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«by Andrew F. Haughwout Federal Reserve Bank of New York Robert P. Inman University of Pennsylvania and National Bureau of Economic Research Abstract ...»

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How Should Suburbs Help Their Central Cities?

Growth and Welfare Enhancing Intra-metropolitan Fiscal Distributions

by

Andrew F. Haughwout

Federal Reserve Bank of New York

Robert P. Inman

University of Pennsylvania and

National Bureau of Economic Research

Abstract

Cities are the location of the great majority of economic activity in the United States, and

produce a disproportionate share of output. It is thus critical for the economy’s long term

growth that cities operate efficiently. In this paper, we review the basic determinants of output growth, with a focus on productivity growth in cities. We then explore the effects of a particular distortion in politically fragmented metropolitan areas. After documenting the interdependence of the suburbs and central city of a metropolitan area, we develop a model that embodies many of the empirically verified aspects, including agglomeration economies and public goods. After calibrating the model to outcomes for Philadelphia, we use it to simulate various policy changes. We conclude that, under the model, some kinds of fiscal redistributions can provide benefits in both cities and suburbs.

The views presented in this paper are those of the authors, and do not necessarily reflect those of the Federal Reserve Bank of New York, the Federal Reserve System or the National Bureau of Economic Research.

Introduction Metropolitan areas host the bulk of economic activity in the United States. In 2007, 83% of population resided in urban areas, and the workers in these metropolitan areas produced an even higher share – 89% – of the nation’s total output. It is thus crucial to the well-being of the nation’s citizens and to the growth of the economy that our urban economies function efficiently. In this paper, we review the sources of the concentration of economic activity in cities, and the challenges they present for economic policy.

We begin with a short overview of the determinants of growth, and then describe the advantages of cities that make economic activity in modern economies so overwhelmingly urban. Many of the productivity advantages of cities take the form of “externalities”: they are benefits (or costs) that individual actors confer on each other, particularly those who are located nearby. Because decentralized market mechanisms are limited in their ability to produce efficient allocations in the presence of externalities, there is a potential role for public policies that internalize these externalities. In the second part of the paper, we present a set of empirical results and policy simulations that illuminate the potential benefits of correcting inter-jurisdictional fiscal externalities in large metropolitan areas. The final section concludes, and points to directions for future research.

II. The determinants of economic growth Economic growth at any level of aggregation, be it a firm, household, city or nation, is determined by a combination of growth in resources devoted to production and the

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of production are land, labor and capital. A common measure of productivity is the output that can be produced by an hour of labor, or labor productivity. Labor productivity is the fundamental determinant of the wealth of society at any point in time, and changes in labor productivity, along with changes in labor input, are the fundamental drivers of economic growth. At every point in time, the amount of labor input times the output produced by a unit of labor is the aggregate output that is available for use by members of the society.

Since worker productivity is so crucial to the level and growth of economies, whether they be households, regions or nations, it is important to understand the sources of growth in productivity. A principle determinant of the output that can be produced by an hour of labor is the skills that the worker brings to the task they are performing. These skills can be either general, like the ability to use math, or job-specific, like the ability to use a lathe to fashion a particular piece of woodwork. A first source of growth, then, is the development of these skills over time. Economies that are more effective at increasing the skills in their work force – sometimes referred to as human capital - will, other things equal, grow faster than those that are less effective.

An important second dimension here is the matching of worker skills to tasks.

Imagine two economies with the same numbers of workers with math and woodworking skills. While the overall levels of human capital are the same, the economy which more effectively matches workers to the tasks that make most effective use of their skills will be more productive and produce more output for all to enjoy.

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depends on the physical capital that workers can use in producing output. A worker with tools can usually produce more than a worker without, and the more and better the tools, the more the output that can be produced.

Another contributor to labor productivity growth is more amorphous – so-called total factor productivity. This is the amount of output that can be produced from a given set of (measured) inputs. One firm may be more productive than another with what appears to be identical inputs because of a wide variety of factors, ranging from the organization of activities within the firms (Black and Lynch 2001) to the specificity with which intermediate inputs are targeted to firm needs (Duranton and Puga 2001).





Importantly for the current study, productivity and output can also be influenced by the characteristics of the public sector. Public sector activities, from the state of repair of public infrastructure to the distortions introduced by taxation, can spill over into every kind of business activity. Many authors, including Helms (1985), Morrison and Schwartz (1996) and Haughwout (2002), present evidence that public spending patterns are a significant determinant of private output and productivity, while Haughwout (2004) and Haughwout, Inman, Craig and Luce (2004) indicate that the efficiency of tax systems has important effects on output produced.

Understanding total factor productivity is crucial for the development of public policies aimed at fostering long run economic growth. Since national stocks of inputs – human and physical capital – evolve relatively slowly and predictably, squeezing more output from these stocks is a major target for public policy. And here, cities play an

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can have significant effects on productivity, and it is to this evidence that we now turn.

Cities and Productivity Since several excellent surveys exist on the way that cities facilitate productivity, we will simply summarize some of the main findings here (see Quigley 1998, Duranton and Puga 2004, and Rosenthal and Strange 2004 for summaries of the theoretical and empirical literature).

Models of the effects of density – the defining feature of cities – on productivity typically divide the effects into two categories. “Localization economies” refer to the benefits that accrue to firms in a particular industry that is concentrated in a given location. A financial services firm, for example, may benefit from the concentration of information and expertise available in a city that hosts many such firms. These benefits may arise from a more flexible labor market that yields better matching of workers to tasks, or from intermediate input producers – perhaps law firms – that operate at larger and more efficient scale. Localization economies have been found to be important features of urban economies, and their benefits appear to operate over very small geographic scales (Rosenthal and Strange 2001).

“Urbanization economies” is the term used to refer to the benefits that accrue to a firm from the overall scale of economic activity in a given geographic area – i.e., benefits that arise from density itself. These benefits might accrue from more efficient scale of operation for public infrastructure systems like transportation, sewer and water systems, or from a larger labor market that allows generic labor to be more readily found. Like

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important determinants of productivity. Hall and Ciccone (1996) estimate that, other things equal, doubling county density leads to a 6% increase in worker productivity.

Below, we embed urbanization economies of two types – a general scale economy and one that operates through public infrastructure – into a detailed fiscal model of metropolitan areas. The model illustrates how these externalities interact with the tax system, and how the interdependence of cities and suburbs in metro areas presents additional challenges and opportunities for increasing productivity in the US economy.

III. City-Suburban interdependence It is by now widely accepted that city and suburban economies move together over time, and that the connection is not simply the result of the fact that shocks to the two parts of metropolitan area economy tend to be correlated. Instead, it appears that negative shocks that are specific to the city also result in reduced well-being in the suburbs (Haughwout and Inman 2002).

What, if anything, this fact implies for metropolitan fiscal institutions and policies is less clear, in part because the structural sources of the correlations remain somewhat obscure. In this paper, we study a structural metropolitan fiscal model that is capable of replicating the correlations between city and suburban outcomes that have been observed by many authors (Voith 1993, 1998; Brooks and Summers no date, Haughwout and Inman 2002). Two important features of the model generate city-suburban interdependence: non-reproducible agglomeration benefits in the city of the sort described above and in Rosenthal and Strange (2004), and suburban production that relies

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jurisdictional externality. The question we address here is whether, and to what extent, these features support suburb to city fiscal transfers. That is, we ask whether such transfers offer the potential to enhance the well being of both city and suburban residents.

The notion that the central city has something of importance to suburbanites is hardly new; see, for example, Jackson's (1985, chapter 8) review of the arguments in favor of municipal consolidation in the 19th century. As municipal annexation slowed in the 20th century, some scholars began to argue that the well-known benefits of metropolitan decentralization promoted by Tiebout (1956) obscured some important arguments in favor of metropolitan governance or other forms of financial assistance from suburbs to cities. Among these arguments were three that became particularly relevant.

First, some authors argued that suburbanites "exploited" the city by benefiting from city-produced public goods without contributing to their construction and operation (Neenan 1970). Theoretically, this kind of direct public good benefit spillover could lead to underprovision of public goods in the city, as city residents equate their own marginal benefit with marginal cost, ignoring the positive externality. Regionalizing public finance could generate contributions for city public goods valued by residents of the suburbs. Yet the solution to this problem is not, in general, intergovernmental transfers: where feasible, user fees and average cost pricing, charged without regard to residential location, is the most efficient means of allocating such public goods.

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metropolitan areas is based on suburban altruism. If suburbanites value the welfare of the geographically proximate poor, then they might wish higher subsidies to these families than the city provides (Pauly 1973). Yet the primary responsibility for determining the level of transfers to the poor generally resides at the state level and the fact that in many states the median voter is a suburbanite. It is not clear that allowing suburbanites directly to choose (and help finance) the level of transfer income received by city poverty households would substantially change the outcomes we currently observe.

Recent research has returned to the theme, albeit from a perspective different from those which dominated the academic literature in the 1970s. Whereas the previous literature had emphasized equity and altruism as motivations for suburbanites to either consolidate with, or at a minimum make financial contributions to, their central cities, the recent literature has explored whether doing so may is in suburbanites' own self interest.

The foundation of this argument is a series of recent papers documenting positive correlations between city and suburban economic outcomes. 1 Figure 1 and Table 1 provide some evidence of this relationship which, on its face, suggests that suburbanites may care about what happens in their central city because it has important implications for what happens to them.

While it difficult to uncover a structural relationship by examining simple correlations among outcome variables, the patterns in the table and figure provide some insight into the structure of the relationship between cities and their surrounding suburbs.

In particular some features of the data rule out, or at least severely undermine, certain 1 See especially Voith (1993, 1998) and Brooks and Summers (no date) A more complete survey is available in Haughwout and Inman (2002).

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correlated for city-suburb pairs. Were the appeal of strongly growing central cities based on consumption opportunities or aid packages to the poor valued by suburban households, standard compensating variations logic (Rosen 1979) would imply that incomes would fall in response to improving central city economic health. Instead the raw data suggest that that firm productivity is playing an important role in connecting cities and their suburbs (Haughwout 2002). If the connection between city and suburbs is on the production side, then we would anticipate that positive productivity shocks to the city would raise incomes in both city and suburbs.



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