Trends in Education and Income in Chicago

Harvard economist Edward Glaeser shows that education is one of the strongest predictors of urban economic growth.   This is particularly the case for older cities like Chicago.  One of the reasons for this is that a higher density of college-educated workers is associated with higher levels of worker productivity.

There is very good news for Chicago.  Recent data for 2016 from the United States Census Bureau’s American Community Survey shows that the city of Chicago now has the highest percentage of college graduates of the seven largest cities in the United States (Table 1).  Almost 2 out of 5 adults twenty-five and older in Chicago have at least a bachelor’s degree. Chicago beats New York City, Los Angeles, San Antonio, Houston, Phoenix, and Philadelphia.  Of the ten largest cities, only San Diego and San Jose have higher levels of educational attainment as measured by the percentage of adults with at least a bachelor’s degree.

If the sample is limited to non-Hispanic whites, Chicago even beats San Diego and San Jose, the home of Silicon Valley.  For this population, over 3 in 5 have a college degree in Chicago.  In some community areas in Chicago like Lincoln Park, Lakeview, and the Loop, about 4 out of 5 have a college degree.

One of the reasons for Chicago’s success in this arena is that the city of Chicago is an attractive place to live and work for college graduates, especially young grads.  Over half of the young college graduates in the Chicago metropolitan area live in the city of Chicago.  This is up from about forty percent in 1990.

Another reason is that migrants to Chicago are more likely to have a college degree.   Last year about 3 of 4 migrants to Chicago from other states and from abroad had a college degree.  Ten years ago only about 1 in 2 migrants to Chicago had a college degree.  It is particularly noteworthy that in 2016 seventy-three percent of foreign migrants to Chicago had a college degree.

If one goes back in time, Census data indicates that adults in the city of Chicago were significantly less educated than their suburban counterparts.  This is no longer the case.  The percentage with a college degree in Chicago is higher now than in the suburbs of the Chicago metropolitan area although some suburbs have higher levels of attainment (Table 2).  For example, 2 out of 3 residents of Evanston have at least a bachelor’s degree.

Although non-Hispanic whites who account for about one-third of the population of Chicago are doing well, the situation for African-Americans and Hispanics is more mixed.  Of the ten largest cities in the United States, African-Americans in Chicago rank seventh and Hispanics rank ninth in the percentage of adults with a college education.

The good news is that both the percentage and number of college-educated African-Americans and Hispanics in the city of Chicago has increased since 2010.  This is also the case for non-Hispanic whites and Asians. In Table 3, data are arrayed on the number and percentage of college graduates in the city of Chicago by race and ethnicity.  The data indicate that the largest gain in the number of college graduates was for non-Hispanic whites followed by Hispanics.  The largest relative gain was for Hispanics (over fifty percent) followed by Asians.  Overall, there was a 20% increase in the number of college graduates in the city of Chicago between 2010 and 2016.   Part of the increase is a result of growth in the number of non-Hispanic whites, Hispanics, and Asians in the city.  For the African-American population, growth in the number of college graduates cannot be attributed to population growth because the number of blacks in the city declined by ten percent during the 2010-2016 period.

In suburban areas, the story is different, as shown in Table 4.  For example, in suburban Cook County non-Hispanic whites are over twenty percentage points less likely to have a college degree than their counterparts in the city of Chicago.  Further, there has only been a one percent increase in the number of non-Hispanic whites with a college degree in the suburbs of Cook County. This is partly a result of a seven percent decline in the non-Hispanic white populations in suburban Cook County.  At the same time, there have been large increases in the number of African-American, Hispanic, and Asian college grads in suburban parts of Cook County.  For example, for the 2010-2016 period, the African-American population in suburban Cook County increased twelve percent.

Further, Chicago public schools that disproportionately serve African-American and Hispanic families have improved considerably. Over the past ten years, CPS high school graduation rates have increased from fifty-seven percent to seventy-four percent. Of high school graduates, a higher percentage are going to college. Test scores are up as well. Low-income students in Chicago outperform other low-income students in other districts in Illinois.  A Stanford study argues that CPS is the fastest-improving school district in the country.

It is worth noting that in the 1980s Secretary of Education Bennett called the Chicago public school system “the worst in the nation.”  Although it is not clear if that was ever the case, it certainly is not now.

Although there is good news on education, the evidence on income is more mixed.  This is partly a product of national trends over the past couple of decades.  For the city overall, median real household income increased three percent last year.  Since 2010, real income has increased close to eight percent  although there is substantial variation by race and ethnicity.  Non-Hispanic white income increased seven percent while Hispanic income increased almost ten percent.  Although household income in the African-American community increased this past year, it is almost five percent lower in real terms since 2010.  Over a longer period of time (since 1979) African-American income has declined even more (twenty-one percent) although non-Hispanic white income is up substantially (forty-three percent).

In the suburbs of Chicago, household income has also increased modestly (about three percent) this past year.  Over a longer period of time, non-Hispanic white income in the suburbs is about where it was at in 1979.  However, median household income for African-Americans in the suburbs has remained constant since about 1979.

Although education has increased in the city of Chicago relative to suburban Chicago, median household income in suburban areas is still significant higher than in the city of Chicago.  In 2016, household income in the city was eighty percent of median household income in the metropolitan area.  This is up two percentage points since 2010.

These changes have driven other important changes in Chicago.  On the positive side, the high concentration of talent in parts of the city is resulting in high skilled jobs following the talent, especially to areas in and around the central business district.  Further, more educated and affluent African-Americans and Hispanics have been able to move to suburban locations for better opportunities for their families.

On the negative side, the large and continued decline in income in the African-American community in many parts of the city of Chicago is cause for concern.  This is resulting in well over half of the children in community areas like Englewood and West Garfield Park growing up in poverty.  It is also resulting in large population declines in communities like Englewood and West Englewood.

 

Early Fall Review—Economic Conditions Continued to Be Good in the Seventh District

Summary: We now have data for the Seventh District economy for the early fall, and they largely indicate that the nice run of good growth in the District continued. As has been the case throughout the year, the manufacturing sector was the driving force behind the good conditions—solid global growth and a revival in the U.S. energy sector continued to support important industries, such as steel, fabricated metals, and heavy machinery. In addition, national auto sales were quite good in September and October after a difficult summer. Outside of manufacturing, most sectors continued to experience slow but steady growth.

Now let’s look at the economic indicators that support this analysis.

Continue reading

Late Summer Review—Seventh District Economy Still in Decent Shape

Summary: Growth in the Seventh District was pretty good to start the second half of the year, even though the pace was clearly slower than that of the first half. As is usual for the District, the manufacturing sector was the driving force behind this development. As I noted in the mid-year review, the boost in manufacturing activity appears to have been driven by growth in the global economy and the energy sector. Outside of manufacturing, most sectors continued to experience slow but steady growth. While the outlook for global growth and the energy sector generally looks good, concerns continue to mount for the auto industry.

Now let’s look at the economic indicators that support this analysis.

Continue reading

2017 Mid-Year Review—A Solid First Half for the Seventh District, Thanks to Revivals in Global Growth and U.S. Oil Production

With the recent release of the Chicago Fed’s June Midwest Economy Index (MEI), we now have a good picture of how the Seventh District’s economy has done in the first half of this year. Overall, things went pretty well, and it appears that revivals in global growth and U.S. oil production are behind the good results. These revivals have lifted some long-struggling manufacturing industries in the District, including steel and heavy machinery. One cautionary note, though, is that the first half of the year has been disappointing for the auto industry, with signs that sales are slowing down to their long-run pace sooner than expected. Continue reading

Seventh District Update, July 2017

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

  • Overall conditions: Growth in economic activity in the Seventh District picked up to a moderate pace in late May and June and respondents’ outlooks for growth over the next 6 to 12 months also improved some.
  • Employment and Wages: Employment growth continued at a moderate rate. While contacts indicated that the labor market was tight, wage growth was only modest.
  • Prices: Prices again rose modestly. Retail and freight prices increased slightly and materials prices were little changed.
  • Consumer spending: Consumer spending increased modestly. Non-auto retail sales were up modestly, but auto sales changed little on net.
  • Business Spending: Growth in capital spending continued at a moderate pace and inventories were generally at comfortable levels.
  • Construction and Real Estate: Residential construction, home sales, and commercial real estate activity increased slightly, while nonresidential construction was little changed.
  • Manufacturing: Manufacturing production continued to grow at a moderate rate. Growth was widespread across industries, though auto production declined some.
  • Banking and finance: Financial participants noted that volatility continues to be low. Business loan demand ticked up and consumer loan demand was little changed.
  • Agriculture: The sector continued to operate under financial stress. The crop harvest is expected to be about average. Hog prices moved up, but cattle and milk prices were lower.

The Chicago Fed Survey of Business Conditions (CFSBC) Activity Index increased to +1 from –8, suggesting that growth in economic activity picked up to a moderate pace in late May and June. The CFSBC Manufacturing Activity Index declined to +3 from +20, while the CFSBC Nonmanufacturing Activity Index rose to a neutral value from –24.

The Midwest Economy Index (MEI) decreased to +0.51 in May from +0.72 in April. Three of the four broad sectors of nonfarm business activity and four of the five Seventh Federal Reserve District states made positive contributions to the MEI in May. The relative MEI moved down to +0.09 in May from +0.65 in April. Three of the four sectors and three of the five states made positive contributions to the relative MEI in May.

Seventh District Update, May 2017

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

  • Overall conditions: Growth in economic activity in the Seventh District slowed to a modest pace in April and early May. Respondents’ outlooks for growth over the next 6 to 12 months also pulled back some, but remained positive on balance.
  • Employment and Wages: Employment growth remained at a moderate rate. While contacts indicated that the labor market was tight, wage growth was only modest.
  • Prices: Prices again rose modestly. That said, retail and materials prices changed little.
  • Consumer spending: Consumer spending decreased slightly overall. Non-auto retail sales levels were flat and sales of light vehicles slowed some.
  • Business Spending: Growth in capital expenditures picked up to a moderate pace. Retail and manufacturing inventories were generally at desired levels, though auto dealers thought inventories were too high.
  • Construction and Real Estate: Residential construction rose moderately, though the pace of home sales was little changed. Nonresidential construction and commercial real estate activity were up slightly.
  • Manufacturing: Manufacturing production again grew at a moderate pace. Growth was widespread across industries, helped by greater demand from the energy sector.
  • Banking and finance: Market participants reported stable market conditions and low volatility. Business loan demand increased slightly and consumer loan demand was unchanged.
  • Agriculture: The outlook for crop income was unchanged, incomes for hog and cattle operations improved, and incomes for dairy farmers deteriorated a bit.

The Chicago Fed Survey of Business Conditions (CFSBC) Activity Index decreased to –9 from +14, suggesting that growth in economic activity slowed to a modest pace in April and early May. The CFSBC Manufacturing Activity Index declined to +19 from +45, while the CFSBC Nonmanufacturing Activity Index moved down to –25 from –5.

The Midwest Economy Index (MEI) increased to +0.70 in April from +0.61 in March, reaching its highest value since June 2014. All four broad sectors of nonfarm business activity and all five Seventh Federal Reserve District states made positive contributions to the MEI in April. The relative MEI rose to +0.64 in April from +0.44 in March. All four sectors and four of the five states made positive contributions to the relative MEI in April.

Seventh District Update, April 2017

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

  • Overall conditions: Growth in economic activity in the Seventh District continued at a moderate pace in late February and March, and contacts expected activity to continue rising at a moderate pace over the next six to twelve months.
  • Employment and Wages: Employment growth continued at a moderate pace. Wage growth was also moderate, and contacts indicated that the labor market is tight.
  • Prices: Retail prices rose modestly. Input costs were up slightly on balance. Metals prices were little changed, while freight costs increased.
  • Consumer spending: Consumer spending was flat overall, though e-commerce activity grew strongly. District auto sales were slightly higher.
  • Business Spending: Growth in business spending slowed to a modest pace. Retail and manufacturing inventories were generally at desired levels. Current capital expenditures grew at a modest pace.
  • Construction and Real Estate: Residential construction rose moderately, though home sales increased only slightly. Nonresidential construction and commercial real estate activity were up slightly.
  • Manufacturing: Manufacturing production again grew at a moderate pace. Growth was widespread across sectors, and conditions in some long-struggling sectors improved again.
  • Banking and finance: Conditions were little changed. Market participants reported high equity prices and low volatility. Business and consumer loan demand increased slightly.
  • Agriculture: Lower crop prices put further stress on the agricultural sector. Milk and hog prices were lower, while egg and cattle prices moved up.

The Chicago Fed Survey of Business Conditions (CFSBC) Activity Index increased to +13 from +6, suggesting that growth in economic activity stayed at a moderate pace in late February and March. The CFSBC Manufacturing Activity Index rose to +50 from +30 (its highest level since late 2014), while the CFSBC Nonmanufacturing Activity Index remained at –8.

The Midwest Economy Index (MEI) increased to +0.27 in February from +0.01 in January. The relative MEI increased to +0.08 in February from –0.09 in January. February’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.

Updated forecasts of Seventh District GSP growth

Updated forecasts of Seventh District GSP growth

Each year, the Chicago Fed provides estimates of annual gross state product (GSP) growth for the five states in the Seventh Federal Reserve District.[1] While presenting last year’s projections, we proposed a new forecasting model incorporating the U.S. Bureau of Economic Analysis’s (BEA) quarterly GSP data. In this post, we again use our quarterly model to generate GSP growth forecasts for 2016 (whose actual values will become available next month) and compare our estimates to those produced by our previous (annual) model described in Brave and Wang.[2]

GSP growth and the MEI

The BEA releases annual GSP data for the prior year each May. However, in an effort to provide a more frequent reading on regional economic growth, the BEA has also been releasing preliminary quarterly estimates of GSP since 2014. While the lag time in the production of these estimates is not as substantial as it is for annual GSP, it can still be rather long. For example, through April 2017, the 2016:Q4 GSP data have not yet been released, and will not be released until May 11, 2017.

The Chicago Fed’s Midwest Economy Index (MEI) provides an even higher frequency reading on economic growth for the five states of the Seventh District.[3] A weighted average of 129 state and regional indicators measuring growth in nonfarm business activity, the monthly MEI (like GSP) is a broad-based measure of economic conditions. After aggregating its monthly values to obtain a quarterly reading, the MEI also correlates quite well historically with Seventh District GSP growth.[4] Figure 1 illustrates this relationship, featuring a sample correlation coefficient of 0.57. [5] For this reason, the MEI forms the basis of our forecasting model for Seventh District GSP growth described in the next section.figure-1

2016:Q4 projections

To project the 2016:Q4 annualized GSP growth rate for each of the Seventh District states, we use the following linear regression model:

equation

This model relates each state’s current quarter GSP growth rate to national (the current quarter’s annualized growth rate of national gross domestic product, or GDP), regional (the current quarter’s MEI and relative MEI, or RMEI, index values), and state factors (the current quarter’s annualized growth rate of real personal income, or PI, and the previous quarter’s annualized GSP growth rate).

National and regional economic conditions play an important role in capturing state-level growth for all five Seventh District states. However, some states respond differently to regional economic conditions depending on the health of the national economy. The relative MEI reflects Midwest economic conditions relative to those of the nation, such that its inclusion in our model is designed to capture the interaction of national and regional factors on state-level growth. The inclusion of lagged GSP and state PI is then intended to capture state-specific factors that our regional and national indicators fail to. This is particularly important for states such as Iowa, where a larger share of economic activity is in agriculture, as the MEI only considers nonfarm business activity.

The extent to which each of these factors contributes to explaining GSP growth in our forecasting model varies across the five states. National growth seems to be the most important factor for Iowa, Illinois, and Wisconsin; but state and regional factors dominate for Indiana and Michigan, respectively.

figure-2

Figure 2 shows our projections for 2016:Q4 for the five Seventh District states and the Seventh District states combined.[6] All five states featured fairly strong growth readings for 2016:Q3. As a result, the model predicts some mean reversion in Q4 for each state. Compared with the other four states, Iowa has a somewhat weaker GSP growth projection of 1.0%. This is explained in part by Iowa’s negative PI growth in Q4, whereas the other Seventh District states featured positive PI growth. On the other end of the spectrum, Indiana has a somewhat stronger projection of 2.3%.

2016 projections

Based on the quarterly GSP data for the first three quarters of 2016 and our projection for the fourth quarter, we can also project 2016 annual GSP growth for the Seventh District states. These estimates are shown in the first column of table 1. Our projection of 1.6% for annual GSP growth for the Seventh District states combined is identical to the national GDP growth rate. There is variation, however, in our annual forecasts across individual states, which can be largely explained by differences in observed growth in the first three quarters of the year (see figure 2). Michigan’s annual forecast is consistent with its strong growth readings in Q2 and Q3. Conversely, Iowa’s large negative growth rate in Q1 led to a negative annual growth rate forecast. Finally, Illinois’s and Indiana’s similar growth rates throughout the year yield similar annual forecasts; and Wisconsin’s weak first quarter weighs down its annual forecast despite relatively strong growth in Q2 and Q3.

table-1

We also present in the second column of table 1 projections from the annual GSP growth forecasting model described here. These projections are quite similar across the Seventh District states; but as we saw last year, the annual model tends to forecast higher growth than predicted by our quarterly model (the only exception being Michigan). In general, we believe the added information provided by considering GSP quarterly data should make our forecasts from the quarterly model more accurate than those from the annual model. However, some caution should be exercised while reviewing even these projections from the quarterly model. For instance, the readings shown in figure 2 may in fact be revised. At this time last year, Iowa had a similarly poor Q1 growth rate that was later revised up to a slightly positive value.

Conclusion

We will release our GSP growth forecasts for 2017:Q1 in June when state personal income data for the first quarter becomes available. These projections can be found in the MEI background slides.

[1] The Seventh District comprises all of Iowa and most of Illinois, Indiana, Michigan, and Wisconsin. Further details are available at https://www.chicagofed.org/utilities/about-us/seventh-district-economy and https://www.federalreserve.gov/aboutthefed/federal-reserve-system-chicago.htm.

[2] Scott Brave and Norman Wang, 2011, “Predicting gross state product growth with the Chicago Fed’s Midwest Economy Index,” Chicago Fed Letter, Federal Reserve Bank of Chicago, No. 293, December, https://chicagofed.org/publications/chicago-fed-letter/2011/december-293.

[3] The entirety of the five states that are part of the Seventh District is considered for the MEI.

[4] The MEI is constructed as a three-month moving average. Hence, to obtain the quarterly average values shown in figure 1, we use the MEI readings corresponding to the last month of each quarter.

[5] We aggregate the five state values to one value for all Seventh District states using their nominal GSP shares. The horizontal solid black line in figure 1 corresponds to the average GSP growth rate over the sample period.

[6] We arrive at the Seventh District forecasted value for 2016:Q4 by aggregating the state forecasts using nominal GSP shares from 2016:Q3.

Revisiting fiscal federalism: Implications of Illinois’s and Chicago’s fiscal problems

Broadly speaking, fiscal federalism is a theory of public finance concerned with how to most appropriately and efficiently provide government services (or public goods) through different levels of government. This theory also involves how to set up the fiscal relationships (e.g., conditional versus unconditional transfers) between the different levels of governments to best provide these services. In the United States (and many other countries), there have traditionally been three levels of government—federal, state, and local—among which to divide up key government functions. According to the purist form of the theory, decentralization away from the federal government promotes welfare gains, as the scale of provision of particular services is scaled to the size of the population being served. This is partly based on the idea that public goods should be defined by geography, such that there are national public goods (such as defense) and local public goods (such as public school systems). Moreover, cost efficiencies—and benefit spillovers—may occur when the level of public service is calibrated to the particular preferences of the electorate in that geography rather than the central government providing the service in a uniform way.[1] Generally, the theory of fiscal federalism has been a guiding principle for the design and delivery of government services in the United States.

In 2008, public finance economist Wallace Oates suggested a revised theory for fiscal federalism.[2] Oates observed that while lower levels of government (states or municipalities) may have explicit rules against running budget deficits or amassing unsupportable levels of debt, they often ignore these restrictions under the hope and belief that a higher level of government (the federal government or states) will bail them out. For Oates, the lower level of government’s political incentives for not having to make difficult fiscal adjustments might outweigh those for exercising fiscal prudence. Therefore, lower levels of government can engage in fiscal behavior that can place burdens on higher levels of government. This reallocation of fiscal costs can undermine the efficiencies gained under the traditional notion of fiscal federalism. In this blog entry, I will consider fiscal federalism, including Oates’s revised version, in light of Illinois’s and Chicago’s recent fiscal challenges. Is the state or the city skirting fiscal rules in the hopes that a higher level of government might bail it out? Are the political incentives not to solve the problems now large enough to forestall any further action to fix them?

New perspectives on fiscal federalism

Oates suggests an important revision to thinking about the actual operation of fiscal federalism. Oates argues that rather than promoting the efficient provision of government services, fiscal federalism can incentivize certain levels of government to try to extract or indeed extract (albeit inefficiently) resources from other levels of government. An example of this is a “soft-budget constraint.” If there’s an implicit understanding that a lower level of government can count on help from a higher level of government when the former gets into fiscal difficulties, the lower level may be encouraged to unduly run deficits and expand debt. Essentially, for the lower level of government, there’s no credibility to any pledge by the higher level of government to not intercede during a time of fiscal stress. The lower level of government operates under the assumption that the higher level of government is interested in the welfare of all of its citizens, so it cannot allow a lower level of government to fail. The key question is why there is a soft-budget constraint? One theory is that the fiscal responsibilities between governments are poorly defined, which can lead to fiscal misbehavior. For instance, local governments may view themselves as providing essential public services that higher levels of government could justify supporting during an economic downturn. So, local governments may not be maintaining a rainy day fund, instead allocating dollars that should have reserved for such a fund to other parts of the budget that are more politically expedient. A second theory is that in many cases, the bond market presently does not—or perhaps cannot—accurately account for the political or financial risk of some government bonds. This may be reflected in fairly positive bond ratings for poorly fiscally performing units of government. Of course, bond ratings are designed to reflect the default risk attached to a specific bond issuance and not necessarily the underlying strength of the issuing government. If the bond covenant provides protections and preferences for the bond to be repaid even in the face of poor fiscal performance, the rating will reflect this. Still, such “mispricing” in the bond market can allow for mischief on the part of lower levels of government. So, for example, if borrowing (to cover a deficit) can continue even in the face of fiscal instability, the only penalty a profligate local government faces is having to pay a higher borrowing rate. Similarly, if the capitalization of poor fiscal performance into land values is not readily recognized (or in the case of strong fiscal performance, not rewarded), the political penalties of poor management may be small, at least to the current stewards. Additionally, if there is a history of bailouts by the federal government during recessions, it can be rational to assume that lower levels of government can be bailed out by a higher level of government that does not face a budget constraint. This belief can breed fiscal misbehavior among lower levels of government.

Considering the fiscal woes of the State of Illinois and the City Chicago, there’s a strong case to be made that all of the aforementioned may have occurred. First, despite frequent and substantial credit rating downgrades, both Illinois and Chicago have repeatedly issued bonds despite their deteriorating fiscal conditions. While these bonds have carried higher interest rates, the ability of the state and local government to take on more debt despite their fiscal problems suggests that the bond market provides little discipline for poor fiscal behavior. Second, Chicago has sought fiscal relief for times when the state has tried to impose a fiscal limit. The state passed new pension contribution requirements for Chicago; and when the costs of funding these requirements became apparent, the city government requested a new schedule for making these payments. Even at the state level, the funds that Illinois received from the federal government in the wake of the Great Recession (as part of the countercyclical aid program instituted under the American Recovery and Reinvestment Act of 2009) arguably helped the state not make fiscal adjustments in light of deteriorating circumstances. In practice, this means that residents potentially overconsume public services because they do not pay the full tax associated with providing the service.

How to make fiscal decentralization more effective

With all that said, this discussion of the theory of fiscal federalism can still extend to whether the “right” level of government is delivering the “right” service and which level of government should be paying for that service. Early childhood education is a good example illustrating the challenges associated with figuring these things out. Often early childhood education is provided at the local level (sometimes, it’s provided at the state level); yet given the national returns to improving educational outcomes, some would argue that this should be a federally funded program.

To determine the size of welfare gains from fiscal decentralization, it is important to calculate the variation in demand for the government services across jurisdictions, as well as the variation in costs for providing these services. If no variation existed, central provision of a uniform public service would probably make the most sense. However, since variation does exist, welfare gains can be realized, assuming the state or local government can estimate the level of service that residents demand. Under fiscal federalism, a multilevel system of government efficiently provides different types of public services to its specific constituencies. A complicating factor is when a government service provides a spillover benefit to another constituency. In a case of a locally provided government service that has a spillover benefit, an efficient form of fiscal federalism would suggest that the higher level of government provide a grant in order to encourage the local government to provide the service in a socially efficient way. An example of this might be a grant from the federal government or state government to a local police force to share its law-enforcement database with others. Oates also argues that in some cases fiscal equalization grants might be called for when a locality lacks the tax base and/or resources or faces high costs in providing particular services.

A new model for fiscal federalism?

Coupled with the original notion of a fiscal federalist system, Oates’s critique suggests a new model may be needed. This model would have two components. First, there would be a binding budget constraint on both the state and local governments. If policymakers in both subnational governments knew that they had to provide truly balanced budgets on an annual basis, they could not create budget deficits under the assumption that their governments could be bailed out by a higher level of government. In practice this would mean that each subnational government would have to have a structurally balanced budget,[3] based on normal trends in the state or locality. Work by Richard Dye and David Merriman[4] has created a structural model of total state expenditures and revenues for the State of Illinois, which allows the future budget performance to be projected under the assumption that the underlying trends in expenditures and revenues are maintained. This type of model allows an estimation of the structural budget gap between expenditures and revenues to be identified.

To be clear, a binding budget constraint would need to exist to determine the structural trend in the state or localities budget. The exception where aid from the federal government could be warranted is in the case of a national recession. During a downturn in the business cycle, maintaining social service and other countercyclical state and local spending can have a positive spillover effect to the national economy and, therefore, reflect good fiscal policy. However, even in this case, the federal assistance should be linked to an objective, rules-based method for determining the timing and appropriate level of federal support.[5] The alternative to permitting federal intervention during a national recession would be to require states to carry larger budget reserves to smooth out what would otherwise be volatile fiscal behavior during a downturn. The size of the reserves could be determined from a stress-test type model, where the sensitivity of the state budget to differing economic scenarios could be estimated. States with more stable revenues and expenditures in fiscal downturn scenarios would carry smaller reserves than those with more volatile taxes and spending.[6] Again, the approach would be to base this on a rules-based system to ensure all states and localities comply. Part of the goal of such a binding system is to improve fiscal transparency: This approach would make the true tax price of providing government services readily apparent.

The second element of this revised federalist model is to do a better job at estimating where spillovers occur in government provision to ensure that the right level of government is providing resources for the service. Robert Inman[7] has consistently argued that it is inefficient for cities—which often have larger shares of distressed population than suburbs and rural areas—to be responsible for funding government programs targeted to this population. His preferred strategy would be for the city government to develop and administer the government programs, but with funding provided at the regional level. Under the usual fiscal federalist structure, the city absorbs the cost of providing a service (to the distressed population) that yields regional spillovers. Inman has further argued that program provision at the local level can be more efficient because those in the local government will likely know the needs of the population better than those in a higher level of government. He suggests that this is what occurs in Pittsburgh: The county funds Pittsburgh’s social welfare programs, and the city is responsible for administering them. When cities are forced to bear these costs alone, this can limit their ability to fund other government services that might encourage private sector investment. An example of a more controversial extension of this idea would be to examine how investments in human capital and education are made. If it can be assumed that there is a national economic return to human capital investment, an education model that is based on local preferences may not be the most efficient. A purely local model would make sense if it can be assumed that the level of education provided meets local taxpayers’ expectations and that recipients of the education stay in the locality. However, under the assumption that promoting labor mobility is desirable, changes in certain expectations for education might be appropriate. For example, state reductions in funding for higher education has been frequently lamented. A clear case for state support could in theory be based on whether the graduates stay in the state after graduation so that the state and taxpayers receive a return on their education investment. Assuming that students at community or regional institutions within the state may be less mobile, state support may be more justified for these types of schools than for a flagship university drawing an increasingly national or international student body that is more mobile after graduation. In fact, in most cases, recent reductions in support for public university systems have been most pronounced for the flagship public institutions. That said, if the spillovers from the national public universities are to the nation as a whole, this suggests that increased federal support might be appropriate. Again, the goal is to identify where the spillover occurs and to better match where the funding comes from with the level of government benefiting from the service provision.

Conclusion

Fiscal federalism’s guiding principles have generally served the United States well throughout its history. However, Oates and others are correct in arguing that these principles, along with the underlying theory, need to be revised—especially given how federal, state, and local governments have behaved over the past few years.

[1] Another gain from fiscal decentralization may be innovation. Allowing service delivery experimentation tailored to the constituency the level of government is serving can lead to breakthroughs in service delivery, which may applied to other jurisdictions.

[2] Wallace E. Oates, 2008, “On the evolution of fiscal federalism: Theory and institutions,” National Tax Journal, Vol. 61, No. 2, June, pp. 313–334, http://www.jstor.org/stable/41790447.

[3] To see what I mean by “structurally balanced budget,” see http://gfoa.org/achieving-structurally-balanced-budget.

[4] See, for instance, https://igpa.uillinois.edu/policy-initiatives/fiscal-futures-project.

[5] For a discussion on how to optimally design federal support, see Richard H. Mattoon, Vanessa Haleco-Meyer, and Taft Foster, 2010, “Improving the impact of federal aid to the states,” Economic Perspectives, Federal Reserve Bank of Chicago, Vol. 34, Third Quarter, pp. 66–82,  https://www.chicagofed.org/publications/economic-perspectives/2010/3q-mattoon-haleco-meyer-foster.

[6] Richard Mattoon, 2003, “Creating a national state rainy day fund: A modest proposal to improve future state fiscal performance,” Proceedings: Annual Conference on Taxation and Minutes of the Annual Meeting of the National Tax Association, Vol. 96, pp. 118–124, http://www.jstor.org/stable/41954399.

[7] Robert P. Inman, 1995, “How to have a fiscal crisis: Lessons from Philadelphia,” American Economic Review, Vol. 85, No. 2, May, pp. 378–383, http://www.jstor.org/stable/2117952.

Job growth in the Seventh District in 2016—A post-benchmarking update

Here at the Chicago Fed, we closely track one of the most important regional economic indicators, the U.S. Bureau of Labor Statistics’ (BLS) payroll employment survey (also known as the Current Employment Statistics, or CES). The survey is important because it provides a good picture of the overall state of an economy and its initial results are released quickly (unlike some other regional data that are released with a lag of a month or more). Unfortunately, the relatively quick turnaround also means we must exercise caution. While we get an initial estimate only three weeks after the end of the reference month, the estimate can sometimes be revised substantially later on. The BLS makes minor revisions to the data one month after the initial release and major revisions once a year, when the survey is benchmarked to the unemployment insurance census (released as the Quarterly Census of Employment and Wages, or QCEW).[1]

The BLS recently released newly benchmarked data, so we now have an update on how well the Seventh Federal Reserve District[2] did in 2016. Table 1 shows that, for the most part, the job growth numbers that the BLS had been reporting before the most recent benchmarking held true. Overall, Seventh District employment grew at a pace of about 1 percent in 2016, with the BLS reporting a 0.9% increase before benchmarking and a 1.1% increase after. In addition, the most recent benchmarking further affirmed the division in performance between the eastern and western parts of the District over the past few years. Job growth for Indiana and Michigan in 2016 was revised up, whereas job growth for Illinois, Iowa, and Wisconsin was revised down. So now, the job growth numbers for Michigan and Indiana in 2016 easily exceeded the numbers for Illinois, Iowa, and to a lesser extent, Wisconsin.

table1

The most recent benchmarking by the BLS also gives us the opportunity to see how well we did at predicting the benchmark revisions using a method known as “early benchmarking.”[3] The main idea behind early benchmarking is that it’s possible to use the QCEW data, which are released quarterly, to predict the major annual revisions to the job growth numbers.

This year we found that, unlike last year, the early benchmarked estimates (which we produced in January 2017) were further from the newly released job growth numbers than the March 2016 benchmarked CES estimates were. Our only consolation is that the early benchmarked estimates did get closer to the newly released numbers for the first half of 2016. I’ll explain what happened a little later.

Let’s look first at how the early benchmarking procedure did for the District as a whole. Figure 1 shows three versions of the Seventh District’s CES data, where the solid portion of a line represents data that have been benchmarked using the QCEW and the dashed portion represents data that have not.[4] The black line is the version released in March 2017 (with benchmarked data through September 2016), the red line is the early benchmarked version that we calculated in January 2017 (with benchmarked data through June 2016), and the blue line is the version released in March 2016 (with benchmarked data through September 2015). Surprisingly, in spite of nine months of additional benchmarked data, the March 2016 benchmarked CES appears to track the newly released data better than the early benchmarked CES.

figure1

The first row of table 2 summarizes figure 1 in terms of December-to-December job growth for 2016. For this period, the early benchmarking method performed notably worse: It underestimated District job growth by 83,000, while the March 2016 benchmarked data underestimated job growth by only 25,000. The remaining rows of table 2 summarize 2016 job growth for District states (figures plotting the data for District states are at the end of the post). This year, Indiana was the only state for which the early benchmarked growth estimates had a smaller error than the March 2016 benchmarked data, though the errors for Michigan were very close. The early benchmarking method did particularly poorly for Illinois, estimating that employment fell by 13,000 for the year when it actually grew by 19,000.

table2

The poor performance of the early benchmarking method was surprising. We expected the early benchmarking method to do better for the first half of 2016 because it could take full advantage of the available QCEW data. And for the second half of the year, we knew by definition that the method would perform the same as the March 2016 benchmarked data because it used that version’s growth numbers. So, given these half-year results, how could the early benchmarking method do worse for the full year? Table 3 shows how. The early benchmarking method’s errors were negative in both halves of the year, while the errors of the March 2016 benchmarked CES were positive in the first half and negative in the second half. So the early benchmarking method’s errors built on each other, whereas the errors in the March 2016 benchmarked data cancelled each other out.

table3

Even though the early benchmarking method did not do well this year, we still think it is a useful tool for predicting benchmark revisions because it can take full advantage of the available QCEW data. We will see what happens in 2018.

figure2

figure3

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figure5

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[1] For more information on the BLS’s benchmarking process, go here.

[2] The Seventh District, which is served by the Chicago Fed, comprises all of Iowa and most of Illinois, Indiana, Michigan, and Wisconsin.

[3] An earlier post discussing the method in detail is here.

[4] As is clear in figure 1, the BLS also revises already benchmarked data, though the revisions are typically small.



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