Local Governments and Economic Freedom

September 19, 2017

In their 1980 book The Power to Tax, economists Geoffrey Brennan and James M. Buchanan introduced the Leviathan hypothesis: the more competing governments there are in an area, the more difficult it will be for them to exploit their constituents. This hypothesis has been tested many times at the country and state levels, but very little work has been done at the local level. It is the local level where residents’ mobility, which helps to constrain Leviathan, is highest. City and county governments can also tax constituents and spend money, but do they also behave in an exploitative manner?

Adam A. Millsap, Bradley K. Hobbs, and Dean Stansel test whether metro area economic freedom increases as local governments become more numerous. The study uses an economic freedom index developed at the metropolitan statistical area (MSA) level as its measure of government exploitation. The study provides the first examination of the relationship between MSA economic freedom and the number of general-purpose governments. The study also controls for a variety of other factors, such as federal aid to state and local governments and regional differences.

Local governments compete with one another for residents and firms, and one way they do this is through local economic and fiscal policy. Since people and firms are mobile, the more competing local governments there are, the harder it is for any particular government to exploit its residents through excessive taxation or to adversely interfere with the economy in other ways.

Key Findings

  • Economic freedom is positively associated with the number of competing government jurisdictions, with some exceptions in the South and West regions.
  • An increase in government competition is associated with an improvement in labor market freedom but has little or no relationship with tax freedom or the size of government.
  • As federal transfers to the states increase, labor market freedom decreases, perhaps because of the separation of local revenue from the quality and amount of local government goods and services, which decreases the need for pro-growth economic policies.
  • The proportion of adults with a bachelor’s degree or more has a positive relationship with overall freedom and labor market freedom, but it has a negative relationship with taxation freedom. Those with more education may be more willing to pay local taxes because of a stronger preference for local government services such as public education. 

Regional Findings

The Northeast and Midwest

  • The Leviathan hypothesis holds: the more competing governments, the more labor market freedom, taxation freedom, and overall economic freedom.
  • In states with more laws governing local government, MSAs have less economic freedom on average.

The South

  • The number of local governments has little or no relationship with any of the measures of economic freedom.
  • The Leviathan hypothesis does not hold for southern regions where government has historically been more concentrated into county governments. 

The West

  • Western governments have historically covered larger areas in order to take advantage of economies of scale when providing services to dispersed populations. 
  • The number of local governments has little or no relationship with any of the measures of economic freedom.

Conclusion

The study finds evidence that supports the Leviathan hypothesis in metropolitan statistical areas in the Northeast and Midwest but not for those in the South and West. Further research is needed to determine why the results vary by geographic region.

Sub-national Indices of Economic Freedom

December, 2015

The literature on economic freedom has primarily focused on nations, where differences are largest. However, though the differences in economic freedom within individual nations are smaller, there are numerous advantages of examining issues at the sub-national level. In this chapter we discuss these sub-national indices of economic freedom and issues related to their use by empirical researchers. For example, there are much smaller differences in culture and other institutions that are difficult to quantify and thereby include in an econometric model. In addition, the geographic boundaries are at least somewhat less arbitrary, particularly at the metropolitan area level. We argue that the existence of the sub-national indices of economic freedom provide great opportunities for future research on important issues regarding the relationship between governmental institutions and a variety of economic outcomes.

Economic Freedom Studies

December, 2015

We synthesize and elaborate on the existing research concerning the role of the Economic Freedom of North America (EFNA) index. Our consensus after reading this literature is that the EFNA index is largely positively related with normatively good outcomes, and negatively related to normatively bad ones, with a few exceptions. The literature considers the EFNA index as a good proxy for institutional quality, regulatory environment, and business-related policies across North American states and provinces. In addition, a significant number of studies take interest in the EFNA as a variable to be explained by factors such as ideology, legal origins, and pro-market think tank spending. The literature on EFNA is still in its relative nascence, but is growing rapidly, and can provide a useful guide towards future policy changes leading into positive institutional transformations and hence better economic outcomes.

Dean Stansel Discusses State Budget Shortfalls on the Ed Dean Show

Dean Stansel, a research scholar at the Mercatus Center, discusses how contributing to state rainy day funds helps minimize the fiscal stress of budget shortfalls.

Calendar Date: 
Jan 27, 2015
MP3: 
https://www.mercatus.org/sites/default/files/Dean-Stansel-on-Ed-Dean-Jan-27-2014.mp3
External People: 
Podcast Types: 
Publish to Announcements page?: 
Image: 
Publish to The Bridge?: 

Dean Stansel Discusses Eminent Domain on WGCU Radio

In a segment on Florida NPR, Dean Stansel discusses the economic impact of eminent domain laws, touching on Kelo v. City of New London.

Calendar Date: 
Jan 21, 2015
MP3: 
https://www.mercatus.org/sites/default/files/Dean-Stansel-Discusses-Eminent-Domain-on-WGCU-Radio.mp3
External People: 
Podcast Types: 
Publish to Announcements page?: 
Image: 
Publish to The Bridge?: 

It's Not the Economy, It's the Politicians

Friday, January 16, 2015

Like last year at this time, many states are opening their legislative sessions with revenues pouring in faster than expected. In Florida, a $1 billion annual surplus is projected. A similar size surplus is projected in Minnesota for their two-year budget. There's even talk of a surplus in California, and New York has a $5 billion windfall from bank settlements. Those unexpected windfalls will provide great temptation for governors and state legislators.

During recessions, politicians typically blame a poor economy, unemployment, or reductions in federal aid for budget shortfalls. But when the money is flowing in, they often choose to go on a spending spree rather than to heed the lessons of the past and exercise fiscal discipline.

According to our new research on state fiscal crises published through the Mercatus Center at George Mason University, mistakes made by politicians during good years are often the cause of big headaches down the road. How a state's windfall revenues are allocated can make a big difference in how it fares the next time the economy hits a recession and it again faces a substantial budget shortfall.

Faced with extra revenue, politicians have three options for how to use the money: First, they can increase spending, on either new or existing programs. Second, they can cut taxes, returning the windfall to the taxpayers from whence it came. Finally, they can deposit the extra revenue in a rainy day fund.

The first option creates higher expectations for the level and growth of spending in the future, so it creates a bigger problem when revenue growth returns to normal. The second two options, returning or saving the unexpected windfall, do not change future budget expectations, so they reduce the severity of any "crisis" that occurs during the next recession. Moreover, since reductions in marginal tax rates specifically encourage productive activity, the tax cutting option also tends to have the advantage of leading to higher economic growth.

Economists measure the amount of "fiscal stress" a state is experiencing during a recession by adding up the amount of tax increases and reductions in spending growth that are necessary to close their budget shortfalls. Using nearly 20 years of state data, our new research examines that fiscal stress along with the various factors that are often claimed to contribute to it. We found that states that increased spending faster experienced greater fiscal stress. States with larger rainy day funds experienced less fiscal stress. Interestingly, states with higher unemployment rates did not necessarily experience more fiscal stress, nor did states that received less federal aid. Previous research has found similar results.

So while politicians like to blame external factors like higher unemployment rates for fiscal stress, we found no evidence that they make much of a difference. Instead, the politicians' own actions - mainly, spending new revenue rather than saving or giving it back - had a great deal of influence.

These findings provide an important lesson about the benefits of using extra budgetary resources wisely. As state legislatures open new sessions in the coming weeks, politicians would be smart to return any unexpected revenue windfalls to the taxpayers by cutting taxes or making contributions to rainy day funds. That can go a long way toward ensuring a less severe crisis the next time there is a downturn.

State Fiscal Crises: States’ Abilities to Withstand Recessions

January 20, 2015

During recessions, states often face budget shortfalls. Some observers believe that these fiscal crises are outside policymakers’ control if there is a declining national economy or if there have been reductions in federal aid. Others believe that if state governments increase the size of their rainy day funds, implement large tax cuts, or avoid enacting large spending increases during nonrecession years, budget shortfalls may be limited.

In a new empirical study of state-level fiscal data for the Mercatus Center at George Mason University, economists David T. Mitchell and Dean Stansel examine these competing hypotheses and conclude that fiscal stress at the state level is positively correlated with spending growth and negatively correlated with the size of the state’s rainy day fund. This study shows that policymakers have greater control over the fate of their states’ finances than they may believe. Spending restraint, tax cuts, and increasing the size of rainy day funds are sound strategies for minimizing future fiscal stress.

SPENDING AND SAVING IMPACTS FISCAL HEALTH

Policymakers face three basic (nonexclusive) options when there is extra revenue during nonrecession years:

  • Use the revenue to increase spending by expanding existing programs or initiating new ones.
  • Return the revenue to the taxpayers through tax cuts.
  • Deposit the excess revenue in a rainy day fund.

DATA AND KEY FINDINGS

The study estimates fiscal stress as a function of the growth in real per capita state spending, the size of the state rainy day fund (also in real per capita terms), unemployment, union membership, Medicaid spending growth, gross state product, and federal grants.

Examining state-level data for these variables using different econometric methods, the study shows that state fiscal stress is associated with spending growth and the size of rainy day funds, but not with the unemployment rate or federal aid.

  • Spending growth. State fiscal stress is positively associated with spending growth. The more a state spends, the more likely it is to incur fiscal stress during a recession.
  • Rainy day funds. State fiscal stress is negatively associated with the size of rainy day funds. The less a state saves for future fiscal crises, the more difficult the crises are likely to be.
  • Unemployment and federal aid. State fiscal stress is not significantly associated with either the unemployment rate or federal aid.

CONCLUSION

History shows that when times are good and revenue is increasing, states that use those windfalls to increase spending tend to face more budget problems during the next recession. Policymakers should resist the temptation to spend that excess revenue in order to help minimize the fiscal stress the state will face in the next recession. Just like families, governments need to avoid squandering resources and instead save for a rainy day.

Dean Stansel Discusses Eminent Domain on the Schilling Show

Dean Stansel Discusses Eminent Domain on the Schilling Show

Calendar Date: 
Oct 20, 2014
MP3: 
https://www.mercatus.org/sites/default/files/Dean-Stansel-Discusses-Eminent-Domain-on-Rob-Schilling-Show.mp3
External People: 
Podcast Types: 
Publish to Announcements page?: 
Image: 
Publish to The Bridge?: 

Does Eminent Domain Even Raise Revenue?

Friday, October 17, 2014
Authors: 
Carrie Kerekes

Proponents of eminent domain for private development -- i.e., of forcibly taking private property and giving it to another private party -- claim it will generate more revenue for state and local governments. The Supreme Court even based its landmark 2005 case Kelo v. City of New London on this assertion, holding that the alleged economic benefits for communities legally justify these takings as "public use."

The claim that eminent domain leads to higher revenues has largely gone unchallenged. We recently examined the available data, and our study finds virtually no evidence that eminent-domain activity for private development is associated with higher government revenue. To the contrary, we find some evidence that eminent domain is associated with lower growth of government revenue in the future.

In other words, governments' primary justification for taking property from private owners like Susette Kelo and transferring ownership to big companies like Pfizer is based on faulty assumptions. In fact, the redevelopment plan for which Ms. Kelo's house (and those of her neighbors in New London, Conn.) was taken never happened. The land was actually used as a temporary dump for storm debris in the aftermath of Hurricane Irene in 2011.

Confiscating someone's home or business and using the land as a dump is an egregious property-rights violation. Even if eminent domain for private development did achieve the objective of producing higher revenues for state and local governments, it would be an abhorrent activity. However, it also has serious negative implications for the future economic prosperity of the community.

Private-property rights are the foundation of a successful market economy. Any encroachments on private-property rights -- like eminent domain -- hamper economic growth and result in lower standards of living than we would otherwise enjoy.

For example, in countries like Cuba and North Korea, where private-property rights are very insecure, entrepreneurs are less willing to invest in the new machines and equipment they need to expand their businesses. Individuals in these countries have a reasonable expectation that any machinery or equipment, or overall business or land itself, may at some point be taken from them by government predation or by individual criminals.

Fortunately, property rights in the United States are relatively secure -- but things are heading in the wrong direction. The Fraser Institute publishes an annual index that ranks countries according to their economic freedom using data in five areas: size of government, legal system and property rights, sound money, freedom to trade internationally, and regulation. In the recently released 2014 Economic Freedom of the World report, the United States fell to 12th, down from the second spot in 2000 and the seventh spot in 2008. In the area of "legal system and property rights," the United States fell all the way to 36th.

Our study's findings confirm that policymakers and the public are right to be skeptical of attempts to justify the seizure of private property with the promise of future financial windfalls. In reality, these encroachments may hamper economic growth and lead to lower standards of living for more than just those who have lost their homes or businesses.

Takings and Tax Revenue: Fiscal Impacts of Eminent Domain

October 13, 2014

The United States Supreme Court decision in Kelo v. City of New London in 2005 sparked outrage around the country. In this decision, the US Supreme Court allowed the use of eminent domain to transfer property in New London, Connecticut, for private benefit, not for public use as set forth in the takings clause of the US Constitution. This case focused the attention of citizens, politicians, and academics on property takings. The general public expressed concern that homes, churches, or other properties can now be expropriated on the grounds that redevelopment could decrease unemployment and increase government tax revenue.

Many regarded the Kelo decision as an abuse of government power and a threat to liberty (Benson 2010; C. Cohen 2006; Lopez, Kerekes, and Johnson 2007). Politicians scurried to reassure troubled voters by examining, and in some cases modifying, state constitutional constraints on the use of eminent domain. Academics published articles that chronicled eminent domain abuse (Berliner 2006), scrutinized state takings for private benefit (Kerekes 2011; Lanza et al. 2013), and analyzed state reforms in the wake of the Kelo decision (Lopez, Jewel, and Campbell 2009; Lopez and Totah 2007; Sandefur 2006a; Somin 2007, 2009).

This paper is an extension of a study that emerged from this literature. Turnbull and Salvino (2009) were the first to empirically examine the relationship between eminent domain for private benefit and the size of state and local public sectors. The purpose of their paper was to test the Leviathan hypothesis proposed by Brennan and Buchanan (1980). This argument states that broader eminent domain powers (i.e., allowing governments to use eminent domain for redevelopment in order to increase employment or to increase the tax base) provide state and local governments additional means through which to increase their overall size. In effect, the 2005 decision in Kelo weakened a constitutional constraint on government size. As a result, state and local public sectors may increase in size.

We utilize the Turnbull and Salvino (2009) model and extend it to investigate the effects of eminent domain from a different angle. The Kelo ruling allows the compulsory transfer of property between individuals based on the claim that eminent domain used for redevelopment results in increases in the tax base that, in turn, convey public benefits. Our question is whether such applications of eminent domain will actually increase revenue. As we discuss below, if more expansive eminent domain powers undermine the security of private property rights, eminent domain for private benefit may cause the tax base to shrink as a result of decreases in private investment. In addition, redevelopment takings may also affect government revenues through potential increases in rent-seeking behavior. Given the significant potential negative consequences that arise when government undermines property rights, it is worth investigating whether eminent domain for development purposes actually generates the additional government revenue it is purported to create.

Continue reading