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Introduction to Public Economics and the State and Local Public Sector MGMT 932 Local Introduction to Public Economics and the State and Local Public Sector MGMT 932 Local Public Economics and Business Strategy Session 1: March 27, 2006 Professor Therese Mc. Guire These slides are for exclusive use in MGMT 932 at the Kellogg School of Management, Northwestern University. No other use is allowed without permission of Professor Therese Mc. Guire.

Road Map q Administrivia v Lectures and class discussions. v Your obligations and due Road Map q Administrivia v Lectures and class discussions. v Your obligations and due dates. v Etiquette. q Warning (or good news): This class is based in microeconomics. q Why this course? v Why is local public economics an important field of study? v Why is it important for you to study local public economics? v How does this course differ from SEEK 470? q An empirical study of the effect of local school quality on property values. q Class discussion of two readings. 2

Possible Organizations to Represent in Testifying on Reform of the Illinois Property Tax q Possible Organizations to Represent in Testifying on Reform of the Illinois Property Tax q The Taxpayers’ Federation of Illinois q ED-RED (Education, Research and Development) v http: //www. ed-red. org/ q q q q q The Governor’s Office The Metropolitan Planning Council Building Owners and Managers Association (BOMA) of Chicago The Civic Committee of the Commercial Club of Chicago Du. Page Mayors and Managers Conference Illinois Association of Realtors The Civic Federation Northern Illinois Commercial Association of Realtors Illinois Municipal League SCOPE (South Cooperative Organization for Public Education) v http: //www. scope-schools. org/ 3

One-page Outline of Expert-testimony Group Projects Reform of the Illinois Property Tax q Due One-page Outline of Expert-testimony Group Projects Reform of the Illinois Property Tax q Due Thursday, April 13. q Required components. v v Names of members of the group (3 -5 members). The organization that the group will represent. The primary issues that the group/organization will address in its testimony. The likely sources of information the group/organization will draw upon in preparing its expert witness testimony. q Other possible (non-required) components v The organization’s most important criteria for evaluating the property tax. v One question (at most two) requesting feedback from your professor. 4

Why is state and local public economics an important field of study? q The Why is state and local public economics an important field of study? q The local public sector plays a large role in our everyday lives. v Our streets are cleaned, our neighborhoods are protected, and our children are taught by local public servants. v We pay significant fees and taxes to various local governments. q A large share of the economy (GDP) is attributable to government activity. v Federal expenditures from own sources as a share of GDP in the US? • 10% 20% 30% 40% -- What is your guess? v State and local expenditures from own sources as a share of GDP in the US? • 10% 20% 30% 40% -- What is your guess? q Markets do not always work well and government intervention may help. v Pollution of rivers and lakes is arguably an outcome of unfettered markets. q Government intervention can make things worse. v Rent control as a response to unfettered housing markets. q Selfishly, state and local government actions can have an impact on your profits. v Creation of Tax Increment Finance districts. q More neighborly (but still selfishly), state and local government actions can improve social welfare. v The creation and maintenance of park lands. 5

Why is it important for you to study state and local public economics? q Why is it important for you to study state and local public economics? q Business leaders are often called upon to advise state and local governments on the important public policy questions of the day. v Blue-ribbon commissions. • Gubernatorial commissions on education finance reform and property tax reform in Illinois in recent years. v Advice/testimony through business member organizations. q Your future place of employment will be appreciably affected, both positively and negatively, by public policies and the actions of public officials. v Changes to local zoning laws. v Decisions to place limits on the growth rate of public expenditures. • TABOR in Colorado. q To be an informed citizen/voter/resident, you need to understand the consequences of different government actions and policies. v California’s Proposition 13. v Milwaukee’s school voucher program. 6

Do Better Schools Matter? Parental Evaluation of Elementary Education Sandra E. Black The Quarterly Do Better Schools Matter? Parental Evaluation of Elementary Education Sandra E. Black The Quarterly Journal of Economics 1999 q A related question -- Does spending on schools matter? -- is one of the most important and difficult questions in public finance. v Why is the question important? q Typical approach: regress some measure of student achievement (say, test scores or labor market earnings) on some measure of school resources (say, spending per pupil or pupil/teacher ratios). v Hundreds of studies. v Wide range of results. v Problems: omitted variables and endogeneity. q Black (and others) take a different approach. v If we cannot reliably estimate the education “production function”, let’s approach the answer by asking, what value do parents place on school quality? 7

Do Better Schools Matter? Parental Evaluation of Elementary Education (continued) Sandra E. Black The Do Better Schools Matter? Parental Evaluation of Elementary Education (continued) Sandra E. Black The Quarterly Journal of Economics 1999 q The empirical strategy: determine the value of better schools by estimating how much more parents are willing to pay for housing located in areas with better schools. v Regress house prices on measures of school quality (say, average test scores). v Problem: omitted variables. • Unobserved aspects of school districts and neighborhoods. q Black’s alternative strategy: estimate how much more parents are willing to pay for housing located on either side of school attendance boundaries within the same school district. v How does this solve the problem? q Black’s result: v A 5 percent increase in test scores (approximately one standard deviation) results in a 2. 1 percent increase in housing prices (an increase of almost $4, 000 at the mean house price of $188, 000) v Black answers the question she poses in the affirmative. q Implications of this result for business leaders? For future real estate developers? For future school reformers? 8

Education 101: Schools are getting better, but not fast enough The Economist, 2004 q Education 101: Schools are getting better, but not fast enough The Economist, 2004 q California is one of the richest states in the country, yet its schools rank poorly on various measures of school quality and success. Why? v Finances. • Proposition 13 in 1978 • Proposition 98 in 1988 v Demographics. • Influx of immigrants. • Outflow of middle- and upper-income whites. v Intransigent teachers’ union. • No voucher programs. • Difficulty of rewarding (punishing) good (poor) teachers. q Lessons for other states. v How like California are other states? v How much of the problem is amenable to public solutions? 9

How to Have a Fiscal Crisis: Lessons from Philadelphia Robert P. Inman American Economic How to Have a Fiscal Crisis: Lessons from Philadelphia Robert P. Inman American Economic Review 1995 q In the early 1990 s, the city of Philadelphia experienced a fiscal crisis. v Maximum tax revenues < Mandated spending – Aid – Other revenues (fees) v After several years of running deficits, the city found that the municipal-bond market would no longer loan it money. q What to do? Two options: v Increase revenues. v Decrease spending. v Difficult to do in Philadelphia at the time because: • Like other declining cities, inflow of poor families and outflow of middle income families. • Like much of the rest of the country, economic downturn. q Focus on revenues. v v What does Inman mean by “maximum” tax revenues? How far can a city push its tax rates before the tax bases move out? t = tax rate B(t) = tax base t. B(t) = tax revenues How responsive is the city’s tax base to tax increases? In economist’s words, what is the elasticity of B(t) with respect to t? 10

Side bar – Price elasticity of demand q Definition v Measure of the responsiveness Side bar – Price elasticity of demand q Definition v Measure of the responsiveness of quantity demanded to a change in own price. v Percentage change in quantity demanded for given percentage change in price. v Calculated between two points on a demand curve: percentage change in quantity demanded divided by percentage change in price, where use average of quantities and prices for calculating percent changes. q Price elasticities of demand will always be negative (why? ), so take absolute value. v Inelastic demand: Elasticity less than one. v Elastic demand: Elasticity greater than one. v Unitary elasticity: Equal to one. q Because demand curves are downward sloping, total revenues (P x Q) can increase or decrease as price increases. v Relationship between total revenues and price increase will depend on elasticity of demand. v Important when determining the revenue consequences of a tax increase. 11

How to Have a Fiscal Crisis: Lessons from Philadelphia (continued) Robert P. Inman American How to Have a Fiscal Crisis: Lessons from Philadelphia (continued) Robert P. Inman American Economic Review 1995 q Revenue hills (Laffer curves). v Top of the hill is defined by the tax rate that maximizes revenues. v If to the left of the top of the hill, an increase in the tax rate increases revenues. • What is the elasticity of the base with respect to the rate? v If to the right of the top of the hill, an increase in the tax rate decreases revenues. • What is the elasticity of the base with respect to the rate? q Inman argues that economic, demographic and political factors placed Philadelphia at or very near the top of its revenue hills for each of its three major taxes. v v Property tax Business income tax Wage tax Bottom line: Philadelphia could not tax itself out of its fiscal crisis. q What types of cities are likely to have “unfavorable” revenue hills? 12

Preview of next class meeting q Review/introduction of basic concepts of microeconomics. v Indifference Preview of next class meeting q Review/introduction of basic concepts of microeconomics. v Indifference curve analysis. v Consumer and producer surplus. • Deadweight loss. v First theorem of welfare economics. q Market failures. v Public goods and positive externalities. • “free rider” problem. v Negative externalities. q Government failures. q Examples and discussion questions. 13