Memorandum

City of Lawrence

TO:              David L. Corliss, City Manager

                   Roger Zalneraitis, Economic Development Coordinator/Planner

FROM:          Rob Chestnut

DATE:           December 15^th, 2008

RE:               Outstanding Issues defined from October 14^th, 2008 memo related to the                            cost/benefit model

In response to items seeking input from commissioners from Roger’s memo, I have included my responses.  My responses are in blue.

. Conceptual Issues

“But-For”

Recommendation: consider and approve one of the following alternatives:

1) provide one benefit-cost ratio for each analysis, but note which one of the three is being provided and note that depending on one’s assumptions about the necessity of the subsidy, the benefit-cost ratio may actually be different; or

2) provide all three benefit-cost ratios with a brief explanation for each (eg- “with no subsidies,” “assuming a subsidy is necessary and is offered,” and “assuming a subsidy is not necessary and is offered”).  This would allow the City Commission to determine with their own judgment whether they believe the subsidy is necessary or even desired, and vote accordingly.

I support 1) above.  We must assume that incentives offered are an important consideration for any project.  In some instances the question is not if the investment will be made, but where the investment will be made.  Almost all projects considered will have multiple location alternatives with incentives included in each option.

In other instances, it is clear that a subsidy is necessary to provide a market return for the investor.  We have seen this case with the Oread TIF project that included an economic analysis necessary by policy. 

The one benefit-cost ratio calculated should include the incentives offered to ensure the benefit-cost ratio meets the threshold defined by the policy.  If the subsidy is not necessary, it should not be offered in the first place. 

The Discount Rate

Recommendation: continue with the current discount rate and methodology. 

I agree that the risk-free rate plus a premium for risk (one rate) is appropriate as is the current methodology.  It is important to note that TIF and TDD projects typically do not have up-front investment to calculate a benefit-cost.  Therefore, the economic study is important to determine if the subsidy is required to establish a minimum rate of return in the market. 

Treatment of Asset Sales and Acquisitions

Recommendation: continue treating asset divestitures as revenue and asset construction as a cost.  This will result generally in a more conservative outcome, as capital costs apply in almost every circumstance, and asset sales in a more limited number.  This is consistent with other cities’ approaches, and avoids treating assets sold and assets acquired differently.

I agree with the recommendation.  The important issue in benefit-cost is the net present value of incremental cash flows, not how revenue and cost are recognized from an accounting standpoint.  Sales produce cash, construction expends cash.  The incremental impact of these events on the rate of return is the key to measuring the overall benefit of the project.

Operational Issues

Cost and Revenue Items from City and County Budgets

Based on this review, and with consideration to keeping the model as simple as possible, one of the four following options is recommended:

1) Keep the model “as-is”- all costs and revenues from the General Operating Fund are included;

2) Exclude transfers only- this line item is largely part of the budget for reconciliation purposes, and has nothing to do with population, technology, or any other driver of City and County budgets;

3) Exclude only items above a certain cost threshold- many expenses and revenues, as noted with an asterisk, above, are small and have little impact on overall costs and revenues.  In order to simplify, we may wish to exclude only items over a certain dollar threshold (in this case $250,000) that are on this list;

4) Exclude all items identified by City and County staff as being non-sensitive to population.

I support 4) above.  I think it is critical to assess what we see as the true incremental

Impact of projects on City services versus a blanket assumption that all costs are impacted.  This will not produce an accurate benefit-cost ratio if the analysis loads down the project with costs that will not be directly impacted by a project.

Counting “Persons” in Lawrence and Douglas County

Type of “Person”                         Original Method                  Proposed Method

Resident, Unemployed*                     1 person                            1 person

Resident, Works in City/County           2 persons                         1 person

Resident, Works Elsewhere                1 person                            .5 persons

Non-Resident, Works in City/County    1 person                            .5 persons

*An “unemployed” resident is defined as any person who lives in the City or County who is not in the labor force.  This includes children, the retired, and those who either choose not to work or cannot find a job.

In the above example, the original method would have yielded 5 new “persons”, whereas the proposed method would show only 3 new persons.  The original method implies that a person who both lives and works within the taxing jurisdiction has twice the impact on costs and revenues as any other person in the locale.  It also implies that a commuter to a job in the taxing jurisdiction has the same impact as an “unemployed” person who lives in the City or County. 

Recommendation: adopt the proposed method for determining how many new “persons” there are in both the City and County.  This will make the calculation slightly more complicated, but will also eliminate a double-count on residents who work in the jurisdiction.

Agreed.  The original method overstates population impact on the analysis.

Average Versus M arginal Costs for Capital Improvements

Recommendation: under most scenarios, an average cost approach is acceptable.  If, however, a particularly large firm moves into the City or an under-served area, staff can use a marginal cost method through manually entering infrastructure costs.  The output should note whether capital costs were calculated or manually entered so the Commission knows how costs were assessed against the firm.

I agree with the recommendation.  Marginal impact on infrastructure would be impossible to determine, and it would likely distort the benefit-cost ratio on both sides depending on timing.  This does not make sense except in situations requiring investments that can clearly be identified with a singular project.

Spending on Construction

Recommendation: do not include construction activity in the model.  There are few if any benefits and many controversies surrounding how to incorporate construction benefits and costs.  It is also a conservative assumption to withhold some benefits, which is generally a preferable approach to measuring benefits.

I would like further information on this recommendation.  It appears to me that construction activities could have significant impact on the local economy despite being temporary.  We often look at economic impacts of concerts and other one-time events; I am not sure why we would exclude activities that could span for a number of months.

If the impacts are not determined to be material, then it may not be relevant to measure.  But, I would like to understand the possible impacts.

Output

The new model is entering the final stages of development.  At this point, it is reasonable to seek feedback on what management and the City Commission would like to see in terms of output.  At the very least, the following is recommended:

• The number of jobs created and capital investment by the firm
• The number of new households in the City and County
• Average wages of the jobs created by the firm
• The number of indirect jobs created by new economic activity
• Additional sales activity in the City and County
• Total revenues for a proposal
• Total costs for a proposal
• Costs of abatements or other incentives
• At least one benefit-cost ratio, and possibly three
• The discount rate used
• Whether capital costs for the new firm are average or marginal
• The net revenues (or costs) over different time periods in the project (years 1-5, years 6-10, years 11-15, and possibly years 16 and beyond for infrastructure projects)
• Sensitivity to key variables

Guidance is sought on whether these outputs are appropriate for the Commission to make recommendations, and if any additional outputs would be desired.  Further, a discussion of which variables to conduct a sensitivity analysis upon is required.

The output summary looks fine.  I will typically look at the assumptions in more depth, but the additional information required for a good decision by each commissioner will vary.  I think the presentations I have seen are concise and very informative.

This model is a significant move forward in understanding the variables for any potential investment.  It is a tremendous asset from my perspective that will improve our decision-making on economic development investments in the future.