Economic Development PolicyPart 3: Demand-side policies (a)

ECON 4480 State and Local Economies

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Demand-side Policies (2nd wave)• Demand-side policies emerged in the mid 1980s as a

response to the shrinking number of industrial relocations: the number of new plants was shrinking while the level of competition among states and localities was rapidly rising.

• States began to shift priorities, focusing less effort on recruitment and more on expanding existing firms and growing new firms.

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Demand-side Policies (2nd Wave)• Demand side policies are based on the view that the

private sector may not always be able to perceive opportunities or to act upon opportunities that may create local wealth.

• The point of demand-side policies is to discover these opportunities and to assist the private sector to take advantage of them, with the aim of pursuing the state’s long-term development goals (i.e., job growth, higher per capita income).

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Demand-side policies (2nd wave)• Demand side policies change the focus away from

putting together the best ‘deal’ for an industrial prospect towards policies that help businesses produce better, more competitive, goods and services.

• And much of the impetus for these policies comes from research that shows that industrial relocations produce just a small fraction of the job growth that occurs within a state.

• Instead, current businesses produce most of the new jobs.

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Sources of Job Growth

• The majority of job growth for a given state is generated by:– Small firms: in the U.S., 57% of job growth

occurred in firms with fewer than 250 employees; 34% in firms with 50 employees or less,

– Existing firms: In Tennessee, existing firms generate five times more jobs than new firms (openings, or births + relocations)

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Sources of Job Growth

• Thus, states should focus scarce resources on – Helping existing firms to grow,– Helping struggling existing firms to retain jobs,

and– Assisting new business start-ups.

• The traditional supply-side policy of recruiting large plants from other states or from overseas comes at a very high cost and a low likelihood of success.

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Job growth by establishment size

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Tennessee Payroll Employment 2001-2014

Establishment Size (Jobs) 2001 2014 Change

49 or less 793,669 916,211 122,542

249 or less 1,457,557 1,616,210 158,653 250 or more 776,106 668,265 (107,841) TOTAL 2,233,663 2,284,475 50,812

Source of Tennessee job growth 2001-2011

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Source: Business Employment Dynamics http://bls.gov/bdm/#data

Demand-side policies

• A few types of demand-side policies have emerged:– State-sponsored venture capital efforts,– Promotion of exports and foreign direct

investment (FDI), and – Geographically targeted policies such as

enterprise zones and tax increment financing.

• Venture capital efforts are discussed below in this powerpoint presentation.

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Venture capital programs

• By the mid-1980s, states accepted the notion that small business is an important key to economic growth, as opposed to recruiting large manufacturing plants.

• Small businesses were viewed as the major generators of new jobs and also the originators of a large share of new innovations and processes.

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Venture capital programs

• Growing small business allowed the states to move away from over-reliance on just a few manufacturing employers to many, but small, fast-growing employers.

• Governor Thornburgh of Pennsylvania said:– ‘It would be better to have 50 small companies

with 100 employees each than one with 5,000.’

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Venture capital programs

• The problem then becomes how best to develop small businesses?

• Business formation, survival, and expansion depend heavily on access to adequate capital.

• In particular, start-up businesses need access to ‘patient’ capital in the form of equity or long-term debt, as much time may be required to turn a profit.

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Venture capital programs

• Since this type of financing is not available from banks and stock exchanges for small firms and start-ups, a state government role is believed to be justified as a remedy to a perceived market failure.

• Access to financing is most critical for small businesses facing rapidly expanding markets or those engaged in extensive product development.

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Venture capital programs

• Supply-side programs do not address this need; IRBs are offered only to established firms with good credit histories.

• Venture capital is a part of equity capital financing: not a loan, the venture capitalist offers funds, and in return, receives a stake in the business.

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Sources of Capital

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Venture capital programs• Venture capital is high-risk financing of small

businesses at the gestation, start-up, and early expansion stages.

• In return for funds, the venture capitalist receives a share of ownership in the business and takes a an active role in providing guidance.

• Returns on investment are long-term and very uncertain.

• High risk can bring high rewards: venture capital investments can bring 20% annual returns or higher over a long period of time.

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Venture capital programs• Reasons used to justify a state government

role in venture capital financing:– 1) the VC industry is unstable: venture capital

funding is very sensitive to the business cycle; state funding adds much needed stability.

– 2) the private VC market tends to overlook opportunities except in a few large markets.

• California, New York, and Massachusetts dominate VC investments; 75% of the dollar investments for the U.S. in 2014.

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VC investments have struggled during the Great Recession

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California Dominates VC Funding

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Venture capital activity• Venture capital activity for the most recent

four quarters (to 2014:Q3):– United States: 4,294 deals, $41.7 billion

investment ($9.7 million per deal)

– Tennessee: 52 deals, $99.7 million investment ($1.9 million per deal)

– Per capita:• United States: 13.9 deals per million population, $135

per capita.• Tennessee: 8.2 deals per million population, $15.70 per

capita.– Source: National venture capital association (www.nvca.org)

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Venture capital programs• Reasons used to justify a state government

role in venture capital financing:– 3) Private VC markets may turn down deals that

offer the greatest local economic development benefits.

• Private VC turns down deals that are very small (less than $500,000); not worth the administrative and monitoring costs.

• These deals may very well produce the growth and innovation desired by states.

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Venture capital programs• The goals of these programs typically revolve

around these issues:– Jobs,– Competitiveness, and– Economic growth (rising per capita incomes).

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Venture capital programs• Several models exist for state involvement in

venture capital.– Direct investment by state agencies (rare),– Investments in a portfolio of private venture

capital partnerships• State invests in several VC firms that target the state,• State gets out of the business of picking winners and

losers.

– Tax credits for investors who invest in private VC funds.

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Venture capital programs• Oklahoma model: Oklahoma Capital

Investment Board (OCIB)– Borrows funds from banks.– Uses borrowed funds to invest in privately

managed venture capital funds (VCFs) that promise to focus substantial investments in the state.

– OCIB guarantees a minimum rate of return to the banks and guarantees against default.

– In case of failure by a VCF, OCIB can raise funds by selling state income tax credits.

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Venture capital programs• Oklahoma model: Oklahoma Capital

Investment Board (OCIB)– Since 1991 inception, the number of VCFs actively

involved in the state has increased from one to 14.– OCIB has committed over $60 million for these

VCFs, leveraging a total investment of $130 million for new small businesses.

– To date, no tax credits have had to be issued to cover losses.

– Benefits: Oklahoma benefits from economic growth and the state enjoys gains from the investments.

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Venture capital programs• Tennessee model: TNInvestco

– Brand new, enabling legislation passed this year.– State provides tax credits to selected VCFs, who

raise capital by selling the tax credits to insurance companies.

– Allocated $120 million (tax expenditure) for this purpose, invested in six VCFs operating in Tennessee.

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Venture capital programs• Tennessee model: TnInvestco

– Goals of state program:• ‘develop the entrepreneurial infrastructure across the

state, • to attract new capital to Tennessee, and • to diversify the state’s economy and create jobs

through the development of “innovation clusters” which result in new companies being spun off.’

• http://www.state.tn.us/ecd/tninvestco/overview.html

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Venture capital programs• Tennessee model: TNInvestco

– Requirements for a business to receive investment from a TNInvestco fund:

– The business must be independently owned and operated. – The business must be headquartered in Tennessee; its principal

business operations must be located in Tennessee, and at least 60% of its employees must be located in Tennessee.

– The business must not be principally engaged in professional accounting, medical, or legal services; banking or lending; real estate development; insurance; oil and gas exploration; or direct gambling services.

– Additionally, demonstration of a high-growth potential will be an important qualification for receipt of funding.

– The business must employ no more than 100 employees

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TNInvestco new project

• Health tech startup Shareable Ink moving to Nashville, lured by TNInvestco dollars, Nashville Business Journal, Wednesday, November 3, 2010.

• Company will receive $4.5 million in local venture capital, including some from a TNInvestco VCF, Tennessee Angel Fund.

• Company will develop and market software that reads physicians writing, digitizes and saves as electronic documents.

• Company moving from Boston area to be closer to the health care industry.

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VC Investment Activity United States 2011Q3 (Million $)

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Venture capital programs• Final observations about venture capital

programs:– VC programs extend the state’s role as a lender of

last resort to business start-ups.– States engage in this high-risk financing expecting

to generate significant long-run returns in terms of economic growth.

– Traditional supply-side financing is low-risk, focused on manufacturers.

– VC funding is high risk, focused on high-growth entrepreneurial companies with spin-off potential.

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Summary and Questions

1. What led to the rise of demand-side policies?2. Most job growth for a typical state occurs in

new, large firms. True or False?3. Demand side policies focus on growing

existing firms, retaining employment, and fostering new firms. True or False?

4. Bank lending is typically not available for business start-ups. True or False?

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Summary and Questions

5. Venture capitalists offer loans to business startups. True or False?

6. What are three reasons given for state government entrance into the venture capital market?

7. Describe the Oklahoma and Tennessee models for venture capital funding.

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