The Wrong and Right Approaches to Michigan’s Economic Malaise

(Note: The following is an edited version of a speech delivered by Mackinac Center policy analyst Jack McHugh before the One Day Tax Seminar in Taylor, Mich., on April 28. Attending the seminar were the state’s leading tax professionals, including those who manage tax issues for some of the state’s largest corporations.)

There are two approaches that government leaders can take to fix a broken economy. One really works, but is harder to do. The other is politically easy, but doesn't work. Guess which one Michigan’s political establishment has adopted?

The easy approach that doesn’t work is called "industrial policy" in the economics literature. It involves government planners picking certain firms to be the recipients of special tax breaks that are not available to most other businesses or picking winners and losers. It’s unfair, and it doesn’t work for many reasons, some of which I’ll mention in a minute.

Nevertheless, in recent years Lansing has been bingeing on the stuff, passing scores of bills authorizing targeted tax breaks and other "incentives." The Jobs 1 package, Jobs 2, the "53 tax cuts" Gov. Jennifer Granholm has signed — none of which are genuine broad based tax cuts — the list goes on, and both parties are eager participants.

Actually, they’ve been trying this for a long time. In 1947, Republican Gov. Kim Sigler created a Department of Economic Development "to coordinate the state’s research in economic fields and utilize all of its research facilities in economic development." In 1963, Gov. George Romney created a Department of Economic Expansion to "encourage the expansion, development and diversification of industry, commerce and agriculture."

In 1975, Gov. William Milliken created the Michigan Economic Development Authority to "expand Michigan businesses and centers of excellence in biotechnology and advanced manufacturing." Sound familiar?

In 1983, Gov. James Blanchard established a state council to create a plan for "focusing the resources of state government on economic development and job creation," and in 1984 he created the Michigan Strategic Fund.

Gov. John Engler created the Michigan Jobs Commission in 1995 and gave it full departmental status. It later morphed into the Michigan Economic Development Corporation or MEDC. Gov. Engler also created renaissance zones and MEGA, which today is called the state’s "flagship" economic development program. MEGA selects particular firms to be the beneficiaries of tax breaks on Michigan’s main business tax, the so-called Single Business Tax, which I’ll have more to say about later.

MEGA credits are usually part of a raft of other tax breaks. These packages can get pretty rich. A good example is a recently announced 20-year, $37 million deal for a new facility in Greenville. It includes a MEGA credit, a federal community development block grant, a local property tax abatement, a Renaissance Zone for the site, plus training assistance money. It amounts to $66,000 per worker if everything goes according to plan — which Mackinac Center research shows hardly ever happens, in which case the cost per job will be higher.

By the way, just to put that in perspective, if we paid this amount to "save" each of the net 184,000 payroll jobs Michigan has lost in the past six years, the total would be $12.1 billion in foregone taxes and outright grants.

Building on the success of all these adventures, this spring Gov. Granholm is launching the 21st Century Debt and Grant program. I’m confident that it will enjoy just as much success as its predecessors in turning Michigan’s economy around. Not much, that is.

The point of the history lesson is to show that it’s not like we haven’t tried this sort of thing before. We’ve been doing plenty of it, for a long time. We’re even thought to be good at it — look at the confections regularly baked up by Site Selection magazine, and MEDC’s claims that it’s the model that other states seek to follow.

Here’s my question, though: At what point will we finally accept that it doesn’t work, and that only broad-based tax cuts and regulatory reform will fix our economy?

For years, the Mackinac Center for Public Policy has consistently presented theoretical and empirical evidence as to why the targeted incentive approach will not work to fix Michigan’s broken economy. A year ago, on the 10th anniversary of MEGA, we released the results of a rigorous econometric analysis of that program’s effect. We found that it had no impact on employment, the unemployment rate or per-capita personal income. Michigan counties with MEGA firms fared no better than those without. For every $123,000 in MEGA tax incentives offered, only one construction job was created — and those jobs lasted less than two years.

Maybe the closing of a Federal Mogul plant in St. Johns two weeks ago with a loss of 420 jobs will do it, given how recently an incentive package was trumpeted that was going to "save" that facility. Exactly two years ago, Gov. Granholm signed targeted tax break legislation deliberately tailored to benefit Federal Mogul. Her press release then claimed the bill "adds muscle to Michigan’s economic development arsenal." She said, "From today onward we will better be able to address the challenges employers face in the fast-changing 21st-century economy, and retain more jobs for Michigan families."

Republican legislators echoed this. Sen. Alan Cropsey said, "The fight for jobs at Federal Mogul is a fight we need to win — for all of Michigan."

Rep. Bill Huizenga said: "This makes it crystal clear that we will do whatever we can to help employees and manufacturers that have been hard-hit by today’s difficult economy."

Rep. Jerry Kooiman, said: "This sends a strong message to Federal Mogul and other companies that the Legislature is serious about removing barriers that get in the way of Michigan being a friendly business and manufacturing state."

He was wrong. The measure sent just the opposite message, that instead of getting "serious about removing barriers to all," Lansing was only willing to lower them for a few. While legislators and the governor chase particular firms with targeted tax breaks, thousands of potential new business start-ups are stillborn as a result of our punishing tax, regulatory and labor climate. Outside of Michigan, since 2003, the U.S. economy has added more than 5 million non-farm payroll jobs, mostly in small and medium businesses, many providing goods and services the central planners could not possibly have predicted — one of the reasons industrial policy does not work. These firms don’t benefit from targeted tax breaks — they pay for them.

Imagine how different things might look today if, instead of handing out narrow "incentives" to high-profile firms or politically "sexy" industries, the state’s bipartisan political establishment had eliminated the obstacles that inhibit job growth here. Nothing would have prevented Michigan from netting its share of those 5 million new jobs. The loss of 420 jobs at Federal Mogul would be an unfortunate footnote in an otherwise booming state economy, rather than yet more evidence of a failed policy.

Let me be even more explicit about that: The object shouldn’t be to "save" or create jobs at a particular plant or industry. We should focus instead on making Michigan such a good place to do business and make money that companies rush to get in, without needing special "incentives." Then we wouldn’t need to care whether company X or company Y comes or goes. There will always be companies X and Y coming and going.

One of the more insidious effects of incentives is that they remove pressure that would otherwise fall on Lansing to improve our business climate. If General Motors and Ford had been unable to get special tax treatment, don’t you think it’s likely the SBT and personal property taxes would have been eliminated or drastically reduced years ago? By the way, the so-called personal property tax is a tax on the tools that businesses use to provide goods and services and create jobs. I call it the "stupid tax."

Whenever targeted tax breaks are criticized, public officials, and possibly some of you, inevitably point to particular employers who supposedly would have departed or never come "but for" such incentives. This is intended to show the value of these, but it really only shows Michigan’s failure to establish a favorable business climate.

Let me give an analogy. Imagine a restaurant with second-rate food, surly waiters, slow service and high prices. When the manager sees a customer getting restless, he rushes over and offers a 20 percent price cut. He also stands on the sidewalk offering discounts to potential customers who look like they might walk on by.

At the end of each day this manager sends glowing reports to the owner of how many sales he "saved" or attracted by offering "incentives." He spends his free time thinking up new incentives that might persuade underwhelmed customers to buy mediocre meals.

Isn’t it obvious that this is not a viable business plan, and that this manager should instead focus on making the food better, the service more pleasant and the prices lower? The owner, employees and diners would be much better off if the place were so attractive that customers stood in line to get in, and the thought of targeted discounts never entered anyone’s mind.

Like that restaurant manager, the extent to which state policy makers brag about their incentive "victories," like that Federal Mogul preening, is a function of their failure to make Michigan an attractive place to do business.

Given all that, you probably expect that I would recommend reducing or eliminating MEGA. You may be surprised to hear that instead, I propose what is in effect a massive expansion.

Before I get into that, though, let me pose a question: Does state government exist to serve the people, or is it the other way around? Michigan’s political establishment often behaves as if the latter were true, and this gets in the way of making the changes needed to turn things around.

Here’s exhibit number one: Government officials who say a tax cut in one area must be "paid for" with a tax increase in another, rather than with spending cuts. We hear this all the time in the SBT debate, so let’s parse it out a bit. "Tax cuts must be paid for" really means that the government is entitled to a certain amount of money that can never be reduced.

But what if we just have more government than we can afford? Michigan doesn’t exist in a vacuum. No one has to stay here, or open a business here, or keep one open. If high taxes and excessive regulations make doing business here less profitable than other places or more trouble than it’s worth, people and businesses can and will leave. There’s plenty of evidence that this is happening already.

Now, in that context, think about what "tax cuts must be paid for" really means: The people exist to serve the government, not the other way around. You may think this is extreme, that no one in government really thinks this way. Consider a place where it’s easier to imagine that they do.

The City of Detroit has 18,600 employees, or one for every 48 residents, and spends $2,859 for every man, woman and child in the city. As a comparison, Indianapolis has just one city worker for every 203 residents and spends just $1,103 per resident, 62 percent less.

To support this spending, Detroit homeowners pay more than twice as much property tax as many other Michigan communities, plus a city income tax. Detroit business owners must also deal with burdensome regulations and a heavy-handed, unresponsive bureaucracy.

Except they don’t, really. Like Michigan, Detroit doesn’t exist in a vacuum. Residents and businesses can always leave. They’ve done so, cutting the city’s population in half, and it continues to drop.

Let’s suspend disbelief for a moment and pretend that every one of Detroit’s 18,600 employees serves a vital purpose and does so as efficiently as possible: It doesn't matter if they do, because unless the city cuts its expenses drastically and gives the savings back as huge tax cuts, the population and job declines will continue, and there will be even less ability to support the city workforce. Detroit just has more government than it can afford.

The same applies at the state level. For years Michigan has lagged behind other states in economic and population growth. We may be at the tipping point of going from poor relative performance to absolute decline in these measures.

Let’s be clear about what this means: Michigan is on the verge of becoming a state characterized by declining incomes, homes that every year are worth less than they were the previous year, and lonely parents whose children and grandchildren had to go elsewhere to find careers. It’s not a pretty picture.

If policy is dictated by a "tax cuts must be paid for" mindset, then the things that need to change to avoid this depressing scenario will not change. Here are two of those: We have perhaps the highest business tax in the nation, and also levy property taxes on business tools and equipment. These two taxes raise around $3 billion a year.

Let’s suspend disbelief again and pretend that every program that money pays for is valuable and is done as efficiently as possible. It doesn’t matter, because, like Detroit, we just can’t afford it anymore. Without major improvements in our business climate, jobs and people will continue to leave, and eventually the entire state will look like Detroit’s empty neighborhoods.

Alright, let’s stop suspending disbelief now, because we all know that state government does not operate as efficiently as possible. Also, we now have a broad consensus that the SBT is too complex and harms our economy. The non-partisan Tax Foundation recently estimated that the SBT rate is 15 percent. That may be a bit on the high side, but not by much. Add that to the 35 percent U.S. corporate tax rate, plus taxes on dividends, and you start to understand management-guru Peter Drucker's definition of profit as "whatever government lets a company keep."

You also start to understand why Michigan’s economy is in such deep trouble. As I say, we now have consensus that the SBT is bad, but in Lansing, this recognition is usually followed up with, "It’s impossible to not replace the SBT with a different business tax, because there’s no way to cut the $1.85 billion it takes in."

That’s not true. I’m hardly the foremost budget expert in this state, although I am one of a minority who want the budget to go down, rather than up. Nevertheless, without much effort I came up with a list of reforms that could save $1.85 billion. This would allow us to replace the SBT with — nothing. Or, to put it a different way, to give every business in the state a permanent 100 percent MEGA credit.

Most of these proposals aren’t even cuts, really — they’re just doing things in smarter ways, injecting competition into government operations or rationalizing government employee fringe benefits. Those that are cuts eliminate non-core functions. There are no starving widows and orphans created by this plan.

I say plan, but it’s really intended not as a precise roadmap, but as an indication of what’s possible. Some of the projected savings are speculative, but I think you’ll agree they’re all plausible and make sense. Here's the list:

Higher Education. Currently, Michigan's 15 four-year universities get state operations grants each year that are essentially determined by legislative mud-wrestling. Each college sends its lobbyist into the appropriations pit, and tries to increase its piece of the pie. The school gets its money whether it has more students or less. After decades of this the result is a bizarre range of grants per resident student ranging from $3,887 at Saginaw Valley to $15,369 at UM-Ann Arbor. Worse, the system provides only weak incentives for colleges to contain costs.
To fix this, the system should be overhauled so that each university gets the same amount per student, and the money follows the student, not the most effective lobbyist.. This would mean that every kid applying to a state university would do so knowing he or she came with a $6,300 annual grant to the school. If colleges were forced to compete for students to get state money, they would "sharpen their pencils," rein in costs, and eliminate the kinds of inefficiencies highlighted in recent audit reports. If the effect was that costs fell by just 5 percent the savings would be $70 million.

Here’s another item: The next time you see a State Police trooper ticketing a speeder, ask yourself this: Why is a routine traffic safety enforcement action being performed by a state trooper, when the same job could be done just as well for much less by a county sheriff deputy? When you include benefits and mandated employer costs, we pay more than $90,000 to keep a state trooper on the payroll for a year. In contrast, the average cost statewide to employ a county sheriff deputy is approximately 77 percent of that amount. The state could give county sheriff departments 77 percent of the amount spent for state police road patrols, and pocket the difference. The effect on public safety would be zero. The savings would be $65 million.
Next on the list is school employee health care. The Hay Group report last year showed that 48 percent of Michigan school employees had "fee for service" health insurance, which is the most expensive kind and provides no incentive or means to economize. In comparison, only 8 percent of government employers nationwide provide fee for service, and only 2 percent of private sector employers. The report found that if the current system were replaced by a single state plan offering generous benefits through preferred provider networks with modest co-pays the annual savings would be $422 million.
We should eliminate the Michigan State University cooperative extension service and agriculture experiment station. Yes, that would mean 4-H clubs and Master Gardener classes would be off the dole. For the rest of what these programs do, let ADM and the other agribusiness firms do it. Not only is government involvement in this area obsolete, it’s a luxury we can no longer afford. This would save $61 million a year.
I’ve already beaten up enough on industrial policy, so I’ll just say that the next item, repealing the "21st Century Jobs Fund" would save $40 million in annual debt service.
Prison privatization – According to a Rio Grande Foundation report, if 5 percent of prisoners are placed in privately run prisons, a state saves 14 percent on overall prison spending, because government-managed prisons respond by "sharpening their pencils." This could save $192 million.
Next — Arts grants. The Department of History, Arts and Libraries budget is $45 million. The "history" portion should come from user fees and the arts portion from voluntary contributions. Cutting spending on libraries in half and eliminating the rest would save $35 million.
Intermediate School Districts probably have less accountability per tax dollar than any other unit of government. A Citizens Research Council report noted that "a number of changes have occurred over the past decade that have reduced the need for ISDs." Let's help them catch up by reducing ISD operations grants, for savings of $32 million.
Due to a quirk in Proposal A, certain wealthy school districts benefit less from per-pupil state foundation grant increases than other districts. (They still benefit, though.) The political response to this is a thing called "20j" payments. Cut this luxury in half for $26 million in savings.
Mass transit. By eliminating protectionist regulations that restrict alternatives, empty buses driven by public employee union members could be replaced by private sector innovations like jitneys, commercial van pools, "call-and-ride" services, car-sharing, and more. This would improve service for transit users and save $112 million. By the way, this is the only item on my list that contemplates a radically different model. When you see the outrageous featherbedding at the Detroit Department of Transportation, and what Senate Appropriations Committee chair Sen. Shirley Johnson often refers to as "all those damned empty buses," it’s hard not be radical. The only beneficiaries of keeping the current model in place are DDOT employees — remember that "Does government exist to serve the people" question?
Next, repealing the "prevailing wage" law that requires above-market level wages be paid on school construction projects would save $150 million
Gov. Granholm proposes sending extra money to school districts that are losing pupils. Here's a better idea for those districts: Consolidate and downsize. In the private sector, this is what an enterprise that's losing customers must do. That's a useful model: It would save $50 million.

Three more:

Reduce the Merit Award Scholarships by 50 percent. When families face hard times the first thing they do is cut luxuries. Non-need based college scholarships are a luxury Michigan can no longer afford. This would save $60 million.
Medicaid and Welfare — Total spending on these two programs is almost $15 billion. More than $6 billion of that comes from state taxes. Medicaid in particular is a command and control monstrosity rife with perverse incentives. Reforming it in ways that give recipients an incentive to economize and take better care of themselves could save hundreds of millions, and actually give recipients more freedom and choice. If just 1.6 percent of the expense could be reduced in this way, the state would save $240 million.
Finally, stimulating growth. Can anyone doubt that eliminating the SBT, one of the most complex and burdensome business taxes in the nation, would be like a shot of adrenalin for the state's economy, especially if we replaced it with nothing? It would send a powerful message that Michigan is open for business. The dynamic effects of such a change on income, property and sales tax receipts would easily raise $300 million.

These items total $1.85 billion.

That's how much the Single Business Tax now takes in.

None of these items are "devastating" to the state, or to education, "vulnerable populations," or even to any particular interest group. Most people wouldn't even notice them.

There’s a school of thought that says government will do the right thing, but only after every other option has been exhausted. Are we there yet? I think we're getting close.

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Jack McHugh is a legislative analyst for the Mackinac Center for Public Policy, a research and educational institute headquartered in Midland, Mich. Permission to reprint in whole or in part is hereby granted, provided that the author and the Center are properly cited.