Going for an Upturn

It is the natural inclination of state and local governments to try to make something happen in a recession. Faced with stagnant tax revenues and a dwindling jobs base, elected officials -- and their appointed economic developers -- feel tremendous pressure to do something to turn things around.

But how do you respond in the face of a worldwide economic crisis? If even the most powerful central bankers around the globe can't quite figure out how to deal with it, what can a state or a city or a county do?

The answer boils down, as always, to the carrots and sticks economic developers and their elected bosses have at their disposal. In the end, this means money -- how much of it does the government extract from businesses to cover its own costs, and how much money does the government provide to businesses in the way of subsidies or incentives?

There's also a difference between the way state and local governments operate. State governments tend to focus on businesses and jobs, and thus they often provide economic incentives along those lines. Local governments tend to focus on real estate, and so often tailor their carrots and sticks to get things built.

In good times, local governments try to squeeze real estate developers for everything they can -- traffic impact fees, water and sewer infrastructure, the cost of building schools. In areas with a strong real estate market, this can add tens of thousands of dollars to the cost of, say, building a house. In a hot market, the developers pass these costs along to homebuyers.

In a downturn, however, local officials are likely to feel pressure from real estate developers to cut these fees and costs. Even though the real estate market usually tanks in an entire region, developers often blame high fees imposed by local governments for their problems. Of course, the truth is a little more complicated. When prices drop, projects that used to "pencil out" for developers no longer make sense to build. So the builders look around to cut costs wherever they can. There's not much they can do about the price of concrete, so they pressure politicians to cut fees.

And politicians often respond. It can be a tough decision, because the purpose of the fees is to cover the cost of infrastructure and services created by the new project. If fees don't cover those costs, tax revenue may have to. Local officials can only pray that the increased taxes from the project's construction will cover the costs that are no longer being reimbursed by fees.

In an extremely deep real estate downturn -- like the one we're experiencing now -- cutting fees won't be enough. The market has tanked so much that hardly any project can be built without deep government subsidies. Sometimes these funds are available through the state and federal governments, either through state bonds (in California, the voters keep approving housing bonds) or through federal mechanisms, such as low-income housing tax credits.

For projects that don't qualify for state or federal funding, local officials face a tough choice. In a community filled with vacant lots and stores going out of business -- and at a time when local tax revenue is in decline -- how much is it worth to get something built now as opposed to later?

There are two ways to look at this question. The first is a cold, hard financial calculation on the part of the local officials: If we throw millions of dollars in subsidies or loans at a development project now as opposed to later, what's the payback in property tax, sales tax and other revenue sources? This analysis requires making lots of assumptions, including the odds that the same project actually will be built later, and if so, when and at what value.

That's fair enough. It's often necessary to justify a big subsidy in a financially strained time.

But there's a second way of looking at making something happen: the psychological effect on the local marketplace. If an investment is made, will there be a sense of optimism as a result?

The answer to that question depends on how long, how deep and how localized you think the downturn is going to be. If you think you've got a good underlying market and are going to come out of the downturn pretty soon, then a deep subsidy might make sense. If, on the other hand, you expect to be part of a long, hard and global recession, you may be building a monument to hard times.