how would you know a good economic development policy if you ...

National Tax Journal Vol. 47, no. 4, (December, 1994), pp. 863-81

HOW WOULD YOU KNOW A GOOD ECONOMIC DEVELOPMENT POLICY IF YOU TRIPPED OVER ONE? HINT: DON’T JUST COUNT JOBS PAUL N. COURANT* one hand and jobs, branch plants, investment, etc. on the other is by no means obvious or straightforward. What is straightforward are some standard propositions about the welfare economics of government intervention in the economy. These may be summarized in an entirely familiar way-unless there is either market failure or dissatisfaction with the income distribution generated by market outcomes, there is no persuasive rationale for government intervention. There is, of course, plenty of market failure that government may be able to ameliorate,’ and there are many reasons to want to change the distribution of income. My claim here is that economists concerned with economic development should direct more effort to evaluating the potential for improving economic welfare (local, state, national, or international, depending on the circumstances) as distinct from measuring (in however intricate, difficult, and sophisticated ways) the consequences of development programs. To the extent that politicians refuse to listen to us, preferring words of one syllable (“jobs,

INTRODUCTION There is an enormous amount of literature on the effectiveness of state and local economic development policies. Most of the empirical literature by economists [very nicely summarized by Bartik, a major contributor (1991)] has been devoted to measuring how effective various kinds of policies are, with the effects measured in terms of employment, business starts, and new branch plants, among other things. Put baldly, what I want to argue here is that, with a few notable exceptions, the existing literature reflects a great deal of effort that could have been better spent asking different questions. What we should seek to measure in our assessments of local economic development policies is changes in the level and distribution of economic welfare. The connection between welfare on the *Department of Economics and Institute of Pubk Poky Studies, University of Mtchigan, Ann Arbor, MI 48109-1220

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jobs, jobs”), it is our duty as economists to attempt, at least at the edges, to help them to understand that jobs are not coterminous with benefits, and that both jobs and benefits generally entail costs.

sources devoted to economic development at the st:ate and local level is used to subsidize capital, radher than labor. While it is quite likely Jhat capital subsidies at the local level ithcrease local employment, it is very unlikely that a capital subsidy of a given doll& amount would increase labor demandIby more than a labor subsidy of the same magnitude.

POLICY GOALS AND THE POLICY LITERATURE

Jobs may be the outcope of most interest to policymakers andf politicians, but the emplrical literature iexamines many outcome measures of development programs. These include, among other things and with many variations by industry and many differ?nt detailed definitions: new plant opelpings; average growth rate of state pr/oduct; employment growth; changes~in output; new branch plants; foreign direct investment in manufacturing; small1 business starts; changes in personal indome (usually per capita); labor intensity bf manufacturing; high-tech employment; new capital expenditure; value-added in manufacturing; size of new branch plants; value of business building permits; number of relocating Imanufacturing ,firms; amount of industrial land.’ Studies1 that use these measures have been eTployed at the state, substate region, +nd local levels. Consistent with the spe/cial emphasis that policymakers place on manufacturing, a disproportionate number of these studies emphasize eith e r manufacturing as a whole or some subset of manufacturing industries. Also, it is fair to say that most of the literat re, and most of the policy effort, has in olved fiscal in“, centives, mostly on theitax side. In principle, however, most oft what I have to say in this paper should be applicable to any kind of developmeAt incentive.

Wassmer (‘1993) reports, using somewhat dated sources, that 28 states have explicit tax abatement policies that are designed to stimulate local economic development, and that 28 states (not necessarily the same ones) have other economic development policies. Bartik (1994) provides further evidence that state and local development policy is ubiquitous and nontrivual in magnitude. As a practical matter, state and local (and, indeed, national) policy regarding economic development seems to be primarily concerned with “creating” jobs.’ When pushed, it turns out that policymakers strongly prefer “good jobs,” the meaning of which is subject to considerable debate, especially cluring elections. Approximately, good jobs seem to be jobs that are fairly secure, pay well enough, and carry suffic:ient benefits so that a family whose adults are employed at between one and two such jobs can own a home, be reasonably insured against medical and other disasters, take occasional vacations, and send children to college.3 Policymakers are often especially interested in manufacturing jobs because they tend meet the criteria for “good jobs ” Indeed, economic development policy is often explicitly directed at increasing manufacturing employment. Against a backdrop of over a decade of declining manufacturing employment nationwide, this emphasis makes for a number of apparent polrcy failures4

PROBLEMS WITH THE MPIRICAL LITERATURE IN ITS OWk TERMS

It is interesting to note, given politicians’ almost universal interest in increasing employment, that the lion’s share of re-

There would seem to bp three general reasons why one might want to measure 864

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SYMPOSIUM ON STATEAND LOCAL DEVELOPMENTPOLICY


-parts industry in the state. (That it also does not tell us whether state income or welfare would rise or fall goes without saying.)

the effect of various policies on any or all of the list of outcome measures given above. (1) It might be that labor demand is the outcome of interest, and that other outcome measures (other than employment itself) are thought to be good proxies for labor demand, or to be part of processes that lead to increased labor demand. (E.g., increased investment, adding to the capital stock, increases the value of the marginal product of labor, and hence labor demanded.) (2) It might be that the outcome measures are of interest, or of value, in their own right. For example, one could have a scientific interest in the processes that generate Gross State Product. Or one could have a political interest in processes that generate rents for valued constituencies. (3) It might be that the outcome measures are good proxies for, or are part of a process that generates, economic welfare.

Unless the inventory tax was on the downward-sloping part of the Laffer curve, the reduction in inventory taxes will generally reduce state government revenues. Given that most states operate under balanced budget requirements, the government will respond, in some combination, by raising other taxes and cutting expenditure. These responses will make the state a less attractive place to live and do business for everyone whose benefits from the inventory tax reduction are less than lost benefits from the other tax increases and spending cuts. There will be changes in the composition of labor supply and local product demand that will, generally, be opposite in sign to what happens in the muffler-parts and related industries. The net effect of the cut in inventory taxes on total employment, manufacturing employment, and income could plainly go either way.6 Without a specific model of the relationship between a given outcome measure (muffler-parts branch plants, in this example) and something that is of policy interest (e.g., employment and income in the state, or net economic welfare of different groups), knowing a lot about what drives the outcome measure is of little or no value for helping to formulate good policy. Such models, or even discussions of why we might want to measure given outcomes of development policies, are conspicuous by their absence in this literature.7

Whatever the reasons for undertaking these measurements (other than purely scientific interest), the user of the research needs to know the relationship(s), if any, between the variable being studied (e.g., increases in new branch plants in a specific manufacturing industry as a share of all business starts in a state) and variables that are of policy interest. Suppose that someone establishes, with great precision, the relationship between, say, general inventory taxes and the establishment of branch plants for muffler-parts suppliers in a specific state in the Midwest. Suppose that the relationship is fairly powerful, and that it has the right sign-cutting the tax increases the number of branch plants. Without further explicit modeling of the industry and of the state’s economy, the preceding information does not tell us whether a reduction in inventory taxes will increase employment in the state, employment in manufacturing in the state, or even employment in the muffler-

Why Do Estimated Effects Vary So Much ? There is enormous variation in the estimated effects of taxes on the various outcome measures associated with business location and business activity. In his paper in this symposium, for example, 865


Bartik reports that the long-run elasticity of business location (measured across all of the outcome measures of the studies he has looked at) with respect to taxes is probably betwelen -- 0.1 and ---0.6. One obvious reason for the large range, implicit in the muffler-parts example and well recognized in much of the literature, is that the uses to which tax revenues are put will generally affect the attractiveness of different locations. Many studies of the effect of development policies attempt to deal with this problem by including rneasures of government spending, especially in areas thought to be of value to capital, as control variables. As it turns out, these help-studies that include measures of public services are more likely to find significant effects of taxes, with the right sign (Bartik, 1991, p. 39). Even so, there remains large variation, and there is also a great deal of variation in estimates of the effect (on various measures of business location and activity) and levels of public spending on specific services. (Bartik, 1991, Appendix Table 2.3) I think that this kind of imprecision in measured effects is unsurprising, and derives from geographic heterogeneity that is extremely difficult to correct for statistically. A dollar of spending on a given public service (e.g., education) will generate different consequences depending on the quality and policies of the school district, or of the complementarities between education aind what local industry is doing. No plausible level of disaggregation is going to pick these differences up. The effects will, in fact, vary by place, the controls for such variation will be imperfect, and, willy nilly, studies that look at different places and times will obtain different estimates of the effects of independent variables as measured. When controlling for the effects of public spending, be it on eclucation, roads, or anything else, looking for an average

effelct means averaging the very different effects in places where government IS well and badly run, or run with varying goals and under varying conditions. The same sort of argument applies to studies of the effect of taxes, especially when such studies do not control for the content of spending. It matters how good (as well as how large) the spending ‘side is. Similar arguments apply to large variances in the estimates of the effects of industrial parks, other summary measures of “business support” and “business climate.” In all of these cases, what the policy or program actually does will vary geographically in ways that are extremely difficult to control for. Thus, studies done in different places will (if well done) measure different effects, and studies done across many places will produce averages that may not be applicable ko any place in particular.8 lmplica trons Knowing the average effects of, say, property--tax rates and bpending on highways is not very valuable in any particular policy setting. In the empirical literature on economic development, the estimated range of effects typically includes both signs and substantial (for policy) differences in magnitudes on both sides of zero. The! policymaker who infers that her town (or state) would act like the average from some set of studies would be much betfer advised to pursue the question of show much her town (or state) looks like places that have large, small, positilve, or negative effec:ts. The average just is not much help when the variances are large and the cause of the large variance is unmeasured, real, policy-relevant heterogeneity. So far, what I have said seems unusually dismal, even for economics. The line of argument that I have taken here sug-

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subsidizes local business location must reduce economic welfare in the local economy.

gests that in order to make practical use of existing and similar empirical work on the effects of economic development policies, we need to do considerably more work, of a very difficult type; we need to characterize what it is about specific localities that can be associated with particular estimates of the parameter values of interest. Fortunately, there is another way: a great deal of practical information on where to look for good government policy can be derived from straightforward applications of wellknown propositions in welfare economics.

Of course, each of the numbered assumptions of Proposition 1 may not hold. It is also possible [and pursued extensively by Bartik (1991>] that economic development policies have desirable distributional effects. In light of the fact that direct redistribution at the state and local level is very difficult, there may be a second-best case for using development policy for distributional ends.’ My claim, to be pursued for most of the rest of this paper, is that only when distributional considerations are adduced, or one or more of the assumptions made above do not hold, can there be a cost-effective role for local development policy. This claim has strong implications for research on economic development policy. It tells us where to look for productive policy opportunities.

WELFARE ECONOMICS AND FACTOR MOBILITY With exceptions too rare to be considered here, local and state economies are small and open: their enterprises and their residents are price takers with respect to traded goods, including traded factors of production. Capital will locate in a given place only if the after-tax return is at least as high there as anywhere else. Labor will be supplied in a given place and to a given activity only if a worker with given tastes and endowment can do at least as well there as elsewhere, given the wage, other working conditions, taxes, and the prices of both traded and nontraded goods. All of this greatly constrains what local economic policy can accomplish. A consequence of those constraints is summarized in the following proposition:

For now, let us assume that the four assumptions do hold, and, in the interest of proving the proposition, examine the behavior of economic development policies in a local economy to which they apply. Consider a local economy that produces output X by means of a production function that uses land (L), labor (N), and capital (K). For our purposes it does not much matter what the particular output of the local economy might be. All that matters is that X is something of value that can be traded, either directly or indirectly, with the rest of the world at a known price. In essence, the local economy is being modeled as a single, profit-maximizing firm (but without any market power) that produces valuable “stuff.” Assume that the amount of land available to the local economy is fixed. In the long run, the supply of capital to the local economy is assumed to be perfectly elastic at a national (or world) real interest rate r.”

Proposition 1 If (1) the local economy exhibits the usual diminishing marginal returns to factors (technically, production sets are convex); if (2) existing taxes on mobile factors of production are levied on the benefit principle, if (3) there is no nonfrictional unemployment, and if (4) the costs of local economic development policy are locally borne; any policy that 867


FIGURE 1. The Size of a Local Economy

r* rs

are determined by marlket forces. These equilibrium quantities &ill depend, of course, on tastes, technologies, world prices, a1Id other econbmic circumstances.

Figure 1 depicts one way to determine the equilibrium size of a local economy in this model. The figure shows an augmented demand and supply of c:apital to the locality On the vertical axis is the net real annual return to a dollar’s worth of capital-the amount of income, after depreciation, that a dollar’s worth of capital will yield when invested in the local econoimy. The horizontal axis measures the amolunt of capital invested in the economy. The downward-sloping curve is the marginal product of capital schedule.”

Develop,ment Subsidiep in the Model Given a set of economic circumstances, market forces will determine the size of a local economy, as depicted in Figure 1. Basically, there are tw broad ways in which government polilcy might be used to change the equilibrium. One IS to try to change the demands schedule-to make capital (and, alth ugh not shown, labor) more productive1 shifting the demand curve out and inlcreasing equilibrium output. The secorId way is to subsidize the employment qf capital (or labor) in the local economy. In this latter case, which is the subject of this discussion, the marginal product ciurve stays put,

0

0

In equilibrium, the returns to capital in the rest of the world and the local economy must be equal, at r*. Thus the amount of capital in the local economy will be K*. This, given a labor supply function to the locality, will also imply an equilibrium amount of employed labor, N”. All of these equilibrium values 868

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on the open market, and incur the cost of transporting it and burying it. The gold would then surely be worth digging up, but in the end all that would be available would be the value of the gold. The costs of transport, burying, and digging would be lost forever.

and policy induces a movement along the curve. There are many ways for governments to subsidize capital. Here, for simplicity, we treat them all as direct reductions in the cost of employing capital in the local economy. Effectively, at least for new capital (quantities above K*) the supply curve given by r” is shifted downward to r”, and the quantity of capital employed is increased, from K” to /C. Recognizing that eventually all capital will have once been new, a case can be made that in the long run a subsidy program shifts the supply curve down along all of its length. This is shown in the dotted line.

This last analogy suggests some of the motivation for supporting capital subsidies. If the equilibrium demand for capital in a community were somehow larger, property values, employment, and wages would indeed be higher. Thus there is pressure on the local government to somehow create the extra demand. Policies that shift the demand curve out have the potential, as we shall see, to cover their costs, but there may be no such policies available. Proposition 1 tells us that policies that move the community along the demand curve cannot cover their costs, but they mimic the consequences of productive policies by increasing output and employment, and they are easy to implement. Moreover, the output and employment are easy to point to, where the costs of the subsidy may be widely dispersed throughout the local economy. While the public debate over such policies is invariably couched in terms of their effectiveness in increasing output and employment, the point of this discussion is that that is the wrong debate. The policies may well affect economic variables, but their certain costs exceed their maximum potential benefits.

What are the costs and benefits of a subsidy of this type? The dollar value of the increased annual local output is given by the lightly shaded area under the marginal product of capital curve from K* to C. (Each point on the marginal product curve gives the output attributable to a small increment of capital. Adding up these amounts, increment by increment, yields the area under the curve as the total increase in output.) The annual cost of generating this output is simply the cost of renting the use of the extra capital (I