What might such policy actions be? The report lays out a blueprint for Bi-National Great Lakes economic leadership:

● By 2010, Develop a Bi-National Innovation Fund and Strategy
● By 2010, Redevelop North America’s Freshwater Coast
● By 2015, Define and Implement the “U.S.–Canada Border of the Future”
● By 2025, Realize BiNational Great Lakes Carbon Goals and Renewable Energy Standards
● By 2030, Create a Common Market for Commerce and Human Capital

As a long-time researcher, observer, and policy-discussion participant in this arena, I am encouraged to find these ideas being resurrected. As long ago as the 1980s, during the very troubled economic times in the Midwest, many of these same observations and recommendations were advanced.

Two developments dampened forward momentum. For one, the region’s economy enjoyed a strong rebound during the 1990s as surging U.S. economic growth shook the region from its torpor. The region’s flagship companies learned much from their global competitors coming out of the 1980s. While the rebound was welcome and enjoyable, some of the driving force behind fundamental policy innovation in regional development policy was lost through complacency.

The second reason: No region-wide dialogue was created on a sustained basis, and no organizations took on a leadership role in driving forward such a regionwide agenda. The sole exception might be efforts to restore and clean up the region’s fresh waters in the Great Lakes basin, which have progressed thanks to regional organizations such as the Council of Great Lakes Governors, The Great Lakes Commission, and a strong supporting cast.

This time around, inspired by new work, such as the Longworth book and Austin’s study, I believe that we will (very soon) see at least some exploratory efforts towards an enduring pan-regional policy network.

It has become almost hackneyed to proclaim that we live in a knowledge economy driven by innovation. The mantra of current economic development gurus is that the race goes to the smartest and the swiftest. Yet, despite this popular consensus that innovation may be the key factor in determining future growth in the economy, we actually know very little about how to measure innovation and what policies might influence innovation.

To begin with, we need a definition. Most definitions of innovation begin with “big bang” product innovation that alters the course of economies and enhances the quality of life. The invention of the light bulb and the airplane, as well as biotech breakthroughs, are just a few examples. But large gains are also made through process innovations that are often more subtle. The application of information technology to banking and financial firms and the advent of inventory and logistics management in retail trade come to mind. These process innovations change the efficiency with which inputs are used while vastly increasing the scale of output. This leads to goods and services that are faster, cheaper, and better. In fact, when the Chicago Fed studied the turnaround in the Midwest economy in the mid-1990s, we concluded that part of the region’s success was based on improving the efficiency of the existing economic base. Innovation in traditional industries explained much of the turnaround, rather than the creation of wholly new industries or products.

In January 2008, the Advisory Committee on Measuring Innovation in the 21st Century Economy issued a thoughtful report on how we might define and measure innovation. The report postulates that, while innovation is critical to the economy, “the nexus between innovation and growth is one of the least understood areas of economic life.” To bring clarity, the committee defined innovation as “the design, invention, development, and/or implementation of new or altered products, services, processes, systems, organizational structures, or business models for the purpose of creating new value for customers in a way that improves the financial returns to the firm.” The report then set about suggesting proxies for measuring innovation.

The committee rejected the notion of coming up with a single, all encompassing measure. Given that the economy and individual firms do not innovate the same way at the same time, the committee felt a single measure would lead to policy distortions. For example, it might be inappropriate to legislate public policy supporting an industry or firm that is going through a rapid period of innovation over an industry whose innovation breakthrough might be several years away. However, the report suggests a clear starting point by emphasizing that we need a better measurement of total factor productivity (TFP)—the change in productivity left over after accounting for the growth in labor and capital. Total factor productivity does provide a measure that can be augmented and refined by several policies to expand data collection on firm investment in key factors such as research and development, technology, and human capital.

So what policies did the Committee specifically suggest? Here is just a partial list:
• Develop annual, industry-level measures of total factor productivity by restructuring the National Income and Product Accounts of the United States (NIPAs);
• Create a supplemental innovation account for the NIPAs in order to expand the categories of innovation inputs and allow those inputs to be tracked as they flow between industries;
• Improve service sector data and increase survey coverage to provide the data needed to improve estimates from the integrated gross domestic product/productivity accounts and supplemental innovation account;
• Improve measurement of intangibles, particularly intellectual property; and
• Better leverage existing data and increase access to enhance research on innovation.

In addition the committee recommended the business community:
• Institute firm-level measurements of innovation to test the correlation on firm performance; and
• Develop and implement best practice in innovation management and accounting.

Another interesting local approach is a new innovation index developed by the University of Michigan at Dearborn’s Center for Innovation Research. This index tracks six subindexes that reflect the state of innovation in Michigan and will be reported on a quarterly basis. The six measures are:
• Trademark applications,
• Innovation workers (measured as a percentage of the labor force),
• Small Business Administration (SBA) loans,
• Venture capital,
• Incorporations, and
• Gross job creation.

The index is benchmarked to 100 for the first quarter of 2007. The most recent reading of the index is 95.8.

These efforts at measuring innovation in the economy continue to be a messy process, but the potential dividends of better understanding and calibrating the role of innovation in economic growth is certainly an important step forward. Hopefully better innovation metrics will help guide policymakers and business leaders to make appropriate investments that will strengthen economic growth.

The Department of Commerce continues the dialogue by hosting a summit in Chicago on May 22 discussing actions to be made to secure America's competitiveness.

Unlike most U.S. states, Michigan’s economy has not enjoyed any net growth during the entire decade. Decline in the state’s automotive industry has kept its economy reeling. In some ways, this experience is reminiscent of conditions from two decades ago. At that time, the domestic automotive industry struggled with energy and gasoline price spikes that had begun during the mid-1970s. Much as today, the automotive fleets of Chrysler, General Motors, and Ford—known then as the Big Three—had been designed on the larger side, which was better suited to a bygone era of cheap gasoline. Accordingly, auto sales by domestic producers were sharply impacted by OPEC (Organization of the Petroleum Exporting Countries) gas price spikes, by a federal gasoline rationing program, and by imports of small, fuel-efficient vehicles from (then mostly Japanese) competitors.

Even so, by the beginning of the 1980s, Detroit was making a comeback with its own small cars; back then, the tail winds from a strong U.S. economy was lifting overall automotive sales. Alas, a second global energy price spike, along with two U.S. recessions during the early 1980s, exerted a horrific effect on Michigan and on the Midwest manufacturing belt. Foreign markets were of little help during this era of a rapidly rising dollar, and the region’s agricultural sector experienced profound declines in prices and land values.

The chart below overlays the payroll job trends of that era with that of the past seven years. Following a peak in Michigan job levels in 1979, jobs declined at a pace of over 2% per year for the next four years before bottoming out at the beginning of 1983. In comparison, the recent payroll job decreases in Michigan have been less dramatic, with a cumulative decline of 5 percent from 2001 to date. Similarly, the average state unemployment for all of Michigan had reached 16 percent by 1983, over double what it is today (see chart below).


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However, it should be noted that Michigan’s economic decline in the current decade has gone on much longer than its decline of the early 1980s. By 1983, Michigan’s payroll employment had begun to climb once again as U.S. consumer purchases of autos rose and as excess inventories of autos were sold off. While recent declines have been less precipitous, the cumulative effect has been no less profound. Annual employment in Michigan has not climbed over the past 7 years, and now stands at over 6% below its level at the beginning of 2001.

How did Michigan households adjust to diminished job and income opportunities in Michigan during the 1980s? In part, Michigan workers and their families left the state in search of opportunities in other regions. Households decide to migrate based on more than local conditions. That is, they also base their decisions on labor market conditions in alternative regions of the country. Although the overall U.S. economy was experiencing recessionary conditions during the early 1980s, Midwest labor markets were far and away more affected. For instance, rising energy prices were spurring economic investment (and jobs) in energy-producing regions, such as Texas–Louisiana and in the western coal fields. Meanwhile, the first surge in high-tech computing production was underway in New England and California, and strong economies were emerging in regions where post-1970s defense spending was growing. The chart below illustrates the difference in unemployment rates between Michigan and the overall U.S. at that time. Michigan’s unemployment rate was 5–6 percentage points above the nation’s from 1980–83.


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As the chart below suggests, more households had been moving out of Michigan than moving in throughout the 1970s, with a net out-migration exceeding 50,000 per year by 1974–75. However, this number tripled by 1981–82, exceeding 150,000 per year. Economic recovery eventually unfolded in Michigan, but it did not pull along net migration into Michigan until the early 1990s.

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Today, labor market conditions in Michigan, while the worst in the U.S., look mild compared with that of the 1970s and 1980s. Still, the pattern of continual payroll job losses since 2001 gives the impression of long-term structural decline rather than a short-term episode. So far, the pace of out-migration from Michigan has reported to be milder as well, averaging -20,000 per year from 2001 to 2006. A contributing factor for restrained out-migration may be the difference in the age demographics of the population between then and now. Historically, those aged 20–39 have been much more likely to pull up stakes and move out of state. Michigan’s population has aged, with only 37% of the adult population of prime (moving) age today versus 48% in 1980.

Still, out-migration from Michigan may yet increase somewhat. Out-migration from the state has been picking up lately as the decade wears on and employment continues to decline. United Van Lines (UVL) has been tracking data on in-movements versus out-movements of its residential moves by state for many years, and these data tend to accord fairly well with government statistical trends on net migration of population. Recent UVL data for 2007 suggest that out-migration of households exceeded in-migration by a 2 to 1 ratio, while the level of net out-migration of moving trucks is approaching the previous trough experienced in 1981.

Many policy leaders and local communities in Michigan are determined not to let the state’s growth fall further into negative territory. There are concerted initiatives to diversify the region’s economy toward technology industries, services, and recreation-tourism. For example, three of Michigan's universities—the University of Michigan, Michigan State, and Wayne State—are teaming up to fashion a research corridor that will further stimulate innovation in the state. The research synergies of the three hope to improve technology transfer, share resources, and attract jobs to the state.

Such efforts may well turn around the state’s fortunes over the long term. But following a long and difficult decade for many of the state’s residents, the road ahead does not look any easier—at least for the immediate future. As the U.S. economy slows during the first half of 2008, domestic automotive sales (and production) are also expected to soften.

It is timely, then, that new information on goods exports for individual metropolitan areas has just been released by the International Trade Administration (ITA), based on U.S. Census Bureau data. Exports figure prominently in regional economies such as ours that are steeped in manufacturing and agricultural production. On a national scale, the ERP describes the many benefits of export activity. In addition to high-paying jobs and incomes, exports spur U.S. producers to innovate to compete with in global markets. So too, as U.S. producers expand to serve global markets, they can often achieve low-cost economies of scale, thereby reducing prices for consumers.

The new data series on metropolitan exports covers goods only. This means the importance of exports to metropolitan economies is understated in the data because exports of services such as medical, tourism, banking/finance, and transportation now account for 28% of U.S. exports. Moreover, metropolitan areas typically specialize in such services, with ongoing shifts toward service concentration now underway.

Despite our lack of data on service exports, a metropolitan area's rank order in goods exports very likely reflects its local service exports as well. In the production process, manufacturing companies purchase many services ranging from finance to management consulting, transportation, design, law, R&D, and advertising. The value of these services become part of the value of the final goods for export, and many of these services are purchased locally. Accordingly, in many instances, a host of value added products from surrounding service companies lies behind a metro area’s goods exports.

Given the Midwest region’s prowess in durable goods manufacturing, it comes as no surprise that metropolitan areas in the Seventh District originate considerable goods exports. The chart below shows export values for several metropolitan areas. The Detroit area leads with a reported $43.3 billion in exports in 2006, comprising 74 percent of Michigan’s exports abroad (see right axis). Detroit’s automotive trade with Canada remains considerable. Currently, the rising value of the Canadian dollar is pressuring production towards the U.S. side of the Michigan–Ontario corridor.

The Chicago area’s total goods exports approached $30 billion in 2006. In addition to traditional heavy manufacturing and food products, Chicago exports medical supplies and equipment and pharmaceuticals.

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Click to enlarge.

In order to gauge the relative importance of exports to metropolitan areas, we make use of recent BEA (Bureau of Economic Analysis) estimates of total metropolitan area product. Dividing a metropolitan area’s exports by its gross product yields a rough measure of each region’s income share that is earned by producing goods for export abroad. By this measure, we see in the chart below that Peoria, Illinois, home of construction equipment manufacturer Caterpillar, derives over 50% of its income from producing goods for export. While this is a useful indicator, it does overstate Peoria’s share somewhat because Caterpillar and other Peoria manufacturers assemble final goods using component parts and services from other parts of the Midwest, the nation, and the world. So part of the measured value of Peoria’s exports reflects the embedded value added of goods and services produced elsewhere. For larger regions, such measures tend to be more accurate since the intermediate components are more likely to be produced within the region.

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The next chart shows export intensity for all of the Seventh District metro areas. Most lie above the U.S. average in export intensity. Open markets abroad are an important part of the economic vitality of these communities.

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Where do District metro areas export? The ITA provides the destination by both country and general region of the world. Canada and Mexico—our NAFTA partners—predominate as export destinations for metro areas (chart below). Europe also remains important, especially Germany, France, and the U.K. In Asia, Japan figures prominently, with China as the fastest growing export destination.


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Finally, the ITA data offer a finer breakdown, indicating both the specific industry categories of exported goods and their destination. As one example, the next chart displays export patterns for the Milwaukee metro area. True to its industry structure, the Milwaukee area exports durable goods such as electrical equipment (e.g., medical scanners and electronic controls) and nonelectrical machinery (e.g., small engines and construction equipment). All major regions of the world (and trading blocs) are destinations for Milwaukee exports.

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The outlook for Midwest exports remains strong. As the 2008 ERP suggests, foreign income growth is likely the strongest impetus to U.S. export growth. As developing nations raise their standards of living, their appetite for manufactured goods rises sharply, as does their demand for food products.

The 2008 ERP also indicates that U.S. exports are very sensitive to income growth abroad. In part, that is because developing countries are investing heavily at home both to produce goods for export and to serve rising domestic demands. For that reason, they purchase capital goods—those that are needed to expand production capacity such as machinery and equipment. Since capital goods are needed to expand production capacity, a slowing economy ratchets down purchases of capital goods and an accelerating economy ratchets up purchases. The U.S. economy specializes in capital goods, such as those produced in Milwaukee and Peoria.

But what generates the income growth in developing countries that, in turn, propels their demand for U.S. exports of capital goods? In part, trade agreements allow developing countries to generate income (from sales abroad) and thereby raise living standards by lowering tariff and nontariff barriers to export sales abroad.

The ERP reports export sales from the U.S. to regions of the world with which the U.S. has recently signed trade agreements. In almost every instance, subsequent export growth to the trade agreement nations well exceeded overall export growth.

Of course, these agreements also make it easier for foreign nations to sell into U.S. markets. In many instances, such foreign competition displaces firms employing domestic workers. Though the overall process of expanding trade is vital to raising living standards both here and abroad, the related labor market upheaval often gives rise to anti-trade sentiment.

Estimates of import sensitivity by individual metropolitan area are problematic. Imports are counted and tracked at the U.S. border and no further. But in a 2003 article, I constructed some rough estimates of import sensitivity by examining a metro area’s industry mix and then weighting a metro area’s industry mix by the degree to which imports had penetrated U.S. markets. I found that large metropolitan areas were not experiencing growth in trade sensitivity to the same degree as smaller and medium-sized metro areas. However, this may be explained by the growing service orientation of large metro areas. Since many of these services do become embedded in the value of manufactured goods, the trade orientation of large metropolitan areas may be understated by my (goods-based) estimates.

Vanessa Haleco-Meyer contributed to this entry.

Plenty of evidence is emerging that state and local governments are headed into a major fiscal pinch. Tax revenues are decreasing across the board, as everything from corporate profits to employment declines. The big question is how well are the states positioned to weather this storm? Is there anything different in the nature of this economic slowdown that will make circumstances more difficult?

Based on some preliminary evidence, the future looks challenging. The Center on Budget and Policy Priorities released a survey of state budget conditions on February 25, 2008. The survey reported 25 states having budget deficits for fiscal year 2009. Specific estimates of the magnitude of the deficits were available for 21 states. These particular states report an aggregate gap of between $36 billion and $38 billion, representing roughly 8% to 9% of total general fund spending. Of the states in the Seventh Federal Reserve District reporting a gap, Illinois has a $1.8 billion deficit (6.6% of general fund); Iowa, $350 million (6%); and Wisconsin, $652 million (4.8%).

The center’s report notes that one of the more vexing fiscal problems is the current instability of property tax revenues related to the housing downturn and mortgage foreclosures. In the 2001 recession, states were able to push expenditures on to local governments because property tax revenues were relatively stable. In the current housing crisis, it is more likely that local governments will be asking state governments for help.

The report also finds that states are rapidly drawing down rainy day funds. These fund levels peaked at 11.5% of annual state spending in fiscal year 2006 and are estimated to decline to 6.7% of state spending by the end of this fiscal year. It is unlikely that this is sufficient to see the states through even a shallow recession.

A final national development is that at the February meeting of the National Governors Association, the governors requested that the federal government offer a fiscal stimulus package for the states aimed at financing infrastructure investments. It is unlikely that this will go anywhere. In the 2001 recession, the federal government offered a $20 billion aid package to the states. Half of the $20 billion was earmarked for a temporary increase in the share of federal support for Medicaid programs, with the remaining half set aside for general grants based on population.

A closer look at the impact of the housing downturn on state and local revenues

The fallout from the subprime loans and foreclosures has had a negative effect on state and local revenues. The United States Conference of Mayors (and the Council for the New American City) hired the consulting firm Global Insight to estimate the implications of the mortgage crisis. The firm estimates that U.S. gross domestic product (GDP) will be $166 billion lower than otherwise because of the crisis and that 524,000 fewer jobs will be created. The firm further estimates a $1.2 trillion decline in property values in 2008.

The report provides estimates of metropolitan growth rates and changes in tax revenues for selected metros and states. For example, the estimated real gross metropolitan product (GMP) growth rate for metro Chicago in 2008 will be 2.23%. This represents a 0.56% reduction, or $3.9 billion decrease, attributable to the mortgage crisis. Metro Detroit’s real GMP growth rate is estimated at 1.3%. A reduction of 0.97% is attributable to the housing slowdown representing a $3.2 billion decline in GMP.

As for changes in tax revenues, the following table provides the fiscal impact estimates for ten states.

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As the table illustrates the fallout goes beyond just property tax revenues. Sales taxes decline because of the reduction in big-ticket items, such as appliances and furniture, that occur during a housing slump. Transfer taxes—the taxes on the passing of a title to property from one person (or entity) to another—fall in response to the lower volume of transactions; in recent years, transfer taxes had become increasingly important to municipalities. All in all, such trends suggest significant challenges.

What is the fiscal state of the states? Not very good. And it appears that the housing slowdown will make conditions more challenging than was found during the 2000-01 downturn.

As the U.S. continues to grow into a knowledge-based economy, human capital and ideas earn a higher premium. Therefore, competition for future economic growth and vitality leaves states and large metropolitan areas vying to attract and retain the young, well-educated population within the U.S., commonly defined as 25- to 39-year-olds with at least a bachelor’s degree. These young and educated adults have certain characteristics that make them particularly appealing to metropolitan areas, such as their especially high mobility and entrepreneurial tendencies.

Among a number of interested parties, policymakers, businesses, and researchers question what attracts these young professionals to certain areas over others. Some of the allure could come from characteristics that are specific to the individual, such as a job offer or personal relationships. However, Yolanda Kodrzycki of the Federal Reserve Bank of Boston, finds that these young professionals also exhibit certain general preferences. They gravitate toward areas that have high job growth, high average pay, and an array of employment opportunities where they feel possibilities and opportunities abound. At this point in their lives, they are the most flexible, and many may still be trying to choose a career path; therefore, a region that will allow them to explore many options is more attractive to these individuals. The payoff to successful “job matching” can be especially high for younger people because payoffs may accrue over a lifetime career supplemented with further learning and development. This implies that certain industry clusters may help attract specialized human capital to a location. A current trend going back two decades has been that cities with a strong technology industry have appealed to a disproportionate number of these young professionals. However, cities that have focused on other knowledge-intensive industries like finance and real estate have done well too. Metropolitan areas that value human capital and maintain a strong regional economy draw in these young and educated individuals.

Besides the direct advantages of high-wage jobs, the clustering of young professionals in an economy provides spillover benefits of knowledge and innovation through networks among firms and workers. Places such as the San Jose area are legendary for frequent job-hopping among workers, who thereby spread innovation more broadly. Such innovations typically involve tacit knowledge and know-how. Looking at patent data, Jerry Carlino has demonstrated how a higher density of skilled workers leads to a higher level of intellectual property.

Aside from economic opportunity, amenities offered by populous urban areas are also thought to attract young professionals. They often prefer to live in lively neighborhood areas within a few miles of the city center and take into account the affordability of this type of housing. Other amenities that appeal to this population include parks or other areas for walking and outdoor recreation, reliable public services including transportation, vibrant neighborhoods, and a dynamic commercial district. However, the extent to which these amenities matter remains the subject of debate and further study.

Warmer climate has been a magnet for the general U.S. population over recent decades. However, cold-weather cities can seemingly compensate with a combination of vibrant economic opportunities and/or big-city recreational and cultural features. The table below, for example, examines working age college-educated migrants from 1995-2000. Although the metropolitan areas that had the five highest net in-migration rates were located in the South and West, both the Minneapolis-St. Paul and Chicago areas posted relatively high net in-migration rates. Indeed, Minneapolis-St. Paul ranked among the top ten highest for that period.

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A recent discussion paper issued by the New England Public Policy Center further explores the regional concentration of young professionals using data from the 1980, 1990, and 2000 Censuses and the 2005 American Community Survey (ACS).

The concentration of young, educated workers in any one region depends on the extent that its young residents achieve college education and the region’s ability to retain them, as well as attracting others from around the U.S. and abroad. As of 2005, New England had the highest concentration of young, educated individuals in the nation, with 38.6% of its 25- to 39-year-olds holding at least a bachelor’s degree compared with 30.1% for the U.S. (see table below). However, overall educational attainment in the U.S. increased between 1980 and 2005, especially between 1990 and 2005 when the number of college educated, 25- to 39-year-olds soared by 22%. The Middle Atlantic, East North Central, and South Atlantic regions outpaced New England’s rise, although they began with lower percentages.

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The discussion paper further calculates a net migration rate from 2004 to 2005. The rate takes the difference between the gross inflow and outflow of domestic young professionals in relation to the base population of that age group. Migration rates are calculated as described but multiplied by 1000 to make it a rate per 1,000 residents. Using this measure, only the Mountain, South Atlantic, and Pacific regions have positive net migration rates of 20.4, 10.9, and 1.0, respectively. The two Midwest regions, East North Central and West North Central, had the two most negative net migration rates of -9.5 and -12.5, respectively, raising concerns about a Midwest “brain drain.” New England ranked third from the bottom with a -6.8 net outflow.

Movements of workers to and from abroad have recently become a more integral part of regional work force composition. Using a similar calculation as above, but only accounting for international inflows due to data limitations, New England comes in second highest with international inflows of 14.4 behind only the Pacific with 17.4. The East South Central region reported the lowest inflow of these individuals with 5.1; West North Central comes in second to last with 7.9. The East North Central barely outpaces West South Central as the fourth and third from the bottom with 11.6 and 11.4, respectively. Again, the Midwest appears near the bottom of the rankings, heightening concerns about not only maintaining or attracting domestic young professionals but gaining international ones. In New England’s case, the net inflow of international young professionals seems to offset the region’s domestic losses, but this does not hold true for some of the other regions, including the Midwest.

Although emphasis has been placed on young professionals, the growth in older workers, those aged 55 and above, will be the largest of any working-age group over the next ten years. The older labor force is projected to grow by 46.7% from 2006 to 2016 — more than five times the projected annual growth rate of the overall labor force of 0.8%. This large projected growth rate results from the aging of the baby boom generation into their “golden years” and still participating in the labor force. Older workers may continue to work due to the removal of the earnings test from Social Security, the increased retirement age for receiving Social Security benefits to 67, decreased employer-provided retiree health benefits, and the improved health status of older individuals.

Another reason for employers and regions to focus on older workers stems from the diminishing education attainment gap between young entering workers and older workers. Dan Aaronson and Dan Sullivan document the dramatic overall rise in educational attainment of the U.S. workforce since the 1970s. Educational attainment has been climbing as younger (more educated) cohorts have been displacing older (less educated) cohorts as they retire. Today, younger workers are only as educated, on average, as those that they displace at the older end of the workforce, and their lesser work force experience may put them at a disadvantage in some respects. All the more reason for employers to turn somewhat to older cohorts for tomorrow’s needed work force skills.

As the number of older workers continues to increase, will firms and policymakers shift some of their attention to retaining or enticing these workers by giving them incentives to extend their careers or possibly return to the work force? Older workers offer benefits to businesses that might not be available from young professionals, such as leadership, experience, and specialized skills gained over their lifetime that can increase productivity and output. On the other hand, these older workers have characteristics quite different from those of young professionals. They tend to prefer more flexible work schedules to balance work and family and to be less mobile geographically. Therefore, they may require a slightly different and possibly more demanding set of economic incentives and living amenities.

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The upshot of these differences is that a falloff in construction activity can be expected to be felt more keenly in those regions whose work forces are more concentrated in home building. At least this is true if construction activity declines are proportionate across regions. And if the rate of decline in construction activity were more rapid in regions outside of the Midwest, this would additionally contribute to some favorable convergence toward the Midwest pace of economic activity. By some reports, speculative home buying activity had been running very hot in many coastal states in recent years.

Data trends also indicate that the pace of recent declines in Seventh District home building activity have been on par with the U.S. Constructed square feet of residences from the McGraw-Hill Construction Dodge reports currently indicate that home-building has in fact been declining about the same as the remainder of the U.S. Since January 2006, the pace of home building has averaged declines of 25 percent year-over-year on a monthly basis in the Seventh District versus 26 percent in the overall U.S. over the same time period. Similarly, the pace of housing starts in the graphs below indicates that Seventh District declines have largely paralleled the U.S. since 2006, though the U.S. level of activity had climbed to a higher peak over the decade. Accordingly, though the construction sector covers more than residential activity alone, steeper-than-average job declines reported in the table above (column 6) are consistent with greater drops in home-building activity in the top construction-job states.

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Click to enlarge.

On the flip side, however, in many parts of the Midwest lagging general economic growth has tended to limit home buying and associated construction activity. In particular, Michigan’s construction employment peaked long ago during the fourth quarter of 2004 (see table above, column 4) and has fallen by 16 percent since then. So, too, housing starts (above) have fallen more steeply in Michigan versus both the U.S. and other District states.

But aside from Michigan’s woes, the pace of national construction employment growth (decline) has been converging (on average) with that of the Seventh District over the 2006-2007 period. The chart below illustrates the year-over-year pace of construction employment growth in the Seventh District versus the nation.

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This convergence cannot be attributed to home building activity alone because construction employment includes the nonresidential sector as well. As measured by jobs, residential building and construction make up 43 percent of the total. However, available data on commercial construction activity also indicates a pace of growth in the Seventh District that is roughly coincident with that of the nation. Consequently, the fact that the Midwest economy has a lesser share of total jobs devoted to new housing construction is likely contributing in some small measure to convergence of District employment growth with the nation’s.

To be sure, this convergence of construction employment will not spare Midwest households from financial loss and dislocation associated with a slowing national economy. As economist Leslie McGranahan demonstrates in a recent analysis, local economic conditions are one of the primary determinants of home foreclosure in addition to a state's foreclosure procedures and the degree of subprime and FHA borrowing. Accordingly, because automotive industry structuring has been weighing heavily on the Midwest economy, home foreclosure rates in Seventh District states are now running ahead of national averages (see figure below). An expected slowing of national economic growth during the first half of 2008 will continue to pressure many Midwestern homeowners who are stretching to meet their mortgage obligations.

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Note: Emily Engel and Vanessa Haleco-Meyer assisted this blog.

Beginning in the 2008 fiscal year, state and local governments with over $100 million in revenues will begin to report the accrued liability they face for funding non-pension post-employment benefits. In government parlance this is referred to as OPEB—other post-employment benefits—with the largest expense being comprised of retiree healthcare. Given that state and local governments have long provided healthcare benefits to both working and retired employees, why is the identification of this burden on the government’s books creating such consternation?

The answer to this question can be divided into three parts—government worker demographics, the size of the obligation and how government has traditionally paid for retiree healthcare, and the difficulty of restructuring employee benefits once granted.

• Government worker demographics. Following the national trend of an aging population, a large share of the workforce of many state and local governments is approaching retirement eligibility. For example, the Illinois Comptroller reports that in FY2006, 65% of public employees in the state were either in their 40s or 50s, up from 41% in 1986. As these workers retire, the pressure on healthcare expenditures is skyrocketing. A report by the Pew Center on the States reports that in California, retiree health costs will rise from $4 billion in 2006 to $10 billion in 2012 and $27 billion in 2019.

• The size of the OPEB liability and traditional method by which government has paid for OPEB costs. Prior to GASB 45, which requires governments to record their OPEB liabilities, most states simply met their retiree benefit costs on a pay as you go basis, where costs are paid out of current revenues. As such, few states actually put aside money to fund OPEB costs. While governments have saved to meet pension obligations, the Pew Center report estimates that 97% of the OPEB liability is currently unfunded. Estimates of the outstanding OPEB liability range from $370 billion (for a subset of governments that have reported their liability) to $1.5 trillion for the entire sector. The size of the unfunded balance differs considerably from state to state (see figure below).

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• Difficulty in restructuring retiree healthcare. In the private sector, a clear strategy for limiting a firm’s exposure to retiree healthcare costs has been to either eliminate or restructure healthcare benefits. A survey by the Kaiser Family Foundation reports that only one-third of large companies still offer retiree health insurance and that these companies have often reduced their premium contribution, leaving the retiree to shoulder a larger share of the tab. The state and local governments that have been the most active in addressing OPEB costs have taken on changes to health benefits, but this has led to several difficult bargaining sessions with public employee unions and frequent legal challenges.

Are there strategies for meeting OPEB obligations?

On March 12, the Chicago Fed and the Civic Federation will host a half-day conference on what governments are doing to meet their OPEB obligations.

Presentations will include officials from the Ohio Public Employees Retirement System (OPERS) and Oakland County, Michigan. Both of these governments have been seen as innovative leaders in identifying and developing a strategy to fund OPEB expenses. Ohio had accumulated over $11 billion in assets by FY2006 to meet OPEB obligations and has moved to restructure benefits as well by placing a cap on lifetime benefits and increasing co-payments and deductibles. While the state has an unfunded liability of $6.5 billion, it has shown fiscal discipline in consistently reducing its outstanding liability.

Oakland County has used a series of fiscal tools over the last 20 years to meet its OPEB liability. These have included:
--in 1985, creating a tiered vesting schedule for retirement;
--beginning in 1987, adopting a policy to fund the full actuarially required contribution (ARC) for retiree healthcare liabilities;
--in 1988, creating a self-insurance pool for active and retired employees;
--in 2000, creating a VEBA trust which allowed the County to create a tax-exempt investment plan; and
--closing the retiree health care plan and creating a defined contribution plan in 2006.

The March 12 Chicago Fed/Civic Federation program will also bring in a number of Illinois governments to discuss their evolving strategies for meeting OPEB costs. This will include representatives from the city of Aurora, the Metropolitan Water Reclamation District, and the Chicago Public Schools. Illinois governments face a particularly acute problem. The Civic Committee of the Chicago Commercial Club has estimated that the state’s unfunded OPEB liability is $48 billion. Given that the state also faces an unfunded pension liability of $40 billion, developing a strategy to meet this challenge will be exceedingly important. Discussions in Illinois have already examined such strategies as issuing OPEB bonds, creating irrevocable trust funds and selling assets to allow for one-shot infusions of capital to help meet OPEB obligations.

For many states, meeting the twin responsibilities of pension and OPEB funding will be dominant public finance issues for some time to come. Given the increasing pressures of funding elementary and secondary education, Medicaid, and deferred infrastructure costs, creating a strategy for managing labor related benefits costs will be critical to the health of the state and local sector.

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As seen in the chart above, exports have generally grown over the past few years and at an especially strong pace since 2004. Since then, exports for the western Seventh District states—Illinois, Iowa, and Wisconsin—have grown on average at a faster pace than those for the nation; the eastern Seventh District states—Indiana and Michigan—have had on average positive growth in exports, although at a slightly lower pace than the national average (see chart below). (A ranking of the Seventh District exporting industries can be found in a previous blog.) Exports from Michigan in particular are dominated by automotive trade in parts and vehicles with Canada. Such trade has grown slowly, in large part because of flat vehicle sales in North America.


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In contrast to Indiana and Michigan, each western Seventh District state hosts companies in particular sectors that have a strong export component. While export sales can be volatile, especially when observed at a specific state-industry level, these industries’ exports have been growing consistently over the past few years. Illinois’ electrical equipment (including machinery and computers), chemicals, transportation equipment, and food industries make up most of the manufacturing and exportable goods of the state—about three-quarters of Illinois’ exports. Chemical, machinery, and computer industries in Illinois have grown, on average, over 10% for the past three years, while the transportation equipment industry has grown about 40% over the same period. The transportation equipment industry’s major manufacturers in the state include Navistar and Tenneco Automotive—two companies listed in Industry Week's U.S. 500 top manufacturers. Other large companies in Illinois’ electrical, chemical, and food industries include Caterpillar, John Deere, Abbott, and, ADM (Archer Daniels Midland Company).

Similar to those of Illinois, Iowa’s food and machinery industries and Wisconsin’s machinery, computer, and transportation industries represent about 50% and 60% of each state’s exports, respectively. Iowa's top commodity exports are corn (except seed corn), pork, and tractors. Wisconsin has many major manufacturing companies, including Manitowoc, Briggs and Stratton, Plexus, Harley-Davidson, and Oshkosh Truck, that help boost exports.

As forecasts of U.S. economic growth for the year ahead are weakening, world economic growth is expected to remain robust. Although advanced economies have GDP projected growth of approximately 2% to 3%, this weakness is bolstered by the other developing regions with projected growth of more than 5% for the coming years. Accordingly, export growth will continue to be an important part of overall U.S. and Midwest growth in 2008.

Note: Vanessa Haleco-Meyer contributed to this blog.

Have you ever wondered how the U.S. can produce so much food with relatively few farmers? On September 24, 2007, at the Federal Reserve Bank of Chicago you could have learned some of the reasons behind the cornucopia of output from U.S. agriculture at our conference The Role of R&D in Agriculture and Related Industries: Today and Tomorrow. The conference explored the role of research and development (R&D) in agriculture, biotechnology, and the food industry, focusing on policies that promote industry growth and rural development. This conference brought together those interested in the R&D issues facing agriculture and related sectors of industry, particularly biofuels and food manufacturing.

The goals of the conference were to examine agricultural R&D from a midwestern perspective, explore the implications of R&D for industry growth, and discuss the influence of government R&D policies on industries and rural development. The sessions of the conference covered the following topics: 1) agriculture R&D and funding, 2) biotechnology and food R&D, 3) biofuels R&D, and 4) a policy discussion about the best ways to promote agriculture-related R&D. Next I’ll highlight a few of the presentations.

William Testa, vice president and director of regional programs at the Chicago Fed, kicked off the day with opening remarks that emphasized the role Chicago has played in the development of agriculture in the Midwest. “Almost from its inception, Chicago has been the nexus and commercial center for a broader region whose wealth emanates from production agriculture,” Testa said. Yet, shifts in agricultural labor due to increased productivity have affected the region’s economy. Testa noted that fewer production jobs in agriculture and related industries have led to struggles in rural development, though agriculture remains a key sector. “At heart, production agriculture must remain in the Midwest where land, climate, and transportation infrastructure are superior,” Testa stated. Moreover, R&D activities have played a key role in shoring up the District economy and offer hope for a bright future. The web of R&D efforts in the Midwest is likely to grow, creating more opportunities for the region through better products and new technologies. Testa concluded, “I am optimistic here today that the dissolution between research lab and factory and farm that has taken place in other regions and in other industries is not our Midwest region’s destiny.”

My presentation opened the first session and emphasized the link between the amazing productivity in agriculture during the last 60 years and agricultural research. Recent data from the U.S. Department of Agriculture demonstrated that, while using fewer inputs than in 1948, the agricultural sector in the U.S. produced more than 2.5 times as much output in 2004 as it did over a half century ago. Of course, the use of some inputs, like fertilizers, has increased. However, the contraction in farm labor more than offset these increases. Yet, there was a shift in the source of agricultural productivity during this period. In the 1948–1980 period, almost three-quarters derived from an increase in inputs per worker, whereas in the 1981–2004 period, two-thirds derived from growth in total factor productivity (TFP), which reflects changes in technology and other factors rather than labor-saving productivity alone. Government policies fostering agricultural research have promoted the long-term health of agriculture via TFP. According to Fuglie and Heisey, “There is a consensus that the payoff from the government’s investment in agricultural research has been high.” There are even greater benefits to the public from agricultural research when one considers the social returns from private research as well as public funding.

Orion Samuelson, agribusiness director at WGN Radio Chicago since 1960, presented the keynote luncheon speech, expanding on this theme of the changes in agriculture due to government policies. He passed along a few of his many experiences related to the changes in agriculture during his association with the industry. Orion touted rural electrification as the single factor that changed agriculture the most in the twentieth century; farm life was transformed by a reliable supply of electricity. He also said that research played a vital role in agriculture’s growth and that research funding should be expanded to sustain the industry’s growth. An example of the key role of research is the ongoing development of drought-resistant crop genetics via biotechnology, which will contribute to the record corn crop this year. Samuelson contended that we’re just seeing the beginning of biotechnology’s impact across the industry. Moreover, he predicted that U.S. agriculture would rise to the challenge of helping feed the world through agricultural R&D, just as it has over past decades.

The final session explored policies that would strengthen agricultural R&D in the U.S. Jeffrey D. Armstrong, dean of the College of Agriculture and Natural Resources at Michigan State University, discussed CREATE-21, a set of proposals to integrate the U.S. Department of Agriculture’s research, extension, and teaching functions and double U.S. funding of agricultural research to about $5.4 billion per year over a seven-year period. Moreover, the funding would become more competitive under CREATE-21, making research better suited to the changing needs of agriculture.

Lastly, Robert L. Thompson, Gardner Chair in Agricultural Policy at the University of Illinois at Urbana–Champaign, looked at the resource constraints facing world agriculture, even as world food demand could double by 2050. In this scenario, research investment is particularly essential for the future as well as it has been in the past. Also, the Midwest may play an even larger role in feeding the world with exports because of the water and land constraints that many regions across the globe face. But increased funding of R&D is needed to meet the rising global demand for food products. Indeed, R&D plays a key role in achieving greater output and in enhancing productivity, which will allow for more exports. Moreover, a better mix of funding with enhanced government participation would benefit agriculture and the world because private sector investment alone will not reach the socially optimal level in all areas of research.

The other presentations at the conference were excellent as well. Most of the presentations from the conference are now available online, so be sure to check them out to learn more about R&D in the agricultural, food, and biofuel sectors. (A special Chicago Fed Letter summarizing the conference presentations will come out in the near future.)

Economists and policymakers often pay close attention to payroll job numbers because they are among the most current and wide-ranging economic indicators available for states and regions. However, payroll job numbers should be viewed with caution as they are subject to revision; that is, an annual revision is undertaken during early March for the data of the previous five years.

The Midwest—comprising Illinois, Indiana, Iowa, Michigan, Minnesota, Ohio, and Wisconsin—saw moderate year-over-year employment growth in the first half of 2007. The Midwest had 0.2% nonfarm employment growth, while the U.S. had a 1.5% gain (see the figure below). Each state in the Midwest posted growth in jobs, except for Michigan and Ohio.

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Most major industry sectors contributed to the Midwest’s sluggish employment growth (see the table below). The region’s manufacturing employment decreased, in large part due to the auto and housing industries’ troubles. Midwest employment expanded in the professional, education and health, and leisure and hospitality sectors, though at a slower pace than in the nation.

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Rising by at least 1 percent, the professional, education and health, and leisure and hospitality industries led employment growth in the region. Because these sectors make up a good portion of the Midwest's industry mix (see the table below), they offset declines or tepid growth in other industries.

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The Finance Industry

The finance industry also helped sustain overall job growth during the first half of this year. Going forward, this sector’s performance could falter as financial firms react to changing credit conditions. In fact, some lenders have reportedly laid off staff in Chicago, Detroit, and Carmel, IN.

The Auto Industry

Indiana, Michigan, Ohio, and Wisconsin all reported declines in manufacturing; those states were heavily weighed down by the declining production activity in the automotive industry. According to the Chicago Fed Midwest Manufacturing Index, auto production in the Seventh District, which comprises all of Iowa and most of Illinois, Indiana, Michigan, and Wisconsin, declined 2% from the first half of 2006. Light vehicle sales and production in the U.S. decreased during the first half of the year (compared with last year) in part because of the ongoing struggles of the Detroit Three automakers (Chrysler LLC, Ford Motor Co., and General Motors Corp.). Payroll auto employment in Michigan reported an 11% drop year-over-year for the first half of 2007. Wisconsin also reported an 11% drop; however, the auto industry makes up a very small share of Wisconsin’s industry mix. Indiana’s auto employment reported a drop of 4%, and Ohio’s decreased by 7%. Automotive employment declines are not confined to production workers. Last month (on September 6), Volkswagen announced its plan to move its headquarters to Herndon, VA, which would shift 800 jobs away from the Detroit area.

Having discussed some of the major industries across the region, I now turn to the employment performance and outlook for the individual states.

Illinois

With strong growth in the professional, financial, education and health, and leisure and hospitality industries, Illinois reported about a 1 percent rise in nonfarm employment for the first half of this year compared with last year. These industries’ growth in jobs outweighed small contractions in manufacturing and government employment.

Indiana

Aside from the drop in manufacturing employment (and essentially no change in the number of jobs in the natural resources and mining sector), Indiana experienced growth in all other sectors. Based on the employment growth in most of its industries, Indiana reported a small increase in total nonfarm employment. Interestingly, the sector with the largest year-over-year growth was construction, even though housing starts and permits both decreased in the first half of the year. Recently, the relationship between housing construction activity and construction employment has remained murky in Indiana and elsewhere. Construction employment has held up better than some might have anticipated.

Iowa

Iowa reported above a 1% growth in total employment partly due to its strong professional and financial industries. For the first half of the year, Iowa also experienced greater than 1% growth in its construction, information, education and health, and leisure and hospitality industries. Similar to Indiana, Iowa recorded a significant increase in construction jobs, even as home building slowed.

Michigan

Michigan reported a drop of 1% in nonfarm employment, which is in line with the rate of decline it has experienced since the beginning of 2006. Job losses were widespread across major industry sectors, with the exception of solid growth in the education and health sector as well as the leisure and hospitality sector.

Minnesota

Minnesota reported a 1% growth in total employment largely because of its expansions in the professional and financial industries. While Minnesota saw some declines greater than 1% in natural resources and mining as well as in construction, these industries form only a small portion of the state’s industry mix. These declines were more than offset by the strength in the professional and financial sectors, as well as by the reported 3% gain in education and health and the smaller 1% gain in the trade, transportation, and utilities sector.

Ohio

Ohio’s overall nonfarm employment experienced a dip. However, this decline was partly offset by the strong growth in its professional as well as its education and health industry. The trade, transportation, and utilities sector also posted a small gain.

Wisconsin

Overall, Wisconsin reported a small increase in total nonfarm employment. Other than a decrease in manufacturing and construction, Wisconsin’s other industries expanded in the first half of the year. Manufacturing excluding the auto industry reported a decline of 1.7%.

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As measured by payroll employment growth, the Midwest economy continues to expand more slowly than the nation. A general pattern of increasing weakness is evident in contrasting the westward states of Iowa, Minnesota, Illinois, and Wisconsin with Michigan, Ohio, and Indiana in the east (see the figure above). Automotive restructuring there, along with flat nationwide sales in light vehicles, continues to account for a lagging pace of payroll employment.

Fuel-efficiency standards have also been criticized for imposing unnecessary and distorting restraints on consumers’ choices of vehicles. Logically speaking, penalties to modify behaviors to align with socially desirable outcomes should be fashioned to most closely target those behaviors that give rise to social costs. Accordingly, rather than forcing fuel-efficiency standards on specific types of vehicles, a preferable approach would be to penalize the actual behaviors that give rise to carbon emissions regardless of vehicle type. That is, a tax on fuel at the pump would be preferred to vehicle fuel-efficiency standards. And a tax per unit of carbon associated with a particular fuel—such as gasoline over diesel—would be preferred to a general fuel tax. Nonetheless, to date, fuel-efficiency regulations have been more palatable to the American public than alternatives such as direct gasoline taxes.

Midwest-domiciled automakers, especially the Detroit Three (Chrysler LLC, Ford Motor Co., and General Motors Corp.), have so far found it more difficult than other manufacturers to achieve CAFE fleet standards on cars and light trucks. Going back to the 1970s and earlier, Detroit Three automakers have tended to offer larger vehicle models for sale, and this specialization has continued into recent years.

The figure below displays the reported average fuel economy in 2006 for major companies selling vehicles in the U.S. market. For both passenger cars and light trucks, the measures of fleet average fuel-efficiency for both Toyota and Honda easily exceed those of the Detroit Three. Indeed, for passenger cars, the fleet fuel economies of Honda and Toyota already approach the hypothetical standard that is being considered for the year 2020.

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CAFE standards may soon become even more onerous for automakers. In June 2007, the U.S. Senate passed legislation mandating stricter standards on both passenger cars and light trucks. By the year 2020, fuel-efficiency standards would rise for such vehicles so that they must achieve 35 miles per gallon. (Such revised CAFE standards will likely be considered by the U.S. House of Representatives during the fall of 2007).

The vehicle fuel-efficiency of major automakers has been changing in recent years. Per the figure displaying the fuel economies of passenger cars below, Toyota’s and Honda’s have gained markedly over those of the Detroit Three during the decade. In contrast, these Japanese automakers have not widened their fuel-efficiency advantages in the light truck category. Within the category, Honda and Toyota have been selling more models that are heavier and less fuel-efficient than they had before; these models would include the Honda Pilot and Toyota Land Cruiser SUV.

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From a Midwest perspective, the region’s light vehicle production facilities tend to be those of companies that will likely find it most difficult to meet more stringent standards. The map below displays the assembly plant locations of the Detroit Three automotive companies, as well as those of the foreign-domiciled automakers. A large majority of the Detroit Three’s light vehicle production facilities are located in Midwest states. In the northern part of the U.S. automotive corridor, which includes the states of Ohio, Michigan, Indiana, Illinois, Wisconsin and Missouri, 24 of its 31 light vehicle plants are owned by the former Big 3 domestics. Accordingly, the region’s residents will be interested to see that any prospective carbon reduction policies are as cost-effective as possible.

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Not everyone believes that GHGs from human activity are significantly contributing to global climate change or, if so, that mitigation policies are advised. Still, it would appear that mitigation policies, including more stringent CAFE standards, will be forthcoming. An informed and judicious choice of alternative policies can contribute to achieving cost-effectiveness while reducing GHG emissions.

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Surprisingly, it is not the Midwest economy’s greater concentration in heavy industry that explains its greater carbon intensity—at least not directly. The figure below reports that the region’s industrial sector accounts for a lesser share of its overall carbon emissions versus the nation’s in its overall emissions. Rather, the region’s electric power sector makes up a larger share of carbon emissions versus that of the U.S., a 42.8 percent share in the Midwest versus 38.4 percent for the nation.

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Nor is it the case that the region’s residents consume considerably more electric power than the national average. Rather, the means of power generation in the Midwest tends toward the burning of coal along with attendant carbon emissions. As shown below, power generation facilities in every Midwest state (save Illinois) burn coal to a greater degree than those of the nation, a 41 percent greater share in May 2007. Illinois’ lower carbon intensity derives from its use of nuclear facilities to generate electric power. Indiana and Ohio are especially dependent on coal to generate power at the present time.

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From these cursory observations, it would appear that, to avoid costs and penalties, the Midwest’s electric power generators would be called on to reduce carbon emissions in the event that state or national policies begin to control GHG emissions. Possible avenues to do so are to rely on more (carbon-free) nuclear generating plants or on renewable means, such as the conversion of wind power to electricity. Various technologies to scrub coal of its carbon are also available or on the drawing board.

In choosing among these vehicles to reduce carbon, cap-and-trade systems are in some respects highly suitable for electric power producers. Electric power plants tend to be large and fixed in number. Accordingly, the issuance, monitoring, and trading of emissions permits can be carried out with little monitoring and administrative cost. Of course, the ultimate costs of achieving carbon reductions remain uncertain. In the 1990s, the nation had favorable experiences with a cap-and-trade market among power producers in reducing sulfur dioxide emissions as required under the Clean Air Act. Emissions were reduced below expectations at costs that were far below expectations. It is hoped that a similarly successful marriage of technological progress and market-based incentives will once again come about.

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In fashioning business-type taxes, policymakers seem to be motivated in two primary ways. First, business taxes are often seen as a popular and expedient way of raising revenue for public services and do so at the expense of the business owners. There is a common notion that such taxes are “progressive” and are drawn from the wealth of well-to-do individuals. However, business-type taxes are imposed on certain transactions and not people per se. For example, a particular tax may be called a “retail” tax if it is imposed on telephone or electricity consumption, implying that the consumer is bearing the burden. But, the same tax may be called a “gross receipts” tax when levied directly on the public utility, implying that unidentified “business owners” are bearing the burden of the tax. Yet, in every action in collecting either tax, they are identical. “Who puts the nickel in tax collection box” makes no difference in real impact.

Similarly, while a business tax may be legally written to fall on the purchase of a business input or on the income of a corporation, behavioral adjustments take place in response to the tax that ultimately shift the final burden of the tax. Most commonly, excessive taxes are shifted forward into the prices of goods purchased by consumers—rich and poor alike; or taxes may be shifted backwards onto people who own the factors of production—laborers as well as nonworking households of various income strata.

If it is true that business taxes are shifted, why do we see that business organizations and business owners vigorously fight business tax hikes in state legislatures and in local city councils? Part of the answer is that taxes are only shifted in the long run. In the meantime, because business operators and owners cannot quickly adjust their behavior in response to tax hikes, the tax burdens may indeed fall heavily on them personally. Only after varying periods of time may businesses fully take offsetting actions, such as reducing investment and labor, retrenching production, or moving to other locales. And looking forward, many opportunities for business expansion may be nullified because of disincentives that are attendant to the expanded taxation.

In this light, the other major consideration of policymakers comes to the fore. State and local policymakers worry about their competitiveness in setting business tax policy. In the United States, “tax competition” is highly active among state and local governments. As localities compete for both jobs and tax revenues, taxes do not generally stray too far out of line. Outwardly, states keep their general business tax structures in line with their neighbors so as not to discourage business investment. So too, states and localities often offer generous and other selective tax abatements.

Tax competition serves not only to keep business taxes from being punitive, but in the competition for local investment, localities are often forthcoming in allowing commercial use of land and providing public services to business. In fact, because businesses do directly use public services such as roads, refuse disposal and public safety services, it is clear that business taxes should seldom or never be reduced to zero but should rather cover related costs. Other similar “business generating” costs that have been advanced in this regard include pollution-type taxes, which are more common in Europe, and the business benefits of allowing “limited liability” organization, which may impose costs on governments if businesses fail catastrophically or in unanticipated ways.

Some observers and analysts believe that local governments do not manage well the negotiations with savvy business firms for selective tax subsidies. For this and other reasons related to tax competition, insufficient revenues will be raised to fund basic services to households, such as public education. Accordingly, efforts to limit competition by statute have been advocated, along with proposals to assist governments in bargaining more effectively with arbiters of mobile capital investment.

Is the limiting of tax competition necessary to save governments from themselves? The answers are not yet clear. However, it can be said that local governments are competing on more than the basis of tax competition alone. Several studies have indicated that the quality of life and other household amenities are increasingly the determinants of metropolitan area growth. Local leaders, and especially big city mayors, have responded to this trend by building infrastructure and offering amenities to attract workers—especially educated and skilled work force—to their cities. Such efforts range from festivals and parks to school reform and public safety. Younger people are often the focus, since they are more mobile in their migration patterns. In tandem, cities often couple amenity initiatives with employment strategies such as college internship programs with local firms, recruitment fairs and regional marketing.

Governments also compete in providing public services to business, and they also construct the regulatory and legal environment in which businesses operate. In considering where and whether to invest, businesses must often look to an uncertain future. In choosing where to invest, they accordingly prefer to have some certainty with respect to state and local government behavior toward business activity. They may ask themselves: Do the state and local governments seem to be committed to standing as an attentive and steady partner in providing services as businesses’ needs change over time? Or has the past record of state and local government been punitive and myopic in expanding business taxation when revenue shortfalls arise?