Talking In Circles About Business Climate

I’ve always figured that if we are going to talk about the “business climate” - and we seem to be doing a lot of that these days – we ought to know what the term means.

.We can all agree that the business climate is a basket of conditions that affect business performance, and that the more favorable the climate, the better business performance should be. But when it comes to choosing which conditions really make a difference, we’re all over the map: some folks think it’s all about taxes, others point to the quality of the labor force, still others to transportation costs, or the quality of public services, or lifestyle amenities or …well, the list goes on and on. And all too often, how business climate gets assessed has more to do with ideology than jobs, businesses and the economy.

I’ve been mulling this over recently because the Montana Policy Institute, a Bozeman based outfit that calls itself a “free market think tank,” just released a paper listing “business friendliness” scores for 25 Montana cities. The release of the paper was reported and apparently taken seriously by an admiring state press, and that sent me to my computer to find out whether the scores really mean something, or just sound like they do. Because there’s a pretty obvious way we can test the usefulness of any business climate rating, and that’s to determine if it’s actually correlated with business performance.  If it is, great. But if it isn’t, it’s not really telling us what we want to know.

Fortunately, I didn’t have to grub around for data to measure business performance, because the good people at MPI had already calculated an “economic vitality” score – based on median per capita income  and job and population growth – for all 25 cities in their study. So it was just a question of determining whether MPI’s business friendliness and economic vitality scores are correlated with each other. And it turns out they are. Here’s the picture:

Each point in the figure represents a city, and the upward drift in the points as you move to right means that more business friendly cities enjoy greater economic vitality. If you go to the trouble of computing the correlation coefficient (.42) you will find that the relationship between the scores is statistically significant. That means, in essence, that the relationship you see in the scatter diagram is real, and not just a fluke. So MPI has given us a business climate measure that really is related to business performance. Pretty impressive, no?

Well no, not really.

The problem is that MPI bases almost half of its business friendliness calculation on the economic vitality score itself. And that’s okay, as long as you like reasoning in circles. What produces good business performance? A good business climate. And what produces a good business climate? According to MPI, good business performance. So good business performance produces good business performance! True, but not very helpful.

None of this prevents MPI from concluding that cities can become more “business friendly” by “maintaining low tax rates on businesses.” But that has to be true, because MPI uses business taxes, along with business performance, in calculating its business friendliness score. In that case, cities that cut business taxes – which is what MPI, the free market think tank, devoutly hopes they will do - will inevitably raise their friendliness scores. That’s just arithmetic. The real question, however, is whether cutting taxes will improve business performance. Take a look at this next scatter diagram. It plots MPI’s economic vitality score against its tax burden score. Again, each point represents one city.

If you can’t see any relationship between tax levels and business performance in this figure, you’re not the only one. The correlation coefficient between these two variables is -.17, way too low to be statistically significant. In other words, the data just don’t allow us to conclude that lower taxes really lead to better business performance.

What has happened here is that MPI had dreamed up a measure of business climate that as a matter of simple arithmetic improves as business tax rates fall. Then they design their business climate measure so that it is spuriously correlated with business performance. And putting the two together they reach the false conclusion that reducing business taxes will improve business performance.

Somehow, the “think” part of “free market think tank” seems to have gone missing.

Tax Plan Politics

You may have been pulling your hair out during the presidential debate the other night for any number of reasons, but one of them was surely that the President and Mitt Romney were making conflicting factual claims about taxes that simply couldn't all be true.

Case in point: President Obama said, over and over again, that Romney planned to cut tax revenues by $5 trillion, thereby swelling the deficit, while Romney said, over and over again, that his plan wouldn’t reduce revenues or grow the deficit at all. Those two claims can’t both be right, can they?

It turns out that it all depends on what you mean by the word “plan.” What Romney is definitely planning is to reduce tax rates by 20% across the board. Over 10 years, that alone would reduce Federal revenue by about $5 trillion, and that’s where the President gets his number. But Romney also says he will get the revenue back from “closing loopholes,”  that is, by eliminating some of the many deductions, exemptions and credits with which the tax system is riddled.

The trouble is that he hasn’t been at all clear about which loopholes he would close, and understandably so.  After all, when you close a loophole, you raise somebody’s taxes, and that’s not something we talk about in polite society.  And a lot of number crunchers have concluded that closing enough of them to make the whole package “revenue neutral” would end up raising taxes for middle income families, which Romney has promised not to do. Romney is also apparently vaguely planning that the problem will be partly solved by that old Republican favorite, supply side economics: lower tax rates = happier “job creators” = more jobs = higher tax revenue.

So while the Romney plan is pretty clear about cutting rates, it’s pretty half-baked when it comes to assuring revenue neutrality. Whether it’s fair or not to call that a plan to cut revenue by $5 trillion – which is what the President  calls it – you can decide.*

Whatever it is, if Romney could make his tax plan work it would have, on the surface at any rate, a certain appeal.  It’s the classic prescription for tax reform: if we shut loopholes, broaden the tax base and reduce tax rates, we can simplify the tax system without a loss of revenue. 

But before we do away with any particular credit or deduction or exemption, it’s important to bear in mind that there might be a good reason it was created in the first place.  For example, the Federal earned income tax credit was enacted to provide tax relief to low income working families. And the mortgage interest deduction is intended to encourage home ownership.  Are those really things we want to give up?

Consider the attempt in the 2011 legislature to eliminate Montana’s energy efficiency tax credits. Montanans who improve the energy efficiency of their homes and businesses can claim a 25% tax credit for the cost of those improvements.  Individuals can claim up to $500 and a married couple filing jointly can claim up to $1,000. Homeowners can install anything from energy-saving appliances and programmable thermostats to energy-efficient windows, and the credit helps them afford these simple improvements that reduce energy use and lower their monthly energy bills.  The community benefits as well, with greater energy independence, lower environmental costs from energy production, and the robust growth of businesses that provide energy conservation products and services. 

The Montana legislature created these tax credits in 1983.  And although thousands of Montanans since then have used the credit to capture energy savings in their homes and businesses, the Legislature in 2011 passed a bill (SB 253), carried by Senator Bob Lake (who’s currently running for the Public Service Commission) that repealed the credit entirely.  Lake’s bill, which initially called for the repeal of a whole slew of other credits, was intended to generate revenue to offset a Republican plan to reduce the business equipment tax

Fortunately, Governor Schweitzer vetoed SB253, which he called “largest tax increase proposed by the 2011 Legislature.” And he was right. In 2010, 29,000 Montana households claimed a total of $10.4 million  in energy conservation credits on their state income taxes. Eliminating these credits would have made low and middle income families pay more (both in higher income taxes and higher energy bills) in order to provide business equipment tax relief.  Almost 70% of that relief would have gone to about 450 large companies with more that $1 million worth of equipment. And the progress Montanans have made in conserving energy would have suffered a sharp setback.

Energy efficiency is the least expensive, cleanest, and most reliable energy resource for Montana utilities— and the same goes for Montana families.  Thankfully a misguided tax policy proposal failed, and Montanans still have the opportunity to take advantage of tax credits that help pay for energy efficiency improvements in their homes and businesses.

* Robert Samuelson, writing in the Washington Post, doesn’t think it’s fair, but he doesn’t think that Romney is being a straight shooter, either.

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A Little Job Growth Fact Checking

Judging by Mike Dennison’s report on the gubernatorial debate in Helena this week, when it comes to explaining what’s wrong with Montana’s economy and what should be done about it, Rick Hill is “on message.” It’s the usual story: we’re falling behind, we have a bad business climate, our taxes are too high, we over-regulate, we need to develop our natural resources (particularly coal), etc.

Now it’s fine to say all that, if you believe it, but it would be nice not to mangle the facts while you’re at it.

For example: Dennison quotes Hill as saying that “We’re trailing all our neighboring states in creating jobs” which “has been a pattern in Montana for almost three decades.” Hill especially envies Wyoming, which he thinks has a better economy than Montana’s because it “embraced coal development” 40 years ago. Well, look at the chart below. It shows trends in total employment in Montana, Idaho, Wyoming and North and South Dakota over roughly the past two decades (1990 to 2010). Employment each year is measured as a percent of its value in 1990, so all the lines start from the same place, 100 in 1990.*

As you can see, we have not been “trailing all our neighboring states in creating jobs … for almost three decades.” We trailed only one, Idaho, and came in ahead of North and South Dakota and yes, even Wyoming.  Of course none of this means that Montanans shouldn’t be concerned about job growth and economic recovery or that we shouldn’t look at what other states have done to promote their economic health. But in looking for states to emulate, shouldn’t we choose the ones – like Idaho - that are doing relatively well? At a minimum, shouldn’t we know which states those are?

The fact that Idaho did a lot better than Wyoming should make us all – including Hill – think long and hard about an economic development strategy based on more natural resource extraction. Here’s another graph. It shows natural resource employment as a percent of total employment in Idaho and Wyoming over the same 1990 to 2010 period.

As you can see, starting out in 1990, natural resource employment was less important in Idaho than in Wyoming. And over time, the relative importance of natural resources in the Idaho economy fell. The strength of Idaho’s economy came from diversifying, away from natural resources and towards high growth sectors – for example, computer manufacturing -  in the national and world economies. Wyoming, which remained more dependent on natural resource production, did not fare anywhere near so well.

Montanans are proud of their history of living off the land as loggers and ranchers and cowboys and miners, and it’s hard to believe that what worked for us in the past won’t necessarily work for us in the future. But like it or not, the world is changing, and the key to our economic future is to make the public investments – in education, infrastructure, research, and communications – that will allow us to change with it.

*I prepared this chart using data from the US Department of Commerce, Bureau of Economic Analysis, Regional Economic Accounts. If you’d like to make a chart of your own, or check to see if I’ve done mine right, you can find the data here.