment growth from 2003 – 2014 (0.000011 x 1912.86) and a 1.9 percentage point increase in population growth. A one standard deviation change would be like increasing the quality of life of Montgomery, AL (-21) to that of Myrtle Beach, SC (1643).

I think the most interesting finding is that quality of life does not affect proprietor employment while economic freedom’s largest effect is on proprietor employment (column 2). According to the BEA proprietor employment consists of the number of sole proprietorships and the number of general partners. Thus it can act as a proxy for the level of entrepreneurship in an MSA. This result implies that economic freedom is more important than things like weather and geographic location when it comes to promoting small business formation and entrepreneurship. This is a good sign for cities located in colder regions of the country like the Midwest and Northeast that can’t do much about their weather or location but can increase their level of economic freedom.

Of course, correlation does not mean causation and these simple regressions omit other factors that likely impact employment and population growth. But you have to start somewhere. And given what we know about the positive effects of economic freedom at the country and state level it seems reasonable to believe that it matters at the local level as well.

Ignoring the adverse effects of the minimum wage may cost taxpayers billions

Today the Obama administration issued a statement calling for a ‘First Job’ funding initiative to connect young Americans with jobs.

The statement laments how difficult it is for young people to find employment and emphasizes how important a first jobs is for future career success:

“After the worst economic crisis of our lifetimes, the United States is in the midst of the longest streak of private-sector job growth in our history, with more than 14 million new jobs created during the past 70 months. But for too many young people, getting a first job—a crucial step in starting their career—is challenging.

When a young person struggles to get their first job, it can have a lasting negative impact on her lifetime income as well as her motivation, pride, and self-esteem.”  

I brought up this same issue 3 months ago in a previous blog post that highlighted the differences in teenage unemployment across cities. And unsurprisingly there are substantial differences – in 2012 teenage unemployment was over 45% in Atlanta and only about 26% in Houston.

So what’s the proposal? A $5.5 BILLION grab bag of grants, skills investment, and direct wage payments to put young people to work. Naturally, the most obvious solution to the teenage unemployment problem is never mentioned – eliminating the minimum wage. In fact, nowhere is it hinted at that the minimum wage may be contributing to teenage unemployment, despite several recent studies affirming this theory.

From a 2013 study:

“Thus, for older workers, the two effects offset one another, and there is little impact on their long-term employment rate. For teenagers, the extra reduction in hiring implies that their employment rates decline. The results are very similar for males and females.”

From a 2015 study:

Using three separate state panels of administrative employment data, we find that the minimum wage reduces job growth over a period of several years”

From a 2015 study:

We find that a higher minimum wage level is associated with higher earnings, lower employment and reduced worker turnover for those in the 14–18 age group. “ (My bold)

From a 2015 study:

I apply the estimator to estimate the impact of the minimum wage on the employment rate of teenagers. I estimate an elasticity of -0.10 and reject the null hypothesis that there is no effect.”

This glaring omission is unconscionable in light of the abundant evidence that the minimum wage harms the least skilled, least experienced workers, which includes teenagers.

As a Prof. David Neumark stated in a recent WSJ op-ed:

“…let’s not pretend that a higher minimum wage doesn’t come with costs, and let’s not ignore that some of the low-skill workers the policy is intended to help will bear some of these costs.”

An all too common occurrence in US policy is that government intervention causes a problem that the government then tries to solve with additional intervention, completely ignoring the possibility that the initial intervention was the source of the problem. In this case, price controls at the bottom of the labor-market ladder have prevented young people from getting on the first rung, so now the government wants to wheel over a $5.5 billion dollar stool to give them a boost.

While this series of imprudent events is not surprising, it’s still frustrating.

We don’t need more federal infrastructure spending

Many of the presidential candidates on both sides of the aisle have expressed interest in fixing America’s infrastructure, including Donald Trump, Hilary Clinton, and Bernie Sanders. All of them claim that America’s roads and bridges are crumbling and that more money, often in the form of tax increases, is needed before they fall into further disrepair.

The provision of basic infrastructure is one of the most economically sound purposes of government. Good roads, bridges, and ports facilitate economic transactions and the exchange of ideas which helps foster innovation and economic growth. There is certainly room to debate which level of government – federal, state, or local – should provide which type of infrastructure, but I want to start by examining US infrastructure spending over time. To hear the candidates talk one would think that infrastructure spending has fallen of a cliff. What else could explain the current derelict state?

A quick look at the data shows that this simply isn’t true. A 2015 CBO report on public spending on transportation and water infrastructure provides the following figure.

CBO us infrastructure spending

In inflation adjusted dollars (the top panel) infrastructure spending has exhibited a positive trend and was higher on average post 1992 after the completion of the interstate highway system. (By the way, the original estimate for the interstate system was $25 billion over 12 years and it ended up costing $114 billion over 35 years.)

The bottom panel shows that spending as a % of GDP has declined since the early 80s, but it has never been very high, topping out at approximately 6% in 1965. Since the top panel shows an increase in the level of spending, the decline relative to GDP is due to the government increasing spending in other areas over this time period, not cutting spending on infrastructure.

The increase in the level of spending over time is further revealed when looking at per capita spending. Using the data from the CBO report and US population data I created the following figure (dollars are adjusted for inflation and are in 2014 dollars).

infrastructure spend per cap

The top green line is total spending per capita, the middle red line is state and local spending with federal grants and loan subsidies subtracted out, and the bottom blue line is federal spending. Federal spending per capita has remained relatively flat while state and local spending experienced a big jump in the late 80s, which increased the total as well. This graph shows that the amount of infrastructure spending has largely increased when adjusted for inflation and population. It’s true that spending is down since the early 2000s but it’s still higher than at any point prior to the early 90s and higher than it was during the 35-year-construction of the interstate highway system.

Another interesting thing that jumps out is that state and local governments provide the bulk of infrastructure spending. The graph below depicts the percentage of total infrastructure spending that is done by state and local governments.

infrastructure spend state, local as percent of total

As shown in the graph state and local spending on infrastructure has accounted for roughly 75% of total infrastructure spending since the late 80s. Prior to that it averaged about 70% except for a dip to around 65% in the late 70s.

All of this data shows that the federal government – at least in terms of spending – has not ignored the country’s infrastructure over the last 50 plus years, despite the rhetoric one hears from the campaign trail. In fact, on a per capita basis total infrastructure spending has increased since the early 1980s, driven primarily by state and local governments.

And this brings up a second important point: state and local governments are and have always been the primary source of infrastructure spending. The federal government has historically played a small role in building and maintaining roads, bridges, and water infrastructure. And for good reason. As my colleague Veronique de Rugy has pointed out :

“…infrastructure spending by the federal government tends to suffer from massive cost overruns, waste, fraud, and abuse. As a result, many projects that look good on paper turn out to have much lower return on investments than planned.”

As evidence she notes that:

“According to the Danish researchers, American cost overruns reached on average $55 billion per year. This figure includes famous disasters like the Central Artery/Tunnel Project (CA/T), better known as the Boston Big Dig.22 By the time the Beantown highway project—the most expensive in American history—was completed in 2008 its price tag was a staggering $22 billion. The estimated cost in 1985 was $2.8 billion. The Big Dig also wrapped up 7 years behind schedule.”

Since state and local governments are doing the bulk of the financing anyway and most infrastructure is local in nature it is best to keep the federal government out as much as possible. States are also more likely to experiment with private methods of infrastructure funding. As de Rugy points out:

“…a number of states have started to finance and operate highways privately. In 1995, Virginia opened the Dulles Greenway, a 14-mile highway, paid for by private bond and equity issues. Similar private highway projects have been completed, or are being pursued, in California, Maryland, Minnesota, North Carolina, South Carolina, and Texas. In Indiana, Governor Mitch Daniels leased the highways and made a $4 billion profit for the state’s taxpayers. Consumers in Indiana were better off: the deal not only saved money, but the quality of the roads improved as they were run more efficiently.”

It remains an open question as to exactly how much more money should be devoted to America’s infrastructure. But even if the amount is substantial it’s not clear that the federal government needs to get any more involved than they already are. Infrastructure is largely a state and local issue and that is where the taxing and spending should take place, not in Washington D.C.

 

 

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.

 

 

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.

Grants to Puerto Rico haven’t helped much

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

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

Puerto rico govt spending

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

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

Total CDBGs Puerto Rico

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

CDBGs per capita, yr Puerto Rico

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

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

More reasons why intergovernmental grants are harmful

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

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

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

CDBGs 9 cities 1950

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

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

CDBGs 9 cities 2014

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

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

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

Local land-use restrictions harm everyone

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

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

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

moretti, land use pic

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

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

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

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

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

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

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

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

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