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June 25, 2007

State-local Business Taxation

To most people, the subject of tax structure is a sleepy one. An important exception is when looming changes to the tax structure raise the prospects for who will pay for public services (and how much they will pay). In characterizing this debate, Senator Russell B. Long of Louisiana once said, “Don’t tax me, don’t tax thee, tax that fellow behind the tree!”

Public discussion also becomes animated when considering whether state and local tax structures (or changes to them) will hinder economic growth and development. That is to say, will tax hikes on business drive away jobs and income?

A recent symposium held at our Bank gathered experts together to consider emerging trends in business taxation. In recent years, there have been significant changes to business taxation in Midwest states, such as Ohio and Michigan. Ohio enacted a modest tax on business gross receipts in 2005, replacing a local tax on capital machinery and equipment. Michigan has phased out its largest business tax and is now considering how to replace the revenues that it formerly generated with its Single Business Tax.

The State of Illinois was considering a large “business” tax on business gross receipts to fund education and a subsidized health care initiative. To pay for it, Governor Rod Blagojevich advocated a large business tax on gross receipts because it would be paid by those who could afford it. Interestingly, the Lieutenant Governor Pat Quinn disagreed on the very same grounds.

Who was correct? As with many such matters, there is no certainty. But at the business taxation conference, I stated that I did not favor the Illinois gross receipts tax, at least on equity grounds. I argued that our most common principle of equity in taxation is a poor guidepost by which to design a state’s business tax structure. By equity, most people mean “ability to pay” such that taxation should progressively burden high-income households relative to low-income ones. The trouble with this approach is that businesses are not households. Businesses are organized groups of people ranging from line workers to mid-managers to active owner-entrepreneurs to silent capital-owning partners.

So who are we really taxing? We are not really sure. In particular, the taxation of business activity often results in changes to product prices that burden consumers rather than wealthy individuals. In the same vein, business taxation can sometimes result in lower wage offers to a firm’s workers. The ultimate result of such “tax shifting” may mean that a tax intended to “soak the rich” may have the opposite result. For example, it is easy to see (and universally accepted) that unduly high taxes on companies that sell gasoline in a state or city are largely shifted forward to consumers of gasoline in that state or city. Why would the companies pay inordinate taxes on the gasoline they sell in Chicago, for example? The answer is that they would not and they do not. This is in part because gasoline (energy) companies sell their products and services into many markets worldwide. Accordingly, when taxes on gasoline are pushed too high in any one locale, the price of gasoline rises until it becomes profitable for companies to sell it there. And since gasoline is presently a necessity for nearly everyone in the industrialized world, low-income households end up paying taxes on it that are a larger share of their household income as compared with the share of high-income households. The intent to achieve equity, in this instance, is foiled.

More generally, analysts have only a fuzzy and foggy notion across the breadth of business taxes as to which ones (and how much of them) are actually shifted to workers and to consumers. And so, to achieve equity, tools such as direct income redistribution or manipulation of the individual income tax are more reliable for this purpose. For this reason, I argue that it is preferable to design state and local business taxes around our notions of efficiency rather than on equity.

In looking at the efficiency of taxing businesses, it is important to recognize that business organizations do use costly government services, including police, fire protection, roadways, and legal protections. Having businesses pay for such services, then, is not only fair, it is efficient in several respects.

In paying state and local governments for their public services, businesses will be motivated to articulate their service needs to these governments, just as customers do with service providers in market situations. In turn, this will promote growth and development in states and localities. The resulting negotiation and conversation between governments and businesses will help identify those essential roads, bridges, and property protections that make businesses more productive. So too the process of haggling over the price and cost of government services to businesses will tend to keep governments cost efficient.

This give and take between business and government will only take place if a state's business taxes are structured as a user charge and not set unduly high in an effort to redistribute income.

The purposeful conversation on business taxes and business service levels will also spill over in positive ways to government service provision to households. In recognizing that “business” taxes are not really subsidizing household services, such as education and health care, households and their representatives will more carefully evaluate the costs and benefits of government services.

The structure of taxes can be a sleepy one. However, those who doze off during the debate may very well find themselves stuck with the tab.


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Posted by Testa at 8:01 AM | Comments (0)

June 15, 2007

The Stability of State Economies

By Guest Blogger Michael Munley

In recent years, Fed Chairman Bernanke and other economists have been analyzing the causes of the increased stability in the U.S. economy, a phenomenon known as "The Great Moderation." Most of their analyses have focused on the national economy, noting that the fluctuations, or volatility, in GDP growth, employment growth and inflation have declined noticeably over the past 25 years or so. But a Philadelphia Fed economist, Jerry Carlino, recently wrote a paper that looks at the issue at the state level and finds that every state has shared in the decline in employment volatility.

Increased stability has numerous benefits for both households and businesses. When employment is growing at more stable rates, people can be more certain of their job prospects, which makes it easier to decide whether to buy a new car, for example. Similarly, businesses have an easier time deciding whether to invest in new machinery when they can be more certain about the state of the economy. In turn, better decision-making by people and businesses can minimize the potential waste in the economy created by bankruptcies and other problems that can arise when people make decisions that turn out poorly.

Comparing the average volatility (measured in Carlino’s paper as the standard deviation of quarterly changes in employment) before and after 1984, Carlino’s results show that the states of the Seventh District all had declines that ranked in the top half of all U.S. states. Michigan ranked 2nd with a 63.6% drop in volatility, Indiana 4th with 57.1%, Wisconsin 8th with 52.5%, Iowa 16th with 45.3%, and Illinois 20th with 42.7%.

The following graph illustrates how the volatility in total employment has changed over time in each of the District states, converging toward the national average.



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One reason for the relatively bigger declines in employment volatility in the Midwest is our concentration in manufacturing and, specifically, our concentration in durable goods manufacturing. Carlino reports that volatility in U.S. factory employment was cut in half after 1984, whereas the declines in employment volatility in services were much smaller. And by my estimates, the volatility reduction in durable goods manufacturing employment was much sharper than that in nondurable goods.

As a result, Seventh District states ranked in the top half of all states in terms of the magnitude of the decline in manufacturing employment volatility. Michigan ranked 1st with a 66.3% drop, Indiana 3rd with 63.1%, Wisconsin 7th with 56.9%, Illinois 12th with 55.7%, and Iowa 22nd with 48.8%.

I’ve also looked at other state-level data series to see if they too reveal evidence of the Great Moderation. The quarterly changes in unemployment rates show similar reductions in volatility to those seen in employment (though the state-level unemployment data only go back to 1976). Real per capita income also shows a reduction in volatility, but the relative reductions are smaller.



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Interestingly, whereas the District’s concentration in durable goods manufacturing seemed to lead to larger reductions in volatility compared with other states, that is not the case with changes in unemployment rates and personal income. As shown in the following table, the Midwest states’ reductions in unemployment and income volatility were rather middling.


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Carlino notes that the economists who have been tracking the Great Moderation have proposed numerous reasons for the decline in volatility nationwide. Explanations include better monetary policy, structural changes (such as improved inventory management, the decline of unionization, the redistribution of jobs from manufacturing to services, banking deregulation), and plain good luck, in that the economy has not faced any significant crises like the oil embargo of the 1970s.

Regardless of the causes, it is clear that changes in employment and other variables are much more stable here in the Midwest than they were 25 years or so ago. Yet while lower volatility has its benefits, it does not uniformly deliver positive outcomes. Typically, volatility rises during a recession (as shown in the graphs above) then settles back down when the economy recovers and employment expands again.

However, that has not been the case in Michigan. Its volatility in all three variables increased during the 2001 recession and retreated since then, but the state economy has not recovered. Michigan's employment has been stabilizing around an average decline in jobs (-0.2 percent per quarter over the past five years). Its unemployment is high; in April the unemployment rate in Michigan was 7.1%, the highest in the nation. And per capita incomes in Michigan are stabilizing around slow growth of 0.1% per quarter, which is below the national average and among the slowest in the nation.

If you buy the assumption that the observed volatility affects the confidence of business and household decision-making, this means that Michiganders could be getting more certain that the local economy is heading in the wrong direction.


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Posted by Testa at 6:34 AM | Comments (0)

June 6, 2007

The mouse that roared: Putting the sale of Chrysler in context

By Guest Blogger Thomas Klier

On Monday, May 14, 2007, DaimlerChrysler Corporation announced it would spin off its Chrysler division by selling it to Cerberus LLC, a private equity company. The news ended speculation regarding a possible sale of Chrysler as well as the identity of its ultimate acquirer. The pending sale of Chrysler has since been widely covered in the media. Some have referred to the sale as a watershed event for the U.S. auto industry, which has been undergoing structural change for a number of years. In recent years such changes resulted in new ways to approach the industry’s underlying problems, such as rising health care costs. Witness, for example, the unprecedented mid-contract negotiations between the Detroit Three, comprising Ford, General Motors (GM), and Chrysler, and the United Auto Workers (UAW), which resulted in increased cost-sharing for health care by employees and retirees of Ford and GM toward the end of 2005.

What follows is a brief analysis that places the sale of Chrysler into context from a Midwest perspective.

Who and what

Chrysler represents one of the most venerable names in the U.S. auto industry. For many years, it was one of the companies simply referred to as the Big Three. In 1998, Chrysler merged with Daimler AG of Stuttgart, Germany, in what was then widely hailed as a merger with great chances of success. By way of a $36 billion transaction, the DaimlerChrysler Corporation (DCX) was born.

However, the bond that was then forged by the merger was not to last for even a decade. On May 14, 2007, DCX ended several months of speculation by announcing its intention to sell Chrysler to Cerberus. This transaction is expected to close during the third quarter of this year. According to the terms of the agreement, Chrysler will subsequently be incorporated as Chrysler LLC. Cerberus will own 80.1% of this entity. DCX, soon to be renamed Daimler, will retain a 19.9% stake.

Cerberus is a private equity company based in New York City. It has controlling interests in a number of companies, representing various industries. Among them are a number of auto supplier companies. In 2006, Cerberus made news by acquiring 51% of General Motors Acceptance Corporation (GMAC), GM’s financing arm.

Chrysler’s footprint

The newly incorporated Chrysler LLC will no longer be a Big Three company. It is now common to refer to the Big Six auto companies in the North American market; they are, ranked in order by U.S. market share: GM, Ford, Toyota, Chrysler, Honda, and Nissan. Chrysler will, however, rejoin GM and Ford as one of the Detroit Three.


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Chrysler is currently in the midst of a downsizing program that was announced on February 14, 2007. That restructuring will reduce its total number of employees in North America by about 13,000. The company is also cutting back its production capacity by closing one assembly plant and shutting down lines at two other plants. The new Chrysler LLC will be more concentrated in the Midwest in its production operations than the other domestic automakers (see map). It will also produce a higher share of its output as light trucks than any other Big Six automaker. Finally, of the Big Six, Chrysler will be the automaker most dependent on the North American market.


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Why does this matter?

These are challenging times for the domestic auto sector. The Detroit Three continue to lose market share, a number of auto parts makers are in Chapter 11 bankruptcy, and the domestic automakers have been in strained negotiations with their unionized employees for the past two years. Delphi—GM’s former parts subsidiary, spun off in 1999 and instantly becoming one of the largest auto parts supplier companies—filed for Chapter 11 in 2005. Negotiations between GM, the UAW, and Delphi about finding a way for Delphi to emerge from Chapter 11 have been going on for over a year.

At the same time, private equity and venture capital firms have been quite active in restructuring the U.S. auto industry for a number of years. Against this background Cerberus’s purchase of Chrysler is noteworthy in that it represents the first time a private venture capital firm has acquired an automaker. As a consequence, by way of becoming a private company, Chrysler LLC will likely have the ability to take a longer-term, strategic approach toward regaining profitability. Yet its owners will want to see a return on their investment along the way.

On the product side, these demands on the company may require refocusing Chrysler products so that they line up with consumer demand. On the cost side, this primarily means addressing the growing health care liabilities that Chrysler, along with the other Detroit automakers, is facing. The next opportunity to do this will arrive soon. This summer the Detroit Three and the UAW are scheduled to negotiate a new labor contract, because the current four-year contract will expire in September. The presence of Cerberus at the bargaining table is likely to change the dynamic of these negotiations.

As the Detroit-based carmakers are struggling to stem their market share losses, Chrysler, the smallest of the Detroit Three, has just been moved into the spotlight by way of its sale to Cerberus. In the process of addressing a number of difficult competitive challenges, Chrysler—the car company that invented the minivan and, in 1980 as it was teetering on the edge of bankruptcy, was bailed out by the federal government—could well set the course for the Detroit Three for years to come.


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Posted by Testa at 5:12 AM | Comments (1)