Feature: The Economic Future of Michigan
An MSU economist argues that Michigan, to recover economically, needs to invest more in higher education and research.
Economic development has been crucial to the mission of MSU ever since the institution was founded a century and a half ago. Today, economic issues are more important than ever before. MSU President Lou Anna Simon has emphasized the university’s pivotal role in shaping the future of the Michigan economy. A few years ago, President Simon commissioned me to write a short book about the Michigan economy. The result was Michigan’s Economic Future, published in 2006 by the MSU Press.
Some people may think that “Michigan’s Economic Future” is an oxymoron, but I don’t. Based on my studies of the Michigan economy, I am cautiously optimistic. It is undeniably true that Michigan’s economy hasn’t grown as rapidly as the economy of the rest of the country. This unfortunate trend has been going on for several decades. But I believe we can do better, if we can break ourselves free from old ways of thinking and doing.
We can only break free from the shackles of the past if we understand the past. Thus, this essay includes a review of where we are now, and how we got here, as well as some suggestions for how to capture a brighter future.
The Shrinkage of Manufacturing
By the middle of the 20th century, Michigan’s economy was the envy of the world. Workers from around the country and around the globe migrated to Michigan in search of jobs in the booming manufacturing sector. Between 1940 and 1970, Michigan’s population grew by 69 percent! In the 1950s and 1960s, per-capita personal income in Michigan was usually more than 10 percent above the national average.
As long as manufacturing was the primary engine of the world’s economic growth, Michigan was in a good situation. But other sectors of the economy have grown faster than manufacturing for several decades. Thus, manufacturing has shrunk as a fraction of the total economy. Manufacturing’s share of the Michigan economy shrank from 38.6 percent in 1977 to only 18.4 percent in 2005.
As a result, manufacturing workers and companies have had to go through wrenching changes, especially in the automobile industry. In the 1950s, the Big Three domestic automakers had a cozy oligopoly, with very little competition. The companies paid generous wages and benefits to their workers, and passed the added costs along to consumers. Over time, however, Japanese automakers exerted more and more competitive pressure. The American automakers were caught with bloated cost structures and lackluster sales.
This has put great economic stress on many Michigan communities, none more so than Flint. In April 2007, Genesee County had an unemployment rate of 8.1 percent, which is higher than the unemployment rate in any other metropolitan area in the state.
The transformation from a manufacturing economy to a high-skill economy is not easy. But it is worth remembering that this is not the first major economic transformation for Michigan. In the 19th century, our economy was overwhelmingly agricultural. But improvements in agricultural technology (many of which were developed at Michigan Agricultural College) made it possible to devote a smaller fraction of the workforce to agriculture. This freed up an increasing portion of the labor force for work in the newly emerging manufacturing sector. Millions of American families made the transition. It was easy for some, and hard for others, but the transition ultimately led to a far more prosperous way of life. Today, we face a similar challenge, and a similar opportunity. Once again, Michigan’s research universities, including MSU, have an important role to play. New technologies developed in MSU laboratories have already had a tremendous positive impact on the Michigan economy. They will continue to do so in the future, as Michigan moves toward an economy dominated by alternative energy, biotechnology, biofuels, information technology, and other cutting-edge sectors.
I emphasize the plight of manufacturing in general, and the automobile industry in particular, because this is by far the most important influence on Michigan’s economic situation today. Based on the rhetoric one sometimes hears, it would be easy to imagine that “high taxes” are the cause of our economic woes. In fact, however, Michigan has never been one of the highest taxing states in the nation. For many years, Michigan’s level of taxation was above the national average, but only slightly. In recent years, we have been below the national average. Moreover, the national average level of state and local taxes has been falling for the last 35 years. Michigan taxes account for a much smaller fraction of personal income than they used to. If we were to tax ourselves as we did in the 1970s, state and local revenues in Michigan would be larger than they are now, by about $8 billion to $9 billion per year.
The Crucial Role of Education
Forty or 50 years ago, it made sense for a high-school graduate in Michigan to say “I don’t need to go to college; I’ll get a job on the auto assembly line.” But that strategy doesn’t work any more. Many of Michigan’s people lack the skills to compete successfully in today’s economy. As long as this situation persists, it will be difficult for Michigan to regain its economic prominence.
In a typical year, Michigan falls about three percentage points below the national average, in terms of the percentage of the population with a bachelor’s degree or more. This lack of education hurts Michigan more than it used to, because the financial payoff to a college education has grown tremendously in the last quarter century. Between 1980 and 2000, the inflation-adjusted earnings of Michigan residents with at least a bachelor’s degree increased by about 29 percent. Over the same period, the earnings of Michigan residents with only a high-school diploma decreased by about 9 percent. And the earnings of those with less than a high-school education fell by an astounding 25 percent.
It is important to maintain and strengthen our financial commitment to education, from pre-school to Ph.D. This is especially important in the case of the physical infrastructure of the schools, which is dilapidated in many school districts, especially in central cities and rural areas. However, although money is necessary to fix the problem, it is not sufficient. Money will not get us where we need to go, unless parents also read to their children, turn off the TV, keep in touch with teachers, and create an atmosphere that is conducive for doing homework. A strong argument can also be made in favor of a longer school year. Our mediocre educational outcomes are more the result of outmoded attitudes and substandard effort than of inadequate funding.
Incomes in Michigan: Good News and Bad News
Earlier, I mentioned that per-capita personal incomes in Michigan were routinely 10 or even 15 percent higher than the national average in the 1950s and 1960s. But our relative position weakened over time, because of the decline of manufacturing and our lagging levels of educational attainment. By 2005, Michigan incomes were nearly five percent below the national average.
Even though incomes in Michigan have grown less rapidly than incomes in the U.S. as a whole, it is still true that the Michigan of today is a very prosperous place. In fact, inflation-adjusted per-capita income in Michigan was nearly three times as high in 2005 as it was in 1950! I emphasize our affluence for two closely related reasons. First, if we focus exclusively on the bad news, we could become paralyzed psychologically. Second, it’s important to remember that the resources really are there, if only we can marshal them to the task at hand. We are not so poor that we cannot invest in our future.
As I say, the resources are there. But they are not distributed evenly. The biggest story of the U.S. economy in the last 30 years has been the massive increase in inequality. The large and growing income disparity has implications for budget policies in Michigan. The income tax is the only tax that collects revenue on the basis of ability to pay. Since the ability to pay taxes has become increasingly concentrated in the hands of those at the top of the income distribution, the income tax should play an important role in solving Michigan’s budgetary problems. I will devote most of the rest of this essay to budget issues.
The Structural Budget Deficit
If we were to put our spending policies on autopilot, public expenditure in Michigan would grow more rapidly than the economy as a whole. In this regard, the biggest culprit is health care. On the other hand, if we were to put our tax policies on autopilot, tax revenues would grow more slowly than the economy as a whole. Our antiquated tax system does not keep up with changes in the economy. Thus, even if the official tax rates stay the same, the tax system applies to a shrinking portion of the economy. For example, most services are not taxed by Michigan’s retail sales tax, but services account for an ever-increasing share of the economy. Consequently, the sales tax covers an ever-smaller part of the economy.
Since public expenditures grow more rapidly than tax revenues, we say that Michigan faces a “structural” budget deficit. Even if the economy were expanding rapidly, we would still fall behind by hundreds of millions of dollars every year. We will not grow our way out of the structural deficit—we can only fix the problem if we change our policies. Unfortunately, the Michigan legislature has not yet summoned the will to do so. As a result, Michigan has lurched from one fiscal crisis to another.
The structural budget deficit means that Michigan would face fiscal difficulties even without tax cuts. A series of reductions in the income tax and the Single Business Tax have made the problems more severe. (The cigarette tax has increased, but this has not been enough to stop the financial bleeding.) As a result, in the last five years, the state has made very substantial cuts in K-12 education, higher education, and many other spending categories. We have also engaged in a number of one-time fixes, such as spending down the “Rainy Day Fund.” These one-time fixes bring in short-term cash, but they intensify the long-term problems. From 2000 to 2006, the cash balances of the State of Michigan deteriorated by $4.2 billion. As a result, the state has gone from a net creditor to a net debtor.
I understand the political attractiveness of mortgaging the future in order to paper over current deficits. In the long run, however, the only ways to fix our budget problems are to reduce spending and/or increase revenues.
Fixing the Budget Mess: The Expenditure Side
Even after the massive budget cutting of recent years, there are still a few ways to cut expenditure. One is through the streamlining and consolidation of delivery of services. In many cases, school districts and municipalities can save money by pooling their resources.
The corrections system is another area of potential expenditure reduction. In the 1980s and 1990s, Michigan’s prison population quadrupled, to about 50,000. This is expensive, since it costs more than $30,000 per year to incarcerate a prisoner. Other states in our region have less stringent sentencing policies than we have in Michigan. If we were to adopt the sentencing policies of other states in the region, we could save about $500 million per year. By releasing some non-violent offenders, we can reduce the rate of incarceration, with minimal risk to public safety.
Health-care expenditure is another potential source of savings. I fully expect that my deductibles and co-pays will go up substantially. Not only do I expect this, but I applaud it. Public institutions will continue to spend money on health care, but they simply cannot afford to increase their expenditures as rapidly as they have been expanding in recent years.
However, I am strongly opposed to any further reductions in spending for the core functions of our K-12 schools, community colleges, and universities. In fact, I advocate increases in expenditure in certain education-related areas. In recent years, at precisely the time when we should have been increasing our investment in education, we have been disinvesting on a massive scale. This policy, like eating one’s seed corn, is wrong-headed in the extreme.
Fixing the Budget Mess: The Tax Side
Obviously, we can’t afford to engage in wasteful spending. When spending can be cut without endangering critical public services, we must make the cuts. However, if we try to balance the budget by relying exclusively on further spending cuts, we will fall farther behind in our ability to provide the educational system and the other public services that are essential to Michigan’s economic future. It isn’t pleasant to contemplate, but we simply have to bring in more tax revenue.
The Single Business Tax (SBT) is scheduled to disappear at the end of 2007. As of this writing, replacement of the SBT revenues is under discussion in Lansing. Some proposals involve full replacement of the SBT revenues. In the current budgetary situation, this is the only responsible thing to do. Some other proposals would blow another hole of $400 million or more in the budget. To do this would be fiscally irresponsible to an extraordinary degree. Even if the SBT revenues are replaced fully, we still face long-term structural problems with our revenue system. These problems need to be addressed.
Since the income tax is the only tax based on ability to pay, I put the income tax at the top of the tax-reform agenda. Michigan can increase its reliance on the income tax in either of two ways. One possibility is to increase the existing rate of 3.9 percent. (The rate was 4.6 percent in the early 1990s, and 4.4 percent as recently as 1999.) An increase in the rate could be coupled with a modest increase in the personal exemption, to protect low- and middle-income families. (The inflation-adjusted value of the personal exemption is only about half of what it was in 1967.)
The other possibility is to adopt a “graduated” income tax, in which the tax rate on an additional dollar of income is higher for those with larger incomes. Most states have a graduated income tax, as does the federal government. (Michigan is one of only six states with a “flat-rate” tax, where all taxable income is subject to the same rate.) We could keep the basic rate at 3.9 percent, or even reduce it, and then institute a higher rate for those with incomes above a threshold, such as $100,000. This would shield all families with incomes below the threshold from paying any additional tax.
If you itemize deductions on your federal income-tax return, you get to deduct the income taxes that you pay to state and local governments. Thus, an increase in the Michigan income tax will be offset partially by a decrease in federal taxes. For someone in the 25-percent federal tax bracket, every dollar of Michigan income tax leads to a 25-cent reduction in federal income tax. The Michigan Treasury receives a dollar, but it only costs the household 75 cents! Thus, the people of Michigan “export” part of their taxes to other states.
I also want to mention one other set of taxes that are ripe for reform. The excise taxes on alcoholic beverages are a fixed dollar amount per barrel of beer, or per gallon of wine. (In contrast, the income tax and the sales tax are a percentage of a dollar value.) Unless the tax rates on beer and wine are changed explicitly, their real revenue-raising capacity is eroded over time by inflation. The beer tax rate has remained unchanged since 1962, and the wine tax rate has stayed the same since 1981. Thus, these taxes raise only a tiny fraction of what they once raised. It would be sensible to convert these taxes to a percentage basis.
Conclusion
The secret to the economy of the future lies in a highly skilled work force. Unfortunately, political decisions in Michigan in recent years have led to massive disinvestments in education. Nevertheless, there is reason for hope, and even for optimism, about Michigan’s economic future. The resources are there. All that is necessary is for us to harness those resources. The people of Michigan can have a bright place in the emerging high-tech, high-skill economy. It will just take a willingness to work hard and invest for the long haul.
Charles L. Ballard is a professor of economics at Michigan State University. He has been on the faculty at MSU since 1983, when he received his Ph.D. from Stanford University. Much of his research involves analysis of public policies, such as income and consumption taxes, tariffs, wage subsidies, credits for health insurance, environmentally motivated taxes, and the Michigan tax system. He has also written on economic education. He has served as a consultant with the U.S. Departments of Agriculture, Health & Human Services, and Treasury, and with research institutes in Australia, Denmark, and Finland. His books include Michigan at the Millennium (co-edited with Paul Courant, Douglas Drake, Ronald Fisher, and Elisabeth Gerber, 2003), and Real Economics for Real People (3rd edition, 2003). His latest book, Michigan’s Economic Future, was published by the MSU Press in 2006. It is available at www.msupress.msu.edu (or 517-355-9543), where MSUAA members receive a 30 percent discount.
MICHIGAN’S CHALLENGE: INNOVATION AND ENTREPRENEURSHIP
How to keep Michigan from ending up like Rome, Mongolia, the Hapsburgs, or Britain.
Michigan’s challenge today is to foster innovation and entrepreneurship in the midst of our transition out of an industrial economy. In the wake of manufacturing’s collapse and the continuing strangulation of our state universities, innovators have not been encouraged to step forward and act as magnets for investment and growth. The question we confront is how to create the right kind of incentives for innovators to come forward and join Michigan’s burgeoning entrepreneurial economy. The answers are no secret, but they require tremendous amounts of political will.
At the Michigan Center for Innovation and Economic Prosperity, based in James Madison College, our research is singularly focused on connecting the people and policies which will foster the innovation and entrepreneurship of the 21st century. Today, we must grow our own new businesses and industries, just as we did 100 years ago when the talent, capital, and entrepreneurship necessary to capitalize on the emerging auto industry came together in Michigan.
How do we do this? We stop throwing money at anybody who promises to create jobs or at a small set of companies that we hope will be the “winners” in the new economy, and focus economic development monies on streamlining the process of business startup and expansion through a “one-stop” shop and “pre-seed capital” open to all businesses. We provide an incentive structure that encourages Michigan entrepreneurs and innovators to devote themselves to serving customers around the world. We facilitate the interchange of ideas and people between our universities and private entrepreneurs and innovators. And we connect our students, especially here at MSU, with the activities of businesses and non-profit organizations so that they become the next Michigan entrepreneurs and innovators.
Encouraging Business Startup through Pre-Seed Capital
Starting or expanding a business in Michigan is costly, frustrating, and time-consuming. What takes eight days in Singapore and a couple of months in Massachusetts (from inquiry to initial startup with facility and even staff) takes many months in Michigan. And it will also require funds to get your product from concept to market-ready form. Once you are up and running with a viable product, venture capitalists will assist with your transition to a market leader. But where do you get funds to get your operation off the ground? Pre-seed capital is the answer, but Michigan is woefully short on the supply of such funds.
In 2005 Michigan began the process of creating its own pre-seed capital fund called the 21st Century Jobs Fund. As it was originally conceived, the fund was to be a 10-year, $1 billion investment in Michigan’s emerging high-tech industries—a grand and promising start! Once the bill worked its way through the legislature, however, most of the money had been earmarked for specific appropriations rather than for pre-seed capital money, and the final program was much less than originally conceived. To complicate matters, portions of the fund have been shifted to other programs to offset the state’s budget deficit. Emerging entrepreneurs and innovators are now thrown back on their own resources; and the collective action dilemma of providing pre-seed capital remains unresolved.
Bringing Innovation to the Market with Business Acceleration
New businesses also benefit from mentoring in business accelerators. Many people are familiar now with business incubators: lab spaces devoted to the cultivation of new products. Business accelerators push the cultivation of new innovations further in both directions. Bringing in market participants to discuss how initial versions of new products might actually be used in the marketplace helps innovators focus product development on things that people actually find useful. And helping new startups with talent recruitment and the commercialization of their product can help to carry the business forward from idea to reality.
Michigan has a network of eleven SmartZones created in 2001 to serve technology-based businesses located near research institutions. Ann Arbor’s Spark! and Troy’s Automation Alley have become leaders in business acceleration; some of the others still struggle to succeed. Michigan’s success in promoting high-tech entrepreneurship will require support of its successful SmartZones and encouragement of the others to adopt better practices.
Investment in Michigan’s Universities through Public/Private Partnerships
Perhaps the most important development needed in Michigan today is the cultivation of strong connections between our world-class research universities and emerging innovators and entrepreneurs. The smokestacks of industry have been replaced by the bell-towers of our universities as the drivers of innovation, and hence, of economic growth. The resulting synergies mean that working partnerships are crucial means of advancing technology, concentrating investment, and moving technology to market. In Michigan, the network to energize these synergies exists, but like the 21st Century Jobs Fund and SmartZones, they are embryonic and insecure. Both public and university policy reform is necessary to allow the synergies to help our state flourish. An integral part of that reform will be the encouragement not only of faculty-private sector linkages, but also the expansion of possible linkages between students and the private sector through internships, part-time employment and contracts.
An economic resurgence is possible in Michigan, if we focus our energies on the right things. However, the talk about business services highlights an important point—the budget must be balanced. One of the most challenging hurdles to overcome in all three of these areas is the lack of funds available to the State. As Dr. Ballard has stated, a balanced budget is a precursor to economic success, but it must be coupled with programs designed to encourage business start-ups through pre-seed capital, business accelerators, and public private partnerships.
Ross Emmett is an associate professor at MSU’s James Madison College and co-director of JMC’s Michigan Center For Innovation & Economic Prosperity (MCIEP). John Fournier, ’07, is a researcher at MCIEP.
