by Dr. Roy Cordato
Senior Economist, Emeritas
Note: This is an excerpt from a John Locke Foundation Spotlight report.
Economic impact studies are everywhere.
Whether it’s to support a new highway project, special tax breaks for solar energy, the building of a civic center or sports complex, or to promote subsidies for Hollywood film producers, you can find an economic impact study, often touting how great the project will be for the state or local economy.
The formula is simple, predictable, and effective. A special interest group that stands to benefit from the project funds an economic impact study that purports to provide hard numbers on the number of jobs, the increase in wages, and the additional output that will be generated by the project or subsidy, and it will do this on an industry-by-industry basis. It makes grandiose claims about how much overall economic growth will be enhanced for the state or region generally. Once the report is completed, the special interest group that paid for the study will tout these results in press releases that will be picked up by the largely uncritical media establishment, ensuring that the political decision makers and others who determine the fate of the project receive political cover.
These studies all have several things in common. First, they typically use proprietary, off-the-shelf models with acronym names like IMPLAN (Impact Analysis for Planning), CUM (Capacity Utilization Model), or REMI (Regional Economic Model, Inc.). Rights to use the models are purchased by professional consulting firms who are hired by the interest groups to do the studies. Furthermore, seldom do those who actually perform the studies have formal training in economics. Instead, their expertise is in using one or more of the aforementioned proprietary models. And finally, all of these studies ignore basic principles of economics and, as a result, do not meaningfully measure what they claim to be measuring—the economic impact of the public policies and projects that they are assessing.
Real economic impact analysis: “the seen and the unseen”
To properly assess the impact of any economic activity, whether it’s building a convention center or sports stadium or installing a vast solar power plant, it must first be understood that the project will yield directly observable activities that one can reasonably expect to occur and there will be economic activities that don’t occur but otherwise would. By definition, these impacts, while real, are not directly observable.
The second category is what economists call opportunity costs. Opportunity costs are the result of the fact that all economic activity uses scarce resources that, under normal conditions, would be used for other purposes had the project under consideration not occurred. Opportunity costs, while real, are by their nature related to resource uses that are diverted from economic activities that would otherwise be pursued and are therefore unseen.
Any economic impact study that does not attempt to assess these opportunity costs cannot legitimately be called economic analysis. In fact, not attempting to take account of the latter is considered to be the biggest mistake that non-economists make when thinking about economic issues. As the nineteenth-century economist Frederic Bastiat famously pointed out: “There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist considers both the effect that can be seen and those effects that must be foreseen.”
For example, let’s imagine that a local government decides that it wants to spend $20 million on constructing a convention center to serve both the local community and possibly outside groups who might use the facility for meetings or conferences. In general, what would a true economic impact study have to take into consideration? Of course, the study would look first at “the seen,” that is, the effect of the $20 million expenditure on the industries that might be directly impacted, such as the construction industry, local suppliers of materials and equipment, labor demand in these industries, etc. These would be immediate effects as the construction begins and is carried out to completion. Of course, local restaurants and hotels might benefit and therefore increase their output as a result of this new business. If labor is paid more in these industries, then these workers will go out and spend some of that money increasing the demand for other products. These are often called ripple or secondary effects of the $20 million expenditure, and they are what are typically called the “multiplier” effect of the initial spending.
The point is that, at least conceptually, these activities actually occur and can be seen. But what must be realized is that none of them is free. Every dollar that is spent as these “impacts” occur and every resource that is used, including labor, has an unseen opportunity cost. Starting with the original $20 million, the question is simple. What economic activities would have occurred if that money remained in the hands of the taxpayer? It would have been spent on various goods and services or saved in local banks and therefore would have had an economic impact that would also have had secondary effects associated with it. This would have to be subtracted from the visible effects.
During the process of building the convention center, as discussed, local resources will be used. For example, the demand for labor will increase which means that for some, wages will be increased in the process of bidding labor away from other possible uses. Some local industries unrelated to the construction of the convention center will see their costs rise and will either contract their business or reduce investment in future expansion. This means that other workers, again those not related to the construction of the convention center, will see a reduction in the demand for their services over what it otherwise would be and would face the prospect of lower wages.
The point to be made here is that this would occur while the visible ripple or secondary effects that are being analyzed are occurring. What needs to be understood is that the measurements of visible effects are actually describing how the building of the convention center, or any similar project, is absorbing resources away from other economic activities. A true assessment of the economic impact of this or any other project would have to estimate the losses due to these unseen activities and subtract them from the values associated with the seen activities.
The fact is that economic impact studies that are typically invoked by interest groups and state and local governments don’t even attempt to get it right. In a description of one of the more common models offered by the U.S Department of Commerce, it is stated that “As policy makers and the public are often skeptical about economic impact claims, you need credible analysis to demonstrate the effects of your project. State and local stakeholders need to understand how a new development may add to income, output, and employment in their economy.” This statement captures the essence of what is wrong with all commonly used economic impact models. It also helps explain why they cannot accurately be labeled as real “economic” models. The possibility of “new development” subtracting from any of these three variables is not part of the vision. There is a reason for this. The possibility that a new project could cause a net reduction in income, output, or employment is ruled out of the models by their methodology. The “unseen” of opportunity costs go unexamined and therefore unaccounted for. Bastiat would label this a “bad economics” I would go a step further and argue that it is not economics at all.