Seventh District Update, November 2016

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First, a different special announcement: The Federal Reserve announced on November 30, 2016, changes that will be incorporated into its Beige Book report starting in 2017. For more information, see the press release.

And now, a summary of economic conditions in the Seventh District from the latest release of the Beige Book and from other indicators of regional business activity:

  • Overall conditions: Growth in economic activity in the Seventh District slowed to a modest pace in October and early November, but contacts expect growth to return to a moderate pace over the next six to twelve months.
  • Consumer spending: Consumer spending increased slightly over the reporting period, primarily reflecting gains at middle-market retailers. Sales of new light vehicles remained strong in the District.
  • Business Spending: Growth in business spending continued at a moderate pace. Retail and manufacturing inventories were generally at desired levels. Current capital expenditures and employment both grew at a moderate pace.
  • Construction and Real Estate: Activity increased slightly overall. Demand for residential construction, residential real estate, nonresidential construction, and commercial real estate all edged up.
  • Manufacturing: Growth in manufacturing production continued at a moderate pace in October and early November, with strong increases in autos and aerospace (though slowing a bit again in autos) and modest gains overall among other industries.
  • Banking and finance: Conditions were little changed. While U.S. Treasury bond yields were up after the U.S. elections, corporate bond spreads declined. Loan demand from small and middle market businesses was little changed, as was consumer loan demand.
  • Prices and Costs: Cost pressures increased modestly, but remained mild. Energy prices remained low, but industrial metals prices rallied. Retail prices changed little, wage pressures were steady overall, and non-wage labor costs picked up some.
  • Agriculture: Record corn and soybean yields, combined with stable corn prices and rising soybean prices, implied that more crop operations than previously expected would at least break even this year.

The Midwest Economy Index (MEI) rose to −0.01 in October from −0.11 in September. The relative MEI increased to +0.25 in October from +0.16 in September. October’s value for the relative MEI indicates that Midwest economic growth was somewhat higher than what would typically be suggested by the growth rate of the national economy.

The Chicago Fed Survey of Business Conditions (CFSBC) Activity Index decreased to −20 from +9, suggesting that growth in economic activity slowed to a modest pace in October and early November. The CFSBC Manufacturing Activity Index remained at +3, and the CFSBC Nonmanufacturing Activity Index decreased to −33 from +12.

Where are the Jobs? Midwest Jobs Recovery by State and Sector

The Great Recession, which lasted from December 2007 through June 2009, had a profound effect on U.S. employment. At its height, U.S. unemployment reached 9.5% and job losses totaled approximately 7.3 million. The current recovery is now entering its eighth year, so it may be a good time to take a look at how many jobs lost during the recession have been recovered as one measure of the nature of the labor recovery. In this blog, we examine the pattern of recovery for all five Seventh District states (Iowa, Illinois, Indiana, Michigan, and Wisconsin) in four industry sectors that were heavily impacted by the recession—construction, finance (finance, insurance and real estate or FIRE), manufacturing, and professional and business services.

Figure 1 provides evidence of the job recovery through September 2016 across industries for the U.S. and the five Seventh District states. The first column for each state shows the number of jobs lost in that sector during the Great Recession (in thousands). The second column shows the number of jobs added during the current recovery (in thousands). And the third column shows the recovery rate (jobs added divided by jobs lost in percent). To provide some perspective on the concentration of each industry’s employment within the state relative to the U.S. total, the fourth column shows an employment location quotient. For example, if you look at Illinois, employment in professional and business services is 1.10 (or 10%) above the U.S. total.

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The first thing to notice is that there is considerable variation in job loss and recovery both within sectors and across states. Two industries, health and education and government, actually added jobs during the recession (except in Michigan, where government employment decreased). However, while job gains have been sustained for the health and education sector, government has actually contracted during the recovery. At the other end of the spectrum, job losses were largest in manufacturing, construction (mining, logging, and construction), and transportation (trade, transportation, and utilities). While transportation has seen a strong recovery (143.6% nationally), the job recovery in manufacturing is only 29.7%, and in construction the figure is 48.1%. On a state level, total non-farm employment recovery ranges from a low of 114.2% to 240.9%. Based solely on this measure, the best job recovery rate among Seventh District states would appear to be in Iowa and the worst in Illinois.

Iowa has consistently outperformed the region and the U.S. in job recovery, both in aggregate and by sector, since the end of the Great Recession (figure 1). A clear contributor was the role of agricultural production and rising farm incomes that the state experienced up until 2015. Currently, low crop prices are weighing on farm incomes, so it may be that this pattern of growth is starting to flatten out. As figure 2 shows, over the longer time horizon, Iowa tracked the rate of U.S. job growth coming out of recession but shows a noticeable divergence starting in 2014.

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Michigan entered the Great Recession significantly weaker than other states in the region and the U.S. as a whole, having continued to lose jobs and suffer economic decline through the recovery from the 2000–01 recession. However, since the end of the Great Recession, the state’s job recovery has accelerated. Particularly noticeable is that Michigan has almost fully recovered its lost manufacturing jobs (98.2%), far exceeding the U.S. (29.7%) and significantly better than Indiana, the most manufacturing-intensive state in the region (73%). Clearly, the auto recovery has been a boon to the state.

Illinois has clearly underperformed both the region and the nation in post Great Recession job recovery, both in aggregate and across industry sectors. While Illinois has more than recovered the total number of jobs it lost during the recession (114.2%), only two sectors of the state’s economy have significantly gained jobs. The leisure and hospitality sector is up 482.3% and the professional and business services sector is up 191.5%. While wages in professional and business service jobs are relatively good, the gains in leisure and hospitality are likely to be lower paying jobs. Now, we look at job performance since January 2000 in four key industries—construction, finance, manufacturing, and professional and business services.

Construction

As we see in figure 3, construction employment in the Seventh District states has underperformed the U.S. with the clear exception of Iowa, which has seen a gain of 40% over the 2000 level. U.S. construction employment has returned to its 2000 level, while the remaining four Seventh District states have yet to reach their January 2000 level, with Michigan particularly hard hit—off roughly 25% over the period. The loss in jobs was particularly sharp in 2009 through 2012. Since then, jobs have gradually but steadily come back.

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Finance, Insurance and Real Estate

Like construction, finance experienced a boom running up to the Great Recession, followed by a sharp contraction during the recession. Figure 4 indicates that the employment declines in this sector were most pronounced in Illinois, Indiana, and Michigan.  Recovery rates are now above the 2000 level for the U.S., Wisconsin, Iowa, and Michigan. Where recovery has clearly lagged is in Illinois and Indiana.

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Manufacturing

Manufacturing has been seen as a relatively good news story during the recent recovery. Particularly in the automobile industry, production levels have been consistently high. In addition, export-led capital goods had strong sales growth until the past couple of years. The question is has the rebound in output been reflected in employment? Figure 5 shows that manufacturing continues to follow a stair-step path when it comes to employment. Since 2000, after a shock, employment steps down; during recovery it tends to level off and not fully recover. Manufacturing continues to see a trend toward higher production with fewer labor inputs. For example, even in Michigan, with record-level auto production, manufacturing employment is still 30% below its 2000 level. Similarly in Indiana, the most manufacturing-intensive state in the Seventh District, employment is still roughly 25% below the 2000 level.

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Professional and Business Services

The sturdiest employment performance emerging from the recession has been in professional and business services. Figure 6 shows that all five Seventh District states (and the U.S.) now have professional and business service employment levels above the 2000 level. Admittedly, the sector was not hit as hard by the recession as many others. Indeed, in many cases employment levels remained above the 2000 level during the worst months of the recession. The clear laggard is Michigan. As the figure shows, Michigan was shedding professional service jobs during the expansionary period emerging from the 2000 recession and then faced an even sharper downturn during the Great Recession. As such, it had had more ground to make up, and by early 2016 it had moved back up to its January 2000 level.

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Conclusion

There is little doubt that aggregate employment growth has rebounded from the depths of the Great Recession. However, as we see in the data, the distribution of those gains has been uneven across states and industry sectors.

The Midwest Feels the Sting of an Extended Agricultural Downturn

On November 29, 2016, the Federal Reserve Bank of Chicago will hold a conference to examine the agricultural downturn in the Midwest and discuss future directions for farming, concluding with a panel discussion on the evolution of agricultural lending. (Check https://www.chicagofed.org/events/2016/ag-conference for more details on the conference, including the agenda, and to register.) Experts from academia, industry, and policy institutions will explore the implications of the downturn for both the farm sector and the broader regional economy. The goals of the conference include understanding key trends in farm income, product prices, and input costs; assessing the primary factors behind the sector’s downturn; examining policies that provide support to farm operations and promote risk management; and discussing the role of agricultural lending under these challenging circumstances, as well as in the next phase for agriculture.

Bountiful harvests since 2012’s drought have replenished crop stockpiles to such an extent that supply has outstripped demand, leading to significant reductions in crop prices for midwestern farmers (see charts 1 and 2). Moreover, livestock product prices have tumbled in recent years (see chart 3). Depressed revenues for crop and livestock operations have translated into lower profits as costs of production have been slower to adjust, particularly for crop farms. This downturn in farm profitability followed on the heels of historically high levels of real net farm income[1] (see chart 4). In addition, diminishing income for farm households and operations negatively affected businesses on the Main Streets of towns across the Seventh Federal Reserve District (all of Iowa and most of Illinois, Indiana, Michigan, and Wisconsin).

This latter point was reinforced through a special question included in the Chicago Fed’s latest Agricultural Land Value and Credit Conditions Survey, to which banks responded during October (results were recently released in AgLetter). Bankers were asked: “Is a weakening agricultural economy leading to weaker Main Street business activity in your area?” In all five states of the District the consensus answer was “Yes,” with varying degrees of certainty—30% said definitely and 43% probably, while only 12% did not agree with this take on current business activity in their areas (15% were not certain of any impacts). Based on these observations, the downturn in farm country appears to have slowed the economy of the rural Midwest on Main Street as well.

As for farm households and farm operations themselves, the U.S. Department of Agriculture (USDA) forecasted real net farm income for 2016 to be $64.3 billion, a decrease of 12% from 2015 and the lowest result since 2009 (the most recent reading that was below the median of $66.9 billion from 1950 to 2016).[2] In 2009 dollars, net farm income for the U.S. averaged $95.2 billion over the previous five years, dipping down from the prior five-year period ($95.7 billion, a level that was the highest since the period from 1949 to 1953). With farm incomes even higher than during the 1970s farm boom, the just-concluded era of high farm incomes looks likely to have set the bar quite high for the current generation of farmers.

Furthermore, looking at the District, farm incomes were even bleaker. Real net farm income for each state is available through 2015. Using these USDA data, we estimate that the net farm income for the five states of the Seventh Federal Reserve District was $9.1 billion in 2015, a decrease of 31% from 2014 and the lowest outcome since 2003. The District’s value was also below that of the median year from 1950 to 2015 of $12.8 billion. District states accounted for only 12.4% of U.S. net farm income in 2015, after hitting 22% as recently as 2013.

The spillover impacts of farm income declines on Main Street activity in the region can be attributed to the relatively large role played by farmland rentals in the District—39% of net rent received by non-operator landlords nationwide. Such rental transactions provided $5.5 billion for non-operator landlords in 2015, down 27% from a peak of $7.5 billion in 2013 (adjusted for inflation). These payments lift the direct economic impact of agriculture on the District, although some landlords reside elsewhere. Also, $3.1 billion in 2015 was paid out to hired labor by farms in the District (down 8.8% from $3.4 billion in 2014). Additionally, District agricultural operations spent $23.5 billion in real terms on purchased inputs that did not originate on farms in 2015 (declining 10% from 2013’s peak of $26.1 billion), implying that farms reduced their purchases from cooperatives, equipment dealers, and other businesses. These negative effects on income and business activity reinforce a pullback in spending by farm households. Hence, the economic fortunes of agriculture radiate out into communities and the businesses of the District, which are sharing the pain of the current downturn.

At our conference on November 29, the first session will dig deeper into the impacts of the agricultural downturn, especially on farm operations and rural economies. The second session will explore trends in agricultural financing, with a particular focus on bankruptcy research. Following the keynote address by Bill Northey, the Secretary of Agriculture and Land Stewardship for Iowa, there will be a session devoted to the role of farm policy during the downturn and potential directions for future legislation. Finally, a panel discussion will look into the evolution of agricultural financing as distress in the sector builds, as well as innovations in response to the changing farm environment. These sessions should enhance our understanding of the agricultural downturn and provide clues about potential changes that will affect the sector’s future. Visit https://www.chicagofed.org/events/2016/ag-conference for more information and to register.

Chart 1.

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 Chart 2.

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 Chart 3.

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Chart 4.

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[1] Net farm income is a standard way to measure the size of returns from agricultural operations. Basically, net farm income equals the value of agricultural production and net government transactions minus purchased inputs, capital consumption, and payments to stakeholders. See www.ers.usda.gov/topics/farm-economy/farm-sector-income-finances.aspx for details.

[2] See http://www.ers.usda.gov/data-products/farm-income-and-wealth-statistics/data-files-us-and-state-level-farm-income-and-wealth-statistics/ for data.

Measuring Tax Capacity for Municipalities in Cook County

Illinois’s fiscal situation will likely require tax and revenue increases. How might we assess a municipality’s tax capacity, or ability to “absorb” a larger tax bill? In our previous blog, we reviewed various methods of assessing tax capacity. Now, we use the municipal-gap method to estimate tax capacities for Cook County municipalities.

The municipal gap is the difference between revenue capacity and expected expenditures. We estimate revenue capacity by multiplying the total equalized assessed property values (EAVs) in each municipality by a standard tax rate-the rate required to bring the total property tax revenues of Cook County municipalities in line with their total expenditures on non-school municipal services. Our measure of (own-source) revenue capacity excludes intergovernmental transfers. We predict expected expenditures based on estimates of each municipality’s socioeconomic and physical characteristics. Finally, we subtract expected expenditures from revenue capacity to get the municipal gap. A positive gap implies that a municipality has a larger tax capacity, and a negative gap implies a smaller tax capacity.

In practice, this analysis need not be restricted to municipalities located within one county. However, differences across counties in property assessment practices, as well as the quality and composition of services provided, may distort differences in the municipal gap. Restricting the sample to Cook County municipalities should limit differences due to these extraneous characteristics. To this end, we also exclude municipalities with smaller populations (those with populations below the 25th percentile for Cook County). Consequently, results from our analysis can be generalized to a subset of Cook County municipalities and expenditures, namely general government, which largely consists of public safety expenditures.

Data Sources and Calculations

Non-school municipal expenditures and EAVs were obtained from the Illinois Comptroller’s Fiscal Year 2014 Annual Financial Report.1 In the report, expenditures are categorized according to their reported functions (e.g., public safety) and governmental fund (e.g., general fund). We calculated non-school expenditures by combining all reported expenses across functions and funds. Revenue capacity was calculated by multiplying each municipality’s EAVs by a standard tax rate, which is the aggregate Cook County expenditures divided by aggregate EAVs; the resulting rate is 12.8%. Both expenditures and revenue capacity are normalized across municipalities by expressing them in dollars per capita.

Estimates of socioeconomic and physical characteristics were obtained from the Census Bureau 2014 American Community Survey 5-year estimates.2 We separated characteristics into two groups: environmental and control variables. Environmental variables are assumed to be more exogenous to the choices of local officials and are used to predict expected expenditures. They include the unemployment rate, poverty rate, population density, and population (logged). In contrast, control variables are assumed to be less exogenous, and either failing to control for these factors or using them to predict expenditures may bias our predictions of expected expenditures. Control variables include the percentage of the population ages 25 and older with a bachelor’s degree or higher, income per capita, the percentage of housing units that are owner-occupied, the median age of the population, and whether the municipality owns or operates a public utility company (this last measure comes from the Comptroller’s report).

Brief Data Summary

Table 1 provides descriptive statistics on expenditures, revenue capacity, and the environmental and control variables. On average, a municipality spends $2,545 per capita on non-school services. Cook County municipalities allocate, on average, 33% of non-school expenditures to public safety, and only 2% to social services. The large gap between average revenue capacity ($4,199 per capita) and average expenditures underscores the fact that we exclude a large portion of all expenditures municipalities face, such as those appropriated to overlapping governments. The sizes of standard deviations reflect substantial heterogeneity in the compositions of expenditures across municipalities, in particular for debt and capital outlay. The minimum value for the other expenditures/expenses category in part reflects reimbursements.

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Calculating Municipal Gaps

We use regression analysis to derive expected expenditures. First, we estimate the effects of environmental variables on the dependent variable, actual municipal expenditures, while holding constant the control variables. Second, we predict expected expenditures using a municipality’s actual values of the environmental variables and the estimated effects.

Table 2 provides results from estimating the effects of environmental and control variables on non-school municipal expenditures. Altogether, we could find no evidence that the environmental variables affect municipal expenditures, controlling for additional factors. In addition, the adjusted R-squared value suggests that we explain roughly 40% of the variation in expenditures (around its mean). Table 3 provides an example of calculating expected expenditures for the City of Chicago (values were rounded to 2 decimal places). Multiplying a municipality’s actual values for the environmental variables by each variable’s corresponding effect results in that variable’s contribution to expected expenditures; summing all the contributions leads to expected expenditures. The final step in the analysis is subtracting expected expenditures from revenue capacity, resulting in the municipal gap.

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Results and Conclusion

Table 4 displays the results for municipalities with the largest and smallest gaps. Glencoe Village is assigned the largest positive gap, with an additional $15,846 in revenue per capita available after appropriating funds for expected expenditures. In contrast, Park Forest Village would require an additional $1,802 in revenue per capita to fund its remaining expected expenditures. How do the results of the municipal gap analysis using expected expenditures compare to those using actual expenditures? Table 5 provides findings for the latter scenario. Results for all municipalities included in our study may be obtained here.

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Mapping the municipal gaps illustrates the geographic discrepancies in tax capacity. Figure 1 displays the municipal gaps calculated using expected expenditures. For comparison, figure 2 displays the municipal gaps calculated using actual expenditures. Results are largely consistent between the two; one primary difference is that tax capacity is larger for several southern Cook County municipalities in the analysis with actual expenditures. Perhaps one unsurprising result is that, in general, northern Cook County municipalities have greater tax capacity than more central and southern Cook County municipalities. However, there are “pockets” of municipalities with smaller tax capacity located within regions that have greater tax capacity, and vice versa.

Figure 1: Gap with Expected Expenditures

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Figure 2: Gap with Actual Expenditures

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In sum, identifying the ability for municipalities to absorb larger tax bills is becoming increasingly crucial to estimating local governments’ capacity to generate additional own-source revenues. Several methods exist that rely on comparisons between each government’s revenue and expenditures under hypothetical conditions. Here, we utilized the municipal-gap method to identify tax capacities for a subset of Cook County municipalities. Among the limitations of our analysis is the fact that we exclude important information on both the revenue and expenditure sides. Our analysis relies on non-school expenditures and property values to derive expected expenditures and revenue capacity. Local officials with more complete information on expenditures (e.g., for overlapping governments and schools) and revenues from additional sources (e.g., intergovernmental transfers) may benefit from estimating tax capacity using the municipal-gap approach, or one of the other methods we talked about in our previous blog.

  1. FY2014 Annual Financial Report data procured from the financial database website.
  2. U.S. Census Bureau; 2014 American Community Survey 5-Year Estimates, http://factfinder.census.gov.

Seventh District Update, October 2016

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First, our ongoing special announcement: As a Midwest Economy blog reader, you may also want to sign up to follow our new Chicago Fed Survey of Business Conditions (CFSBC), which is a survey of business contacts conducted to support the Seventh Federal Reserve District’s contribution to the Beige Book. The Chicago Fed produces diffusion indexes based on the quantitative questions in the survey. Click here to sign up for email alerts and click here to view the latest release.

If you are a Seventh District business leader and would like to share your perspective on current economic conditions with us, you are welcome to participate in the CFSBC. Please send an email with your contact information to thomas.walstrum@chi.frb.org.

And now, a summary of economic conditions in the Seventh District from the latest release of the Beige Book and from other indicators of regional business activity:

  • Overall conditions: Growth in economic activity in the Seventh District continued at a moderate pace in late August and September, and contacts expect growth to remain moderate over the next six to twelve months.
  • Consumer spending: Growth in consumer spending increased only slightly and store traffic remained low. The sales pace of autos in the District remained strong, but slowed slightly.
  • Business Spending: Growth in business spending remained at a moderate pace. Retail and manufacturing inventories were generally at desired levels. Current capital expenditures and employment both grew at a moderate pace.
  • Construction and Real Estate: Activity increased modestly overall. Residential construction was little changed, while nonresidential construction, residential real estate, and commercial real estate activity all increased slightly.
  • Manufacturing: Growth in manufacturing production picked up to a moderate pace. Activity continued to be strong in autos and aerospace, while gains remained modest overall among other industries.
  • Banking and finance: Conditions were little changed. Equity prices declined slightly and volatility was low. Loan demand from small and middle market businesses continued to rise. Consumer loan demand increased modestly.
  • Prices and Costs: Cost pressures were unchanged and remained mild. Most energy and metals prices were flat and remained low, though steel prices fell some. Retail prices changed little and wage pressures were steady.
  • Agriculture: Low expectations for farm incomes continued, with contacts expecting that a profitable soybean harvest would not be enough to offset an unprofitable corn harvest.

The Midwest Economy Index (MEI) increased to –0.04 in August from –0.16 in July. The relative MEI moved up to +0.11 in August from +0.01 in July. August’s value for the relative MEI indicates that Midwest economic growth was slightly higher than what would typically be suggested by the growth rate of the national economy.

The Chicago Fed Survey of Business Conditions (CFSBC) Activity Index increased to +7 from −16, suggesting that growth in economic activity picked up to a moderate pace in late August and September. The CFSBC Manufacturing Activity Index increased to +6 from +3, and the CFSBC Nonmanufacturing Activity Index increased to +8 from −27.

Poor fiscal performance a problem for both state and local governments in Illinois

For a recent Chicago Fed Letter article, I looked back at the fiscal performance of Illinois’s state and local governments and found that, taken together, Illinois governments had been consistently spending more than they had brought in since at least the late 1980s. I also found that while the typical U.S. state often spent more than its revenues over this period, the extent of Illinois’s overspending (or under-taxing) was significantly greater. Finally, I found that the biggest difference in spending between Illinois and the typical state was that Illinois governments spent more on pensions.[1]

As I discussed in the article, in order to compare Illinois’s fiscal performance with other states’, I had to combine the data for state and local governments together. This was necessary because each state divides responsibilities for its activities differently between state and local governments (for example, some states fund K–12 schools primarily through state revenues, while others fund them primarily through local revenues).

That said, one question that naturally arises from my analysis is this: Was it Illinois’s state government, its local governments, or both that engaged in overspending (or under-taxing)? While it is not feasible to use the U.S. Census Bureau data I used for the Chicago Fed Letter to compare the performance of Illinois’s state or local governments with those of other states and their localities, it is possible to compare the performance of Illinois’s state government with that of its local governments.

There is one important caveat to the comparison that follows. During fiscal years (FY) 1988–2013, an average of 25.2% of local government revenues in Illinois came from the State of Illinois. This means that local governments in Illinois depend quite heavily on revenues from the state government to balance their books, and that some amount of overspending (or under-taxing) at the local level could be the result of unpredictable declines in revenues from the state government. However, at least for FY1988–2013, this does not appear to be the case, because the percentage of local revenues coming from the state was relatively stable (the standard deviation was 1.9 percentage points). Any overspending at the local level, then, was largely the result of locally made decisions.

Figure 1 plots expenditures as a share of revenues for the State of Illinois and for the sum of local governments in Illinois since FY1988.[2] Over these years, local governments (summed together) have never spent less than they brought in. Perhaps surprisingly, the State of Illinois often performed better than local governments, though it did much worse in the years following the 2001 and 2008 recessions. The state spent less than it brought in in seven out of the 26 years the data cover—which is not a good performance, but better than the performance of local governments.

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Because the Census Bureau data lump all 6,963 local governments in Illinois[3] together, it is impossible to know from the data which of these governments are responsible for the overall overspending (or under-taxing). Poor fiscal performance could be concentrated in a few large governments or be widespread. While it is well beyond the scope of this blog post to gather data on the overall fiscal performance of thousands of local governments, I am able to look at the performance of local governments’ pension systems, which is insightful because as I noted earlier, pension spending was one of the biggest contributors to overspending (or under-taxing) by Illinois governments.

Perhaps the best summary measure of the condition of a pension system is its unfunded liability. This is the difference between the discounted present value of all the future payouts the pension has promised to make and the value of the pension’s assets. The unfunded liability, then, is the amount that taxpayers will have to contribute to the pension system in order for it to be able to cover all of its promised future payouts.

Table 1 shows a breakdown by locale of the total unfunded pension liability facing Illinois state and local governments at the end of FY2014.[4] Of the $158.2 billion total, $104.6 billion (66%) was the responsibility of the state government and the remaining $53.6 billion (34%) was the responsibility of local governments. Beyond the state versus local government comparison, things get complicated because some pension systems cover overlapping geographies. The City of Chicago has six separate pension funds covering its workers, and there are three for Cook County employees (Cook County holds almost the entirety of Chicago and a number of its suburbs[5]). On top of that, most municipalities have their own police and firefighters pensions, and there is a single pension system for all other non-Chicago municipality workers called the Illinois Municipal Retirement Fund.

Even though the system of local government pensions in Illinois is somewhat complicated, it is clear from table 1 that the City of Chicago is disproportionally responsible for the accumulation of local unfunded pension liabilities. A little over one-fifth of Illinois’s population is in Chicago, but Chicago is responsible for more than half of local government unfunded pension liabilities in Illinois. Chicago residents owe $10,492 per person to their city’s pension systems, on top of the $8,130 per person they owe to the state pension systems.

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To make the comparison of the unfunded liabilities of Illinois’s local governments clearer, I show in table 2 the total per capita state and local unfunded liability by place of residence. There is one wrinkle acknowledged within the table, however, which is that Chicago residents are responsible for the pensions of all Illinois teachers, while Illinois residents outside of Chicago are not responsible for the pensions of Chicago teachers. Thus, perhaps a fairer comparison is to count the unfunded liability of the Chicago teachers’ pension fund as a state-level liability. While this change reduces the unfunded pension liability faced by Chicago residents by 13%, they still would owe a total of $17,506 per person to various Illinois pension systems. Those living outside Chicago would face a smaller, but still quite large, liability per person ($11,954 in suburban Cook County and $10,553 outside Cook County).

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While suburban and downstate police and fire pension systems make up a relatively small part of the total unfunded pension liability of Illinois’s state and local governments (5.6%), pension systems for some municipalities may be in much worse shape than others, so that these liabilities can still matter quite a bit. Table 3 shows the unfunded liabilities for police and firefighters pensions for the 25 most populous cities in Illinois. Chicago is in the worst shape, but residents of Moline, Rock Island, Evanston, and Peoria all owe more than $2,000 per resident to their police and firefighters pension systems. Some cities are in much better shape. For example, residents of Urbana owe fewer than $500 per resident to their systems.

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This blog post shows that overspending (or under-taxing) has long been a problem for both the State of Illinois and the local governments in Illinois, with the accumulation of unfunded pension liabilities playing an important role at both levels of government. And while the City of Chicago has built up a larger unfunded pension liability than that of suburban Chicago and downstate Illinois, every region of Illinois bears some blame for overspending (or, once again, under-taxing).

[1] See the Chicago Fed Letter for a detailed explanation of how I calculate pension spending.

[2]See Chicago Fed Letter for details about how these figures are calculated. Expenditures include the change in pension liabilities.

[3] 2012 Census of Governments (https://www.census.gov/govs/cog/).

[4] All unfunded liability data come from the 2015 Biennial Report of the Illinois Department of Insurance Public Pension Division, http://insurance.illinois.gov/Reports/Pension/pension_biennial_report_2015.pdf.

[5] Technically, a portion of O’Hare Airport—and therefore Chicago—is in DuPage County.

What is Illinois’s Tax Capacity?

A recent study ranked Illinois 47th among U.S. states and Puerto Rico for its fiscal health.1 Particularly concerning was the report’s finding that the combination of total debt, unfunded pension liabilities, and underfunded other post-employment benefits amounts to 61% of total state personal income. In contrast, the same figure for other Seventh District states ranges from a high of 38% in Michigan to a low of 16% in Indiana. Given the magnitude of Illinois’s debt, any plan aimed at improving the state’s fiscal solvency will likely require both expenditure cuts and tax and revenue increases.

So what is the taxable capacity of Illinois? Two broad issues arise. First is the issue of fairness: Would further taxation violate society’s notions of imposing undue burdens on those who can least afford it? Second is the issue of impairing economic activity: Would further taxation discourage economic activity or otherwise drive out taxable wealth to an unacceptable degree?

In this blog post, we describe several methods for identifying a community’s tax capacity. In general, researchers have attempted to measure and compare capacities for specific places by calculating hypotheticals that rely on norms or averages across all places. For example, how much revenue might we expect to raise in a community if we imposed average tax rates there? And how much should a community be spending on public services, given its population characteristics and its need for services? And importantly, how do the two estimates differ? Are there obvious gaps between resources and needs?

Gordon, Auxier, and Iselin (2016)2 used such a representative revenue and expenditure approach to estimate this hypothetical gap in funds a state has available for government operations. The study documents that there is enormous variation in the amount of revenue states collect and what they spend on public goods and services. To drill down to tax capacity, the study measures what each state would collect in revenues and spend on government services if it followed national averages, adjusted for state-specific economic and demographic factors. Table 1, section (1) shows the actual gap, or the difference between actual revenues and expenditures, in FY2012, assuming that states rely only on revenues that they raise themselves through taxes and fees. The gaps are sizable, but adding in federal transfers largely erases the gaps. Turning to the hypotheticals as they relate to tax capacity, Table 1, section (2) compares representative revenues, or revenues that a state would raise if it had an average tax structure, to representative expenditures, or expenditures if the state had an average spending per capita. In contrast to the actual gap, the representative gap remains even after the addition of federal transfers in all of the Seventh District states other than Iowa. In this hypothetical case, if Seventh District states (other than Iowa) adopted a nationally representative tax structure, they would not have sufficient resources even after federal transfers to provide a representative level of public expenditures.

table1

Haughwout et al. (2003)3 developed a more refined analysis, termed the “revenue-hill” method, that estimates the deterioration in tax capacity that takes place as higher tax rates discourage taxable activity. The revenue hill builds a hypothetical schedule of tax rates and revenues that demonstrates how fully a city is utilizing its tax base. The goal is to build a “Laffer Curve” that allows policymakers to estimate the economic effects of the next tax dollar (e.g., effect on employment). The closer the measure is to the top of the hill, the closer the city is to exhausting its tax capacity. Once a city is over the top of the hill, increases in tax rates will become so unproductive that revenues actually decline. These measures can be constructed for each tax base a city might use. Therefore, while a city may have reached capacity for one tax base (e.g., sales tax), it may still have capacity in another (e.g., property tax). Haughwout et al. (2003) examined four cities—New York, Philadelphia, Houston, and Minneapolis—and found that only Minneapolis was “comfortably” below its revenue hill, and thus had additional tax capacity. In the case of Minneapolis, additional taxes could provide net benefits to property owners. New York and Houston were at the top of their revenue hills, implying that additional taxes would have a negative impact on employment.

Finally, Bo Zhao and Jennifer Weiner of the Boston Fed suggested the “municipal-gap” method for measuring tax capacities across municipalities in Connecticut, by recognizing that taxable capacity can only be measured in the context of a government’s particular needs and resource costs in providing adequate services.4  For example, limited tax capacity can exist when a community faces higher costs or fewer resources for providing public services (or both). In both cases, it can be driven by economic, topographic, and demographic factors specific to the community (e.g., a relatively high rate of poverty or significant risk of extreme weather).

First, one identifies revenue capacity. Revenue capacity is defined as the ability of municipalities to raise revenue from all of the sources they are authorized to tax, even if they choose not to tax a particular base. Capacity is calculated using the “representative tax system” approach, where all communities use a standard uniform tax rate against the tax base. The rate is determined by ensuring that the statewide rate raises enough revenue to cover existing expenditures. Second, one identifies expected expenditures–the average level of spending based on the municipality’s underlying socioeconomic and physical characteristics. This number is is calculated using regression analysis to predict a municipality’s expenditures based on actual values of the underlying characteristics. One purpose of deriving expected expenditures is to remove the variation in expenditures due to the choices of local officials who may favor particular government programs.

The study focused on the costs of providing largely non-educational local services, primarily public safety. It found that large fiscal disparities in Connecticut were primarily driven by their differences in revenue raising capacity. The uneven distribution of the property tax base coupled with the relative dependence on property tax revenues in the state meant that resource-rich municipalities had, on average, per capita revenue capacity eight times that of resource-poor towns. The cost of providing municipal services was less dispersed, with the highest-cost municipalities spending 1.3 times that of the lowest-cost towns. Importantly, the study also found that non-school revenue grants from the state had limited effect in reducing fiscal disparities.

What can tax capacity studies tell us about Illinois’s fiscal problems?

Illinois has a particularly difficult choice when it comes to future tax adjustments. First, the debt overhang at the state level is so large that any future tax increases will necessarily be directed to paying down debt rather than purchasing new services. Incremental tax increases will pay for services already consumed and, as such, it is difficult to see how future taxes will provide governments with resources to support programs that enhance growth. Second, capacity studies, such as Gordon et al. (2016), suggest that Illinois has already reached its capacity limits. While it would be a stretch to adapt this to the revenue-hill concept of actual declines in revenues in response to tax hikes, it does imply that Illinois has little room to increase taxes without reducing economic activity in ways that would be damaging. The depth of the problem increases when recognizing that many Illinois municipalities also face revenue gaps that would make the compound effects of a state tax increase coupled with a local increase that much worse. As these studies show, there tends to be considerable variation in both the level of expenditures and available revenues across any state when it comes to financing government services. The question then becomes what is the geography of tax capacity in Illinois?

In a second blog, we will apply local revenue capacity and service cost to Illinois municipalities. Stay tuned to see what fiscal disparities might exist for municipalities in Cook County.

  1. Norcross, E., & Gonzalez, O. (2016). Ranking the States By Fiscal Condition.
  2. Gordon, T., Auxier, R., & Iselin, J. (2016). Assessing Fiscal Capacities of States.
  3. Haughwout, A., Inman, R., Craig, S., & Luce, T. (2003). Local Revenue Hills: Evidence from Four U.S. Cities.
  4. Zhao, B., & Weiner, J. (2015). Measuring Municipal Fiscal Disparities in Connecticut.

Seventh District Update, September 2016

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First, a (repeat) repeat special announcement: As a Midwest Economy blog reader, you may also want to sign up to follow our new Chicago Fed Survey of Business Conditions (CFSBC), which is a survey of business contacts conducted to support the Seventh Federal Reserve District’s contribution to the Beige Book. The Chicago Fed produces diffusion indexes based on the quantitative questions in the survey. Click here to sign up for email alerts and click here to view the latest release.

If you are a Seventh District business leader and would like to share your perspective on current economic conditions with us, you are welcome to participate in the CFSBC. Please send an email with your contact information to thomas.walstrum@chi.frb.org.

And now, a summary of economic conditions in the Seventh District from the latest release of the Beige Book and from other indicators of regional business activity:

  • Overall conditions: Growth in economic activity in the Seventh District picked up to a moderate pace in July and early August, and contacts expect growth to remain moderate over the next six to twelve months.
  • Consumer spending: Growth in consumer spending slowed notably with most segments reporting little change in sales. Auto sales slowed some, but remained strong.
  • Business Spending: Growth in business spending picked up to a moderate pace. Retail inventories were somewhat higher than desired because of softer sales. Current capital expenditures picked up to a moderate pace, while hiring continued at a modest rate.
  • Construction and Real Estate: Activity increased slightly overall. Residential construction and home sales increased slightly. Demand for nonresidential construction picked up some, and commercial real estate activity increased slightly.
  • Manufacturing: Growth in manufacturing production picked up to a moderate pace. Activity continued to be strong in autos and aerospace, and increased in most other industries.
  • Banking and finance: Conditions improved modestly. Equity prices were higher, volatility was low, and loan demand from small and middle market businesses grew modestly. Consumer loan demand increased slightly.
  • Prices and Costs: Cost pressures were unchanged and remained mild. Most energy and metals prices were flat and remained low. Retail prices changed little and labor cost pressures were steady.
  • Agriculture: Already low expectations for farm incomes deteriorated over the reporting period as the potential for a record national harvest pushed prices down further.

The Midwest Economy Index (MEI) decreased to −0.14 in July from −0.04 in June. The relative MEI moved down to +0.03 in July from +0.38 in June. July’s value for the relative MEI indicates that Midwest economic growth was quite close to what would typically be suggested by the growth rate of the national economy.

The Chicago Fed Survey of Business Conditions (CFSBC) Activity Index increased to −18 from −23, suggesting that growth in economic activity remained at a modest pace in July and early August. The CFSBC Manufacturing Activity Index increased to a neutral value from −31, while the CFSBC Nonmanufacturing Activity Index declined to −27 from −18.

Detroit and Chicago: Real Property Value Comparisons

Both Chicago and Detroit have become poster children for city government financial stress in recent years. Chicago’s city and school district alike have been running structural deficits, meaning that the government has been covering its normal operating expenditures by issuing or over-extending debt and running down its assets. Both Chicago’s municipal government and school district face large shortfalls in required contributions for the future pensions of current and retired employees. Both have raised local property taxes as partial steps toward balancing their budgets. In the case of Detroit, the city has only just emerged from Chapter 9 bankruptcy while its school district teeters on insolvency under state-mandated “emergency manager” operation.

Are these places comparable in terms of their outlooks and situation? The value of real property in each place offers one fascinating indicator of the resources available to their local governments, as well as a look into how private homeowners and commercial property owners perceive the general prospects of Detroit and Chicago.

Why examine real property values? In some sense, real estate and improvements are long-lived assets that are largely fixed in place. In the market for these properties, buyers and sellers must assess and incorporate the government fiscal liabilities and service benefits – present and future – attached to these properties in the prices at which they buy and sell. High (and rising) property values may indicate that home owners and commercial property owners expect that the prospects for value in these locations are good and that they will continue to improve. And from the local government’s perspective, high values indicate that there may be room for further imposition of local taxes to fund government services, if need be.

Nuts and bolts

The estimation of the value of real property—land and improvements– in a locality is far from an exact science. The actual sales prices of property can be thought of as one reflection of an individual parcel’s value. However, as we saw during the financial crisis last decade, sales transaction prices can be very volatile, and sometimes speculative. More practically, parcels of property do not turn over frequently, so that transactions prices of all property parcels are not observed in any one year. In practice, then, local public officials often rely on various estimation methods in assessing the value of property for taxation purposes, most of which involve using a sample of information from similar properties that were sold during a year. From the recorded sales price and a property’s particular features such as size, location, age, and configuration, the property assessment office infers the value of each property and, ultimately, the total value of property against which taxes are levied.1 These taxable values are often termed assessed values or sometimes equalized assessed values and often represent some fixed percentage of market or true value.2

In the charts, we draw on such data from the local and state governments of Detroit, Chicago, and Illinois to estimate the market or true value of real property in both Detroit and in Chicago.3 For Detroit, figures on total assessed property value are published in the city’s Comprehensive Annual Financial Report (CAFR). By law, assessed value must amount to one-half of true value in Michigan. And so, to arrive at our estimates of full value, we simply double the assessed value. We believe that this yields a far upper bound on the value of residential property in Detroit because there is much evidence that, following the steep plunge in Detroit’s property market over the last decade, assessments were not reduced to accord with actual market value in a timely fashion.4

Drawing on prices of homes that recorded sales, the following chart shows that average home prices began to fall in 2004, while assessed value did not begin to fall until 2009.Detroit_Assessed_HomePricesFor Chicago, a prominent local government “watchdog” and research foundation has long been using state and city data on recorded property sales by class of property to estimate full market values.5 The accuracy of these data is believed to be reasonable, though far from exact.6

What do we see?

Due to lags in data availability, the estimates below are representative through calendar year 2014. The charts display total property value across all types, as well as the largest category in both Chicago and Detroit, that being residential property.

As shown here, Chicago real property value rose dramatically during the early part of last decade before dropping off just as dramatically. Detroit’s property values remained flat. However, Detroit’s apparent stability belies the fact that assessed values of residential properties have not been allowed to fall off in tandem with actual market transactions price there. As measured by volume of sales, the market for residential real estate in the city of Detroit became almost nonexistent during this period.7 Few homes were sold using conventional financing; almost all of them sold for cash. By some estimates, prices of homes sold fell by many multiples during this time, though they have since been heading back up in parts of the city.

Even using generous measures, and with rising home prices in some neighborhoods, residential property value overall in Detroit have continued to drift lower in recent years. In contrast, following the steep decline, Chicago property values have begun to recover for both residential and commercial (not shown) property.

Most telling, at over $80,000 per resident, the value of overall taxable real property in Chicago remained markedly higher than that of Detroit as of 2014. By even our generous measure, Detroit’s property values were only about $25,000 per resident.Detroit_Chicago_PropValuesDiscussion

It would appear that, as measured by real estate values, Chicago’s economy and prospects remain much stronger than Detroit’s. And from a local government perspective, Chicago’s taxable resources with which to pay down liabilities and fund public services appear to be much larger. Of course, there are myriad political and institutional factors at play that render such a simple assessment of wealth inadequate to characterize the fiscal capacity of these cities. In both places, for example, property wealth is concentrated in a subset of places such as near the downtown areas and along the waterfronts. Accordingly, it may be difficult to tap available property wealth selectively because existing statute largely requires that tax rates be applied uniformly. And voters and their representatives may be reluctant to allow tax hikes at all. Similarly, there may be different levels of sensitivity to taxation in these two places and among different constituencies. For example, the imposition of new and higher taxation may cause economic activity and investment to decline more sharply in one place as opposed to another.

More broadly, we might ask whether property wealth is a good indicator of potential resources that local governments may draw on to fund services. A look at more U.S. cities may be helpful. The next chart undertakes the same exercise for the most populous cities. Here we see that Chicago continues to look fairly robust by this measure, though less so than the cities of San Diego, Los Angeles, Austin, and New York City.MajorCities_ProvValues

  1. Assessed value of property for taxation purposes is often a fixed percentage of market value across all property parcels, or else it is a fixed percentage across all parcels of a certain type or class such as residential, commercial or industrial. In turn, estimates of full value of all property can be made by taking sample average ratios of “assessed value/sales price” and applying these ratios to all parcels’ assessed values.
  2. Equalized assessed values refers to the practice of further adjusting the totalities of assessed value of property across jurisdictions so that each locale’s assessed valuation represents the same or “equalized” value in relation to (percent)  sales price or true value.
  3. The city of Detroit also taxes tangible personal property of commercial enterprises such as computing equipment and furniture; Chicago does not.
  4. Using sales price and assessed values for a sample of 8,650 residential parcels in 2010, Hodge et al find an average assessment to sales price ratio of 11.47, which suggests an average over assessment or property values many times over. See Timothy R. Hodge, Daniel P. McMillen, Gary Sands, and Mark Skidmore, 2016, “Assessment Inequity in a Declining Housing Market: The Case of Detroit,” Real Estate Economics.
  5. See https://www.civicfed.org/sites/default/files/Estimated%20Full%20Value%20of%20Real%20Property%20in%20Cook%20County%202005_2014.pdf
  6. Discrepancies arise because only sample values of real estate transactions are available in any one year. In addition, full value projections derive from the median value of property in each class. However, the median property value may not represent the entire distribution of property values.
  7. See http://www.urban.org/sites/default/files/alfresco/publication-pdfs/2000739-Detroit-Housing-Tracker-Q1-2016.pdf

Seventh District Update, July 2016

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First, a (repeat) repeat special announcement: As a Midwest Economy blog reader, you may also want to sign up to follow our new Chicago Fed Survey of Business Conditions (CFSBC), which is a survey of business contacts conducted to support the Seventh Federal Reserve District’s contribution to the Beige Book. The Chicago Fed produces diffusion indexes based on the quantitative questions in the survey. Click here to sign up for email alerts and click here to view the latest release.

If you are a Seventh District business leader and would like to share your perspective on current economic conditions with us, you are welcome to participate in the CFSBC. Please send an email with your contact information to thomas.walstrum@chi.frb.org.

And now, a summary of economic conditions in the Seventh District from the latest release of the Beige Book and from other indicators of regional business activity:

  • Overall conditions: Growth in economic activity in the Seventh District continued at a modest pace in late May and June, and contacts expect growth to remain modest over the next 6 to 12 months.
  • Consumer spending: Growth continued at a moderate pace. Auto sales remained robust.
  • Business Spending: Growth remained modest. Most retailers and manufacturers reported comfortable inventory levels. Current capital outlays remained modest and plans for future outlays declined. Hiring continued at a modest rate, and there was an uptick in expectations for future hiring.
  • Construction and Real Estate: Activity increased slightly overall. Residential construction was little changed, while home sales increased in most locations. Demand for nonresidential construction increased slightly and commercial real estate activity rose modestly.
  • Manufacturing: Growth remained modest. Activity continued to be strong in autos and aerospace, but remained weaker in most other industries.
  • Banking and finance: Developments were mixed. Financial market volatility increased significantly, driven primarily by the United Kingdom’s vote to exit the European Union. Business and consumer loan demand grew slightly.
  • Prices and Costs: Cost pressures were unchanged and remained mild. Most energy and metals prices were flat and remained low. Retail prices were flat and labor cost pressures were steady.
  • Agriculture: Corn and soybean price gains led more farmers to lock in prices for the fall harvest, though the increases were not enough to change contacts’ expectations that farm incomes will be weak this year.

The Midwest Economy Index (MEI) decreased to +0.12 in May from +0.28 in April. The relative MEI declined to +0.53 in May from +0.71 in April. May’s value for the relative MEI indicates that Midwest economic growth was somewhat higher than what would typically be suggested by the growth rate of the national economy.

The Chicago Fed Survey of Business Conditions (CFSBC) Activity Index decreased to −24 from −21, suggesting that growth in economic activity remained modest in late May and June. The CFSBC Manufacturing Activity Index declined to −28 from −17, while the CFSBC Nonmanufacturing Activity Index ticked up to −22 from −23.



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