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Urban Fiscal Policy

Holger Sieg

University of Pennsylvania

Department of Economics

Some Urban Facts

• 250 million Americans crowd together in 3 percent of the country that can be considered “urban.”

• The 20 largest U.S. metropolitan areas account for more than 50 percent of total GNP.

• In 2011 more than 50 percent of the world population were living in cities and urban areas.

• Economic prosperity and growth is largely a function of urbanization.

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Types of Cities

• Traditional commercial cities with distinct city centers and central business districts such as New York, Philadelphia, Chicago, San Francisco, Seattle, Washington, Boston, etc.

• Traditional industrial cities that are build around manufacturing industries such Detroit, Pittsburgh, Cleveland, Buffalo, St. Louis, Rochester, etc.

• Modern “edge cities” that do not have a traditional city center such as Silicon Valley or Los Angeles.

• Nevertheless these modern cities play a very prominent role in the U.S. economy.

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Manhattan• The five zip codes that occupy the mile between 41st and 59th

Streets in Manhattan employ 600,000 workers more than new Hampshire or Maine.

• They earn on average more than $100,000 each giving that piece of real estate a larger annual payroll than Oregon or Nevada.

• Between 2009 and 2011 the American economy largely stagnated. Wages in Manhattan increased by 11.9 percent.

• In 2010, the average weekly wage in Manhattan was $2404 which is 170 percent more than the U.S. average.

• An average 1200 square foot apartment in Manhattan has a price tag of $1,000,000.

• Construction costs of a new 1200 square foot apartment are approximately $500,000. Hence, existing apartments sell with a mark-up of 100 percent.

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Silicon Valley

• It is a remarkable fact that the most famous modern example of an industrial agglomeration is in an industry that has the best access to new technologies.

• If an industry should have been able to disperse with access to modern information and communication technologies, it should have been computing.

• Yet computers and software development are exactly industries that are spatially concentrated.

• Silicon Valley is not city in the traditional sense with a well-defined downtown or a mono-centric central business district. Instead it resembles more an “edge city.”

• Functional definition of a city: industry, governance, commerce, safety, culture, social networks, religion.

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Detroit• Detroit is a prime example of an industrial city that was built around

on key industry.• In 1950 Detroit had 1.85 million people and was the 5th largest city in

the US. In 2008, it had 777 thousand people, less than half its former size.

• Detroit’s median income is $33,000 about half of the US average.• In 2009 the unemployment rate was 25 percent which was 9

percentage points higher than any city and 2.5 times the national average.

• The murder rate in Detroit was 10 times higher than NYC.• The average house in Detroit costs approximately $82,000 which is

well below construction costs. 86 percent of all houses in Detroit were built before 1960.

• Six of the 16 largest cities in 1950 lost more than half of their population: Buffalo, Cleveland, Pittsburgh, New Orleans and St. Louis.

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The Challenge

• Why do we choose to live in densely populated metropolitan areas?

• If cities are the engines of economy growth, how do we create viable and successful cities?

• How we deal with the challenges that arise to due density, congestion and proximity?

• How we deal with urban distress such as poverty, racial segregation, underperforming urban schools and crime?

• How do we manage urban decline?• How do we deal with environmental challenges?• What are the implications of urbanizations and economic

growth in developing countries?7

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Decentralization in the U.S.

• Most modern economies including the U.S. have adopted a decentralized organization of government.

• In the U.S. there are primarily three forms of government: the federal government, the 50 state governments, and approximately 90,000 local governments such as counties, cities, municipalities, townships, school districts.

• We will see in this course that cities and municipalities are an important component of any well run government.

• Fiscal federalism is concerned with understanding which functions and instruments are best placed in the sphere of decentralized levels of government.

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Decentralization in the U.S.

Fiscal Federalism

• Fiscal federalism is concerned with "understanding which functions and instruments are best centralized and which are best placed in the sphere of decentralized levels of government" (Oates, 1999).

• To understand city governments, we need to study of how competencies (expenditure side) and fiscal instruments (revenue side) are allocated across different, vertical layers of the administration.

• An important part of its subject matter is the system of transfer payments or grants by which a central government shares its revenues with lower levels of government.

• Federal governments use this power to enforce national rules and standards.

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The Cost of Uniformity

• Uniform provision of public goods and services will only meet the needs of the entire population when preferences are homogenous.

• When populations are not, any form of uniformity must be a compromise between competing levels of demand.

• As along as the costs of differentiation are small, there is a strong argument for policy decentralization.

• Consider for example the provision of local education. Some households value education a lot while others value it less.

• In a decentralized system households are mobile and can live in a community that provides a tax and expenditure policy that suits the preferences of the households.

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Accountability• Politicians may pursue a range of different objectives.• Some may be public-spirited while others are largely interested in

their own private gains.• A government is accountable if voters can determine whether it is

acting in their interests and sanction them appropriately, if they do not.

• Elections may only be crude instrument to punish inefficient politician.

• It might be desirable to organize competition among politician in order to control them. Competition among different decentralized governments can exercise as a disciplinary force and break the monopoly power of large central governments (Brennan & Buchanan, 1980)

• Voters vote against an incumbent if his performs is bad relative to others (yardstick competition).

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Federal Spending

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Federal Revenues

The Role of the Federal Government

• Up to the 1960’s, the federal government primarily provided national defense and provided a limited amount of “social insurance.”

• The provision of national defense at the federal level makes sense. It is inefficient for states or cities to provide their own armies.

• The provision of social insurance such as unemployment insurance and social security was primarily a response to the Great Depression. (Medicare was not created until 1965.)

• Social insurance programs largely redistribute resources from the younger, healthy, and working part of the population to the older, sick, unemployed or retired part of the population.

• Since the 1960’s the federal government has vastly expanded its size and taken on new roles, primarily in the provision of health care, housing, transportation, and education.

• It is less obvious what the economic rational is for these federal activities. 15

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State and Local Spending

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State and Local Revenues

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• The course will focus on the important role that cities and local governments play in the modern economy.

• We will view cities as economic organizations, not unlike publically held corporations.

• There are “shareholders” called owners (or renters) of residential land and property.

• Shareholders’ voting rights are not in proportion to the value of the shares owned but rather in terms of one-man-one-vote.

• The “board of directors” is elected by the shareholder and is called the city council. The chairman of the board is the major who is either elected by the council or elected directly.

• The major appoints a management team for the cities various product lines: street cleaning and maintenance, education, recreation, libraries, etc.

Cities and Local Governments

Production of City Services• Each service has a production relationship requiring labor, capital,

and materials.• The city corporation finances itself with equity (taxes) or debt

(municipal bonds), and pays its labor negotiated (union) or competitive (non-union) wages.

• Labor may own a share of the city and thus may exercise significant control at the ballot box if labor unions dominate local elections.

• The city corporation sells services to its customers who buy these services with a “yearly contract” (taxes) or perhaps with a per unit fee (user chargers).

• The customers include city residents as well as non-shareholders such as businesses as well as residents of nearby suburbs and cities. These individuals commute to the city for work or leisure.

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The Purpose of Cities

• The primary economic purpose of city-corporations is to protect and enhance a region’s competitive advantage through the provision of important services for residents and businesses.

• Public goods include the provision of infrastructure such as roads, ports, airports, and communication systems.

• Important services are those with significant consumer interdependencies such as safety, environmental protection and school services.

• Each city corporation is in direct competition with other city corporations.

• If a city does not provide its services efficiently, then consumers will leave the city and go elsewhere.

• This leads to a fall in land prices (=share values) and if revenues are not sufficient to cover costs to financial crises.

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International Competition

• Countries, which design their system of city and corporate governance well, will encourage efficient cities which attract residents and businesses.

• If the system of city governance is poorly designed in a country, then cities cannot compete. Economic growth and welfare declines.

• For example, an inefficient system of city governance places an undue burden on cities to deal with poverty.

• Well run cities will require good internal management, favorable rules of city governance, and informed and diligent shareholders.

• These cities have honest (at least not corrupt) and well-trained leaders, appropriate federal and state policies that support the cities, and informed voters that participate in local elections.

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What’s in it for you?

• As investor or shareholders (owner of real estate), lender (banks and bondholders), worker (teacher), or customer (resident or business), you have a vested interest in ensuring that your city is well-run.

• If you don’t, you run the risk of losing your job (if your company fails), losing most of your wealth and being forced into personal bankruptcy (if housing prices collapse), losing your life (if crime gets out of hand), or sacrificing the future of your children (if they attend bad schools).

• This course will provide you a better understanding of how to finance and manage a city-corporation to maximize the consumption and investment benefits of its citizens.

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