City Journal

William J. Stern
State Capitalism, New York Style
New York's economic development strategy is good for political insiders but bad for the economy.
Summer 1994

In February 1994, New York City and State and the Disney Corporation announced a “public-private partnership” in which the city and state will lend Disney $21 million at 3 percent interest, which Disney will use to rehabilitate and reopen the landmark New Amsterdam theater on West 42nd Street. The agreement is an attempt to give the 12-year-old state- and city-sponsored 42nd Street Redevelopment Project a much-needed push.

It may seem odd that New York City and State, both of which are facing serious fiscal problems, are lending money at bargain rates to a highly profitable corporation whose chairman earned $200 million in 1993. In fact, it is perfectly in keeping with the economic development philosophy that New York officials have pursued for the past three decades—a philosophy I call “state capitalism.” It is a philosophy based on the idea that these governments can act as all-knowing capitalists, allocating capital in a way that will maximize the creation of wealth, jobs, and tax revenues for New York.

State capitalism favors older industries over newer ones, established companies over up-and-coming ones, and the politically connected over ordinary citizens. It is a strategy that has failed, as evidenced by a variety of economic data. Forbes reported in January 1994 that one-third of Americans who lost their jobs during the recent recession lived in New York State, and that the state lost almost 10 percent of its private-sector jobs over four years. State capitalism takes three basic forms: tax breaks for specific corporations to keep them from leaving New York; public-private partnerships, or subsidies for favored developments; and developments that are built, owned, and operated by the government.

Tax Breaks for Corporations

In the first type of state capitalist venture, the state and city act as bureaucratic deal-makers. In order to prevent certain businesses from leaving the city, the governments award them a variety of tax breaks, cheaper energy costs, and other concessions. The businesses receiving these dispensations are almost always large, high-profile enterprises whose departure from the city would not only cost jobs and tax revenues but also cause embarrassment to New York’s political leadership.

Consider the deal the city cut in 1987 with NBC. The network was supposedly evaluating whether to relocate its headquarters from 30 Rockefeller Plaza either to New Jersey or to a proposed Donald Trump development on the west side, which the developer was calling “Television City.”

At first the city rejected any deals if NBC remained at Rockefeller Center. The deputy mayor for economic development pointed out that granting a reduction of existing taxes to a company that still had 13 years left on its lease would require a “complete reversal of city policy.” The city normally grants tax abatements only when a property is “valueless” or when its owner makes improvements; in the latter case, the abatement is for a share of the increase in the land’s value that comes with the improvements. NBC, the deputy mayor pointed out, wanted the city to forgo taxes it was already collecting on Rockefeller Center.

But the city changed its mind and reassessed the entire Rockefeller Center complex, lowering the tax rate until 2006, when the city is to begin phasing in a higher rate over 17 years. The city projected this agreement would save NBC $73 million in taxes. Moreover, the city would become the temporary owner of the network’s expanded Rockefeller Center space, entitling NBC to hundreds of millions of dollars in city industrial bond financing, as well as a full sales tax exemption. Adding up all the advantages of the deal they were offering, city officials estimated it would reduce NBC’s anticipated Rockefeller Center costs by half a billion dollars.

Other examples of this practice are numerous (see box). It is understandable that the city would wish to persuade a large employer to remain in the city. But the practice of ad hoc deal-making to induce particular companies to stay is misguided. For one thing, it creates an incentive for businesses to threaten to leave, even if they have no intention of doing so.

For another, it is extremely unfair both to ordinary taxpayers and to those businesses that are not recipients of a deal. New York politicians loudly criticize the Reagan era as one in which the government lavished the rich with tax breaks. It is downright hypocritical for them to enter into agreements giving large, wealthy corporations tax advantages not available to smaller, less affluent businesses.

This disparity points up the fundamental flaw of such deals as an economic development strategy. If even some of the city’s largest corporations find taxes and energy costs so burdensome that they consider leaving, the effect of these same costs is at least as great on small and midsize businesses and on entrepreneurs deciding where to locate a new venture. But because the thousands of little decisions made by entrepreneurs garner no publicity, the city offers few incentives for small firms to stay or start in New York.

The city and state’s deal-making is driven by politics, not economics. Its primary virtue is that it avoids the embarrassment that New York’s political establishment suffers when a big company leaves the city. Keeping a firm in the city by offering it tax breaks and subsidies serves only to disguise the essential truth that in the highly competitive global marketplace, the cost of doing business in New York is too high for everyone.

Public-Private Partnerships

The second economic development method used by New York’s state capitalists is the “public-private partnership,” in which the government subsidizes selected corporations in order to induce them to make their own investments in New York City.

The 42nd Street Redevelopment Project exemplifies two of the problems with this practice. First, results come slowly if at all. The project was initiated in 1982. A dozen years later, no one would suggest that 42nd Street has been revitalized. In fact, the existence of the project may very well have retarded the area’s development during the 1980s, as the uncertainty created by the involvement of state and city government made potential investors wary.

Second, such partnerships ignore basic economic realities. The central reason for financial difficulties in the theater district—half of Broadway’s 35 theaters were dark this past season, and there has been virtually no commercial real estate development in the area—has been New York City’s deep and lingering recession. Government can best help the theater district by adopting policies that aid instead of hinder the overall New York economy. The redevelopment project reflects the illusion that the government can somehow reach into the body of the economy and give a transfusion to a vital organ, allowing it to thrive even while the rest of the body is withering.

Battery Park City, a lower Manhattan development consisting of luxury apartments and offices, has been loudly proclaimed as a government success story. It was initially financed in 1972 with $200 million of moral obligation bonds issued by the state; the Battery Park City Authority has paid approximately $14 million a year in debt service since then. There has been much talk of expanding the activities of this “profitable” authority, northward on the Hudson as well as within the present project area.

Battery Park City is indeed an impressive development. But how much sense does it make for the government to have subsidized it? There was no shortage of office and luxury apartment development by the private sector in New York City during the 1980s. In fact, with hindsight, we can say there was a sizable over-expansion in lower and midtown Manhattan, which market forces have been correcting since 1988. In other words, the state government subsidized exactly the kind of development that went on all over the city without government subsidy.

Of course, at the time the project was initiated, officials did not know that this kind of expansion was going to take place. But that is precisely the point: How could they have known? How can they ever know? Even if individuals in state and city government could allocate capital with a kind of divine wisdom, these state capitalist projects take so long from inception to completion that all the assumptions that justify the initiation of a project no longer hold true by the time it is completed. The accelerating speed of change in the global market economy is simply not compatible with the slow pace that characterizes all state capitalist endeavors.

The Battery Park City “success story,” then, is actually an excellent example of the inefficiency of state capitalism. Battery Park subsidized office space and luxury apartments, goods that were widely available, at a time when there was a severe shortage of low and moderately priced housing in New York City. It is rather like the government-run department stores of communist Bulgaria, which would often have a wide variety of socks available even though no shoes could be purchased anywhere.

Yet another example is the South Street Seaport, a city, state, and federally financed shopping complex on an East River pier and nearby Fulton Street. Today many of the restaurants and shops that comprise the Seaport complex are in financial difficulty, squeezed by high rents and the city’s recession. Surveys have shown that the patrons of the area are people who, if they were not shopping and eating at the Seaport, would be frequenting establishments in other parts of Manhattan. Government has subsidized yet another zero-sum activity that merely alters who gets what slice of the economic pie and contributes nothing to the making of a bigger pie.

Government Developments

In the third type of state capitalist project, the state or city dispenses with subsidies, deals, and partnerships and enters a business itself.

The World Trade Center is a prominent example of this development method. The Port Authority of New York and New Jersey, a bistate institution, began construction on the Twin Towers in 1966. The idea was that the World Trade Center would house export and import companies, enhancing New York’s position as the trade capital of the world. In fact, the center’s tenants are mostly government agencies and financial firms. The project has served primarily as a subsidized competitor for other commercial real estate developers.

The Javits Convention Center is another example, one in which I became involved as chairman of the Urban Development Corporation (UDC). The state had initially financed the project in 1980 through the issuance of term bonds by the Triborough Bridge and Tunnel Authority (TBTA). A convention center, of course, has little to do with bridges and tunnels. But the TBTA became the financing vehicle because it had the necessary credit to issue bonds, while the UDC, the authority responsible for initiating the project, had nearly brought the state into bankruptcy in the mid-1970s. Because an authority, rather than the state government itself, issued the bonds, voter approval was not required. Yet our grandchildren will be paying off the debt incurred in the center’s construction.

The state established a bewildering set of bureaucracies to oversee the project. A UDC subsidiary called the New York Convention Center Development Corporation (CCDC) would build the center. The TBTA was an equal stockholder in the CCDC; the chairmen of the UDC and the Metropolitan Transportation Authority (which oversees the TBTA) each had two votes on the CCDC board. Another corporation was organized, the New York Convention Center Operating Corporation (CCOC), to take over from the CCDC and manage the facility after it was built. The CCOC’s board is appointed by the governor, the mayor, and the leaders of the State Legislature. (Note that New York’s state capitalists use the terminology of market capitalists—subsidiaries, stockholders, board of directors—even though their activities are monopolistic and ultimately supported by the taxpayers.)

If one drew an organizational chart for the convention center project, there would be no box or even boxes at the top. Literally no one was responsible for a project that cost taxpayers more than $2 billion, after inflation. When I arrived at the UDC early in 1983, construction had been underway for two years. I soon discovered that a major engineering problem was being hidden from the public: the “nodes,” an essential part of the center’s unique space frame design, were not passing quality assurance tests and thus were unsafe. Since there were no direct lines of organizational authority, the only way I could do anything about the problem was to take my case to the press, hoping an uproar would develop that would influence events in the right direction—which, fortunately, is what happened. The safety problem was cured, but the project concluded two years behind schedule and some $300 million over budget.

I also discovered that the center’s planners had conducted no serious investment analysis before undertaking the project. As is typical in state capitalist projects, the UDC had prepared detailed statistics purporting to show what is called the “multiplier effect.” These reports estimated the amount of money that the convention center’s visitors and construction would add to the city’s economy. Extrapolating from these data, the reports estimated the number of permanent and temporary jobs that would be created, the amount of taxes collected by the city and state, revenue generated for the city’s hotel, restaurant, and entertainment industries, and so forth. Based on these estimates, the project was pronounced economically sound, financially viable, and “profitable” for the city.

The trouble with this kind of analysis is that it does not present any alternate investment analysis. It ignores the question: What if the same money had been used to build something else—a computer software industrial park, a high-tech fish farm, a biomedical research facility?

Even more important, it does not calculate the “demultiplier” effect of such a project. It fails to ask: What if the tax money spent on building and managing a convention center had been left in the pockets of the citizens and businesses of the state, to be employed in the normal market economy? We will never know the answer to this question. But it requires an enormous leap of faith and ignorance of economic history to reject the principle that if individuals and businesses are allowed to make their own investment decisions in a market economy, the results are generally far superior than if the government makes those decisions for them.

A New Strategy

State capitalism has been New York’s dominant economic development philosophy for three decades. During that time, New York’s economy has steadily declined. Using figures provided by the U.S. Bureau of Economic Analysis, the Empire Foundation estimates that between 1963 and 1992 New York’s Gross State Product grew only about half as much as the nation’s Gross Domestic Product. New York’s personal income growth during the same period lagged behind that of the nation as a whole by almost 30 percent, and the state’s job creation rate was less than one-fifth of the national rate.

State capitalism has, however, enabled a group of political insiders to enrich themselves at taxpayer expense. New York’s economic development policies have produced what Eastern Europeans call a nomenklatura—a privileged class of people who benefit handsomely from government involvement in the economy, at public expense. New York’s nomenklatura includes politicians, public finance specialists on Wall Street, politically connected lawyers, public relations people, and lobbyists.

New York should abandon state capitalism in favor of a new economic development strategy based on the principle that the market can allocate capital far more productively than government. Such a strategy would have two parts.

First, remove the impediments to doing business in New York. New York’s leaders must not only cut overall taxes and regulations, but also carefully examine the types of taxes they levy and eliminate those that are the most counterproductive. If we need to encourage the formation of small businesses, why do we have state and local capital gains taxes? If our energy costs are already uncompetitive, why did we require Con Edison to pay $1.3 billion in state and local taxes in 1993? The latter tax is especially perverse, given that most of the deals the state and city cut to keep large corporations here involve a reduction of energy costs—which are driven higher by the taxes utility companies pay.

Second, reduce the size and scope of New York’s government. New York is inhospitable to business in large measure because the private sector must support an enormous welfare state. In a highly competitive global economy, New York simply cannot afford a government of its present size. Entrepreneurs know the burden they will bear if they invest or start a business in New York, and it is increasingly easy for them to go elsewhere.

New York might look for an example to the new governor of New Jersey, Christine Todd Whitman, who has embarked on an ambitious tax-cutting program. At the same time, she has challenged New Jersey’s state capitalists, repudiating a plan to subsidize the move of the NBA’s Philadelphia 76ers to Camden, vowing not to use tax money to lure the New York Yankees across the Hudson, and suggesting that the state sell the Meadowlands sports complex. Governor Whitman’s willingness to challenge the nomenklatura of her state should be an inspiration for New York’s political leaders to do the same.

New York has become economically uncompetitive, and it is becoming increasingly difficult to hide this fact behind deals, partnerships, subsidies, and other state capitalist endeavors. If we are to prosper in the twenty-first century, we must adopt a new economic development strategy, one that unleashes the market economy rather than tries to create wealth by bureaucratic fiat.

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