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An Economic War

June 1, 1996


Alice M. Rivlin Vice Chairman, Federal Reserve Board

The following keynote address was presented by Rivlin on May 21, 1996, at "The Economic War Among the States" conference, National Academy of Sciences, Washington, D.C.

We're here to talk about a war, an alleged war among states and localities right here in the U.S.A. We're here to discuss whether this alleged war is a bad thing, who's winning, who's getting hurt and how much, what, if anything, ought to be done and by whom. We're not talking about a shooting war. We're actually talking about something that sounds like a good thing, namely competition among states and localities for jobs and industry. The weapons in this war are incentives used by states and localities to get new industry to move into the area, presumably relocating from somewhere else or just expanding into a new location. These incentives can be tax breaks, reductions in property tax assessments or other types of business taxes; they can be favorable financing, loans at below-market rates financed by tax-free industrial revenue bonds or some other instrument. They can be special public expenditures for roads or airports or worker training or schools or sanitation or something else.

At first glance, one might ask what's new about it, and isn't this kind of competition a good thing? Haven't states and localities always competed for jobs and industry, both here and abroad, using whatever incentives they could lay their hands on? After all, much of America's infrastructure was the result of the desire for economic development built as an incentive to commerce and industry. The opening of the West is a story of economic incentives—state, local, federal. It's a story of roads and canals and railroads and ports subsidized with public funds, of loans and land grants and other subventions. There were big mistakes as well as successes, but a lot of these public incentives did what they were supposed to do. They opened markets, they gave access to resources, they attracted business and created jobs, they raised incomes, and they provided an economic base for thriving communities. Not all of the investment was physical. We talk now about creating human capital. That's a 20th century phrase for a very strong 18th and 19th century idea that gave us public schools, land grant colleges, state universities, hospitals, clinics and medical complexes. The incentives for economic development have also given us laboratories and science parks, the research triangle, Route 128, the Dulles corridor, concentrations of high tech enterprises around research universities from sea to shining sea.

In recent years the competition has, of course, become more global and more sophisticated and more arcane. Governors and mayors prowl the international airways racking up more overseas frequent flyer miles than Carmen San Diego and visiting trade fairs in places that they could barely pronounce. Lesser officials work the closer territory, touting the home attractions, trying to get companies to move from Maine to Texas or from California to Colorado. The successes are visible. Once-depressed communities in many places have hundreds of new jobs, a new mall, a new community college, significant prosperity and hope where neither was before.

This all sounds very positive. So why are we gathered in this auspicious room talking about war and listening to the arguments that something destructive is going on out there that ought to be stopped, or at least channeled into more constructive directions? The argument for concern is that competition among places has escalated into a bidding crescendo that is injuring the winners as well as the losers. Economic change, global competition, the decline of some traditional resource-based industries and the migration of others to developing countries have made many states and localities so desperate for new industries and jobs to go with them that they are engaging in self-defeating and mutually destructive practices. They have developed new lures to snag the most attractive fish, the national and multinational companies that are increasingly wandering the global landscape. Ingenious tax privileges or financing schemes whose true long-run cost to the taxpayer may not be apparent have been designed to attract footloose companies with declining loyalties to the old country or to the founder's hometown, eager to cut costs and widen the profit margin and not deeply committed to the well-being of any particular place.

The packages of incentives get more elaborate and more expensive, like the offers to Heisman trophy winners. As the bidding escalates, potentially mobile companies play one community off against another. A point may be reached where the losses to the bidding states and communities outweigh the gains. The tax breaks erode the tax base and public services suffer. Public money is spent subsidizing the entry of new companies into the area, companies whose history and loyalty may be elsewhere, rather than providing needed services to the companies already part of the community and its culture, and to their long-time resident employees.

And the new companies may not live up to the bargain. They may have misjudged the market or the location and they may soon move on. The net result may be that despite a few big winners, the average community ends up with less tax revenue, lower quality public services and lower average income than if the competition had never begun. Anecdotes about the excesses abound, states putting up more money per new job than could possibly be recouped over a decade or more. Companies taking the bait then reneging on the expected investment or the number of jobs. It's harder to measure the opportunity cost—what could have been bought with the taxpayers' money that went into these incentives.

What this conference is about is thinking: How real are these costs, how general are these anecdotes? Do the costs outweigh the advantages? If at least some of this competition is destructive, is there a way to reduce the cost? Is there a role for the federal government or for collective state action? That's what everybody came to discuss and will be discussing as the conference moves on. It's an interesting and a difficult problem. There's lots to be said on both sides. I think the reason it's so interesting is that it is a piece of a larger and a more fundamental set of questions that are now being debated in various forms all over the country—on the airwaves, in the boardrooms and the backrooms, in Congress and state and local legislatures, and especially in the upcoming political campaign.

There are really two questions; one is: How can we raise the average standard of living in America gradually over the coming decades so that people can have hope for themselves and their children and their communities? And second, what kind of leadership should be taken by the central government and what by states, local communities and the private sector? We're all very focused on this question right now because we have to elect a president and a Congress. That's the occasion for asking what the federal government should do to enhance prosperity and provide this basis for hope in the future. Candidates have to think about it. They have to propose answers to the questions: What should the federal government do? What can I promise that I can reasonably hope to deliver if I get elected? That's always hard, but I think it's especially hard right now. I submit that it's not hard because federal policy is going badly. On the contrary, it's hard precisely because federal policy is going so well. The things that we expect the federal government to do and that it knows how to do—defend the nation and keep the macroeconomy on an even keel, for example—are going fine. It's the things that we aren't sure the federal government knows how to do at all that aren't going too well and make us focus on what the federal government's role is and what other people can do.

This wasn't so true four years ago. If you'll cast your mind back to the last election season there were obvious problems with the economy at the national level. We had a slow recovery. We weren't creating jobs very rapidly. The unemployment rate was relatively high, stuck in the 7s. There was talk about falling back into another economic recession or a double dip. There was the budget deficit—it was high and it was rising out of control. It was $290 billion or nearly 5 percent of the GDP in 1992, and it was headed up on everybody's projections. It was unsustainable. We were in a situation where we were accumulating debt service and would soon have to cut back on everything else or raise taxes just to pay the increasing interest on the debt. It was a use of saving which everybody regarded as unproductive and a drain on future growth. So something had to be done about that.

There were more fundamental problems, too: lagging wage growth due to slow productivity growth, rising inequalities of income, a widening gap between those with skills and education and those without. Both candidates, but especially the winning candidate, President Clinton, addressed all three of these problems. The first two, the most obvious federal responsibilities, jobs or the state of the macroeconomy and the budget deficit were most prominent in the campaign. The president, or the candidate, made some breathtakingly specific commitments. He promised to create 8 million new jobs in four years and cut the deficit in half at the same time. Those were rash and risky commitments, and there were some on his campaign staff, I was not one of them but I know a lot of them, who were very nervous about it. They feared that the candidate was overpromising and might rue the day that he had been so specific. Yet six months before the 1996 election, both these promises have been fulfilled. Over 8 million jobs have been created, or more than 8 million people are working in early 1996 than were working in early 1993, and the net number of jobs since early 1993 seems likely to pass 9 million by mid-summer. Moreover, increasingly these jobs are good jobs, disproportionately in higher-wage occupations and industries. Unemployment, which was 7.1 percent in January 1993 is now down to 5.4 percent. Indeed, it has hovered in the 5.5 percent range for over a year, a lower level than many economists thought sustainable, and without any clear sign of accelerating inflation. Indeed, the misery index, the sum of unemployment and the consumer price index, is at its lowest level in several decades. Profits, investments and stock prices reflect the generally strong performance of the economy at the aggregate level.

As a member of the economic team that labored hard to craft President Clinton's 1993 deficit reduction package and defend it in the Congress, I'm personally particularly gratified by the spectacular success in reducing the deficit. Even a Congress of the same party as the president had a hard time swallowing the package. No one enjoys voting to cut spending or to raise taxes, and the Clinton plan required both in equal measure. It was designed to cut about $500 billion cumulatively off the deficit over four years, and it has done that and more. As we look now it has reduced the deficit by nearly $700 billion over that period. Opponents predicted that the plan would throw the economy into recession and that, as a result, the deficit reduction would not be achieved. The package passed by one vote in each chamber, but it passed and it worked. And the deficit, which was $290 billion in fiscal year 1992, was down in the past year to $164 billion. Both the administration and my erstwhile colleagues at the Congressional Budget Office projected it will be in the range of $140 billion for 1996, or almost exactly half what 1992 was. And surprising statistics released in the last couple of days show that if we're lucky, and if the trend holds up, we may do better than that.

Moreover, in the last few months a very remarkable thing has occurred. Both the president and the leadership of the Congress have converged on the same fiscal policy goal, measured by the same standard. All are committed to balancing the budget by 2002 using the fairly conservative economic assumptions of my former colleagues at the Congressional Budget Office. This convergence has been lost in the cacophony of partisan wrangling of how to reach it, but it's worth some attention to Washington watchers. For much of the 1980s, policy-makers argued about whether balancing the budget was a worthy objective. Supply-siders said deficits didn't matter. President Reagan said not to worry, we would grow out of it. President Bush agreed reluctantly to a good deficit deal, then backed away from it. Only a year ago in the aftershock of the 1994 election, our administration was uncertain, despite its huge success in deficit reduction, whether to commit to the painful measures needed to reach balance. Only a few months ago, Republicans and Democrats were arguing about how fast to balance the budget and what assumptions to use in assessing the necessary policies. That's over. We've converged on a goal.

To be sure, mere agreement on the goal doesn't solve the problem. The president and the Republican leadership propose different ways of doing it. The Republicans want a larger tax cut, offset by larger reductions in projected spending, especially in Medicare, Medicaid, education and the environment than the administration believes wise or necessary. The contrast between the two plans started out stark, but narrowed considerably in the marathon negotiations that went on in December and January. When those negotiations broke off so that the presidential candidates could go run in the primaries, the two sides were actually very close. There's still hope that they might come back together, although the hope fades as the country moves into the election season.

The good news, then, is that by all the usual aggregate measures—inflation, unemployment, profits, stock prices, even the budget deficit—the economy is functioning as well as it has in decades and better than most industrial economies do. The combination of monetary and fiscal policy, and perhaps a bit of luck, is producing almost optimal macroeconomic results and there's no reason to think the economy is likely to veer off the track any time soon. The bad news is that the fundamental problems of wage stagnation and rising income inequality, also prominent in the 1992 campaign, have not been solved by the macroeconomic improvement. And few Americans express any optimism about the economy. Polls, the press, the pundits, all confirm widespread anxiety and pessimism. Many people feel they're struggling to maintain a decent standard of living. The supporting evidence is abundant: slow growth in real family incomes, a widening gap between rich and poor, young people with just a high school education or less unable to earn what their parents did, unable to look forward to buying a house or raising a family in a safe neighborhood. The economic worries blur into the social ones—crime, drugs, violence, family and community disintegration.

The tools of macroeconomic policy, the things the federal government is pretty good at, can't address these concerns. Although the failure of monetary and fiscal policy to keep the economy on the track, that is, the failure to avoid a serious recession or an accelerating inflation, could make all of this a lot worse. Moreover, the federal government cannot solve these other problems alone and, in any case, cannot solve them quickly. A presidential candidate can promise he'll work hard on them, but he cannot promise he will solve them.

What would help most? Presumably, over the long run, a big improvement in the skills of the labor force brought about by more people getting more and better education and training. The federal government can play a role here. It can encourage more students to continue their education beyond high school. It can provide more resources for preschool education, for enriching classroom instruction in schools with many children from low-income families. It can challenge states to set goals for students and help them train teachers to better reach those goals. It can encourage states to address a particular problem in American education like making the transition from school to work smoother for those not going on to college. It can consolidate the long list of federally funded training programs and empower dislocated workers to seek training best suited for them by putting a voucher in their hands and holding training institutions accountable for results.

In fact, as everyone will quickly recognize, the Clinton administration has fought hard for all of these items and is trying to increase their funding, fend off cuts and make the programs more effective. But the federal government doesn't control the schools. It provides only a fraction of total funding for elementary and secondary education. Federal programs will make a difference only if they energize parents, students, teachers, business and community leaders to seize control of their own institutions and radically increase their commitment to quality outcomes. The federal government doesn't really have the tools for doing that. The need for community action goes beyond education. The economic and social problems that Americans face now, and they are serious ones, are not the ones that the federal government can fix with a law or a program. These problems—rising inequality, low productivity and low wages, crime, violence, racial conflict, teenage pregnancy, dysfunctional neighborhoods—are problems that can be solved, if they can be solved, only by a widespread outpouring of community energy and concern, reinforced by the joint efforts of schools and churches, businesses and unions, governments at all levels. What's needed is a bottom-up revolution in which groups of citizens in localities across the country come together to identify what they believe is most necessary to revitalize their community and work together to make it happen. Part of this effort has to focus on jobs and employment.

So this is the dilemma that this conference is facing. Brighter futures for Americans require energizing community effort to develop local and regional economies, the economies best suited to the resources that are there, to develop skills needed to compete in the modern economy, to improve public safety and revitalize neighborhoods. To put out that effort, communities need to feel accountable and responsible. They need to feel that their actions, sensibly planned and sustained, can make a difference. It's not productive to deprive them of tools or of the sense that they are somehow in control of the outcomes. The problem is that states and communities have very unequal resources and that the instruments available to them to attract more resources, especially the promises of lower taxes, can lead to lower service and less public effort to build the capital, human and physical, needed to develop the local economy.

This is part of the reason that the federal government grew and took on new functions over the last 60 years. We needed some basic infrastructure like a federal interstate highway system supported by a uniform national tax. Competition to reduce the tax rate and attract more sales of gasoline could have led to a very uneven national road system with rough, slow patches detrimental to national and local economic development. Leaving retirement policy to 50 states also would probably have worked out badly. States competing for business and employment would have lowered payroll taxes, provided lower benefits to older people. The achievements of the Social Security system, a dignified independent old age for almost everyone, would simply not have happened.

We've done those things. And it does not follow that the central government can or should fix the remaining problems. Most of us don't believe that the central government should manage the schools or make decisions that affect the location of business. We don't want a national bureaucracy moving companies around, making decisions about winners and losers. We do want communities to be able to plan their futures, take charge, make something happen.

So what is the solution? I don't have all the answers, but one that appeals to me is to encourage states to make their tax policies more uniform, to compete on the excellence of their services, not on the lowness of their taxes. That's not totally fanciful. We could have, by interstate compact or some other means, a much more uniform state taxation of businesses. For example, one could have a uniform sales tax rate. One could get away from the problem of competition at the border, people driving across the state line to purchase big ticket items in a jurisdiction with a lower sales tax. A common tax could be shared by the states on a formula basis and it would also have to apply to mail orders. More appealing, I think, is a common shared corporate profits tax. It would be much easier for multistate companies to file a single return for all the jurisdictions in which they operate. It would take a lot of the strain off their tax departments and leave them not having to make the ingenious calculations of where the income was earned to minimize the tax. The proceeds could be shared on a formula basis.

Europe is moving in this general direction. In a free trade area it helps to have some uniformity in business taxes, and we could do that. But what about the firm-specific incentives that are the central focus of this session? Is there a benefit to limiting them in the name of fairness, fairness to the existing companies, or preventing deterioration of services, an argument that outweighs the risks of inhibiting states and local community action? That's the question to be discussed at the conference. My own views are that we should try cooperation, voluntary agreement, rather than prohibition or federal preemption, and that we should put a lot of faith in the common sense of properly informed citizens.

Two suggestions: One would be that perhaps as a follow-up to this conference there be developed a uniform set of information standards or guidelines that states and localities would voluntarily adopt. Those would spell out that incentives must be transparent, that there must be an effort to weigh the costs against the benefits. It must be shown what the company is likely to get out of this deal, what employment is reasonable to expect, and whether these benefits are commensurate with the cost to the community. One wouldn't want to overburden the process with endless forms and calculations. But some standards of transparency would help and would give informed citizens and legislatures a sense of what they're really buying and what the cost is.

Second, voluntary agreements among states and jurisdictions to use the incentives that benefit the whole community rather than those that do not—to emphasize investment in training, education, general purpose infrastructure such as roads, airports and sanitation that can be used by everybody and that may leave a permanent, positive impact on the community, even if the particular company moves on. The voluntary agreement would emphasize those things in preference to tax reductions or extremely firm-specific funding. In other words, it's OK to offer a community college but not a secret tax break. This approach, although more difficult, strikes me as preferable to trying to develop any rigid rules or federal preemption. But there are a variety of opinions on this. You will hear them all as the conference develops. That's why it's a good topic for discussion and for debate. Thank you.