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Federal Reserve Bank of St. Louis working papers are preliminary materials circulated to stimulate discussion and critial comment.

Applied Microeconomics

Out-of-Shool Suspensions and Parental Involvement in Children's Education

Do parents alter their investment in their child’s human capital in response to changes in school inputs? If they do, then ignoring this effect will bias the estimates of school and parental inputs in educational production functions. This paper tries to answer this question by studying out-of-school suspensions and their effect on parental involvement in children’s education. The use of out-of-school suspensions is the novelty of this paper. Out-of-school suspensions are chosen by the teacher or the principal of the school and not by parents, but they are a consequence of student misbehavior. To account for the nature of these out-of-school suspensions, they are instrumented with measures of “principal’s preference toward discipline.” The estimates show that, without controlling for selection, the level of parental involvement is negatively correlated with the number of out-of-school suspensions. Once selection is accounted for, the effect disappears that is, out-of-school suspensions do not affect parental involvement in children’s education.

Optimal Auditing and Insurance in a Dynamic Model of Tax Compliance

We study the optimal auditing of a taxpayer’s income in a dynamic principal- agent model of hidden income. Taxpayers in our model initially have low income and stochastically transit to high income that is an absorbing state. A low-income taxpayer who transits to high income can underreport his true income and evade his taxes. With a constant absolute risk-aversion utility function and a costly and imperfect auditing technology, we show that the optimal auditing mechanism in our model consists of cycles. Within each cycle, a low-income taxpayer is initially unaudited, but if the duration of low-income reports exceeds a threshold, then the auditing probability becomes positive. That is, the tax authority guarantees that the taxpayer will not be audited until the threshold duration is reached. We also find that auditing becomes less frequent if the auditing cost is higher or if the variance of income is lower.

Immigration Policy and Counterterrorism

A terrorist group, based in a developing (host) country, draws unskilled and skilled labor from the productive sector to conduct attacks in that nation and abroad. The host nation chooses proactive countermeasures. Moreover, a targeted developed nation decides its optimal mix of immigration quotas and defensive counterterrorism actions. Even though proactive measures in the host country may not curb terrorism directed at it, it may still be advantageous in terms of national income. Increases in the unskilled immigration quota augment terrorism against the developed country. By contrast, increases in the skilled immigration quota can reduce terrorism in the developed country if skilled migrants have a small marginal impact on terrorism there. When the developed country assumes a leadership role, it strategically should reduce its skilled immigration quota to induce more proactive measures in the host developing country.

The Distributional Burden of Instant Lottery Ticket Expenditures: An Analysis by Price Point

This article examines the distributional burden of different price-point instant lottery games. Theoretical reasons exist for expecting higher-priced instant lottery games to be less regressive than lower-priced instant games. Using county-level data on sales by price point for six states, the empirical results show that higher-priced instant games are less regressive than lower priced games. In addition, regressivity is rejected in favor of proportionality for some instant lottery games. The analysis also reveals that counties having a higher-percentage of low-income households have higher sales of lower-priced instant games, but differences in the distribution of household income have no significant impact on higher-priced instant sales. Taken together, the findings suggest that large differences in the distributional burden of individual instant games are masked if aggregated instant-lottery sales data are used.

Foreign Direct Investment, Aid and Terrorism: An Analysis of Developing Countries

Using a dynamic panel data framework, we investigate the relationship between the two major forms of terrorism and foreign direct investment (FDI). We then analyze how these relationships are affected by foreign aid flows. The analysis focuses on 78 developing countries for 1984- 2008. Our findings suggest that all types of terrorism depress FDI. In addition, aid mitigates the negative effects of total and domestic terrorism on FDI; however, this is not the case for transnational terrorism. This finding highlights that different forms of terrorism call for tailoring mitigating strategies. Foreign aid apparently cannot address the causes and supply lines of transnational terrorism. Aid’s ability to curb the risk to FDI for total and domestic terrorism is extremely important because (i) domestic terrorism is an overwhelming fraction of the total terrorism for many developing nations, and (ii) FDI is an important engine of development for these nations.

The role of schools in the production of achievement

What explains differences in pre-market factors? Three types of inputs are believed to determine the skills agents take to the labor market: ability, family inputs, and school inputs. Therefore to answer the previous question it is crucial to understand first the relative importance of each of those inputs. The literature on the production of achievement has not been able to provide an estimation that can take the three factors into account simultaneously at the student level. This paper intends to fill this gap by providing an estimation of the production function of achievement where both types of investments (families and schools) are considered in a framework where the inputs are allowed to be correlated with the unobserved term, ability to learn. I do that by using parents’ saving for their child’s postsecondary education to control for the unobserved component (i.e., ability to learn) in the production of skills. The estimates for the role of family inputs are in line with previous …findings. Additionally, the estimates of school inputs show that they are also important for the formation of students’ skills even after controlling for ability to learn.

International Oligopoly, Barriers To Outsourcing And Domestic Employment

Barriers to outsourcing that are being currently implemented in the US effectively tax its companies who “export” jobs through outsourcing. The objective is to raise domestic employment. Given that many of the important international markets where the US has a comparative advantage feature non-atomistic firms, we evaluate the implications of such policies in an oligopolistic context. We find that while an outsourcing tax favors domestic workers by causing firms to switch to a greater use of domestic sources (the substitution effect), the loss in international competitiveness has a negative volume effect (the output effect), which pulls in the other direction. First, we identify the conditions that determine the relative strengths of these effects, which inform us about the conditions under which such a tax achieves its stated objective. Next, we consider the international policy interdependence that arises when a competing nation also engages in such a policy. An interesting finding is that even if a unilateral tax by the US raises its employment, this may turn around in a Nash policy equilibrium, where the competing nation abandons free trade and also engages in unilateral outsourcing policies. Finally, we extend the basic model to look at the effects of credit shortage and product differentiation. Interesting findings are that both a credit crisis (as in recent years) and increased product differentiation tend to worsen the employment effects of the outsourcing tax. The qualitative nature of our findings is similar between Cournot and Bertrand competition, suggesting that our results are robust to the mode of strategic behavior.

Crime and Arrests: Deterrence or Resource Reallocation?

We use monthly time-series data for 20 large U.S. cities to test the deterrence hypothesis (arrests reduce crimes) and the resource reallocation hypothesis (arrests follow from an increase in crime). We find (1) weak support for the deterrence hypothesis, (2) much stronger support for the resource reallocation hypothesis, and (3) differences in city-level estimates suggest much heterogeneity in the crime and arrest relationship across regions.

Economic Freedom and Employment Growth in U.S. States

We extend earlier models of economic growth and development by exploring the effect of economic freedom on U.S. state employment growth. We find that states with greater economic freedom – defined as the protection of private property and private markets operating with minimal government interference – experienced greater rates of employment growth. In addition, we find that less restrictive state and national government labor market policies have the greatest impact on employment growth in U.S. states. Except for labor market policies, we find that state employment growth is influenced by state and local government policies, but not the policies of all levels of government, including the national government. Our results suggest that policy-makers concerned with employment should seriously consider the degree to which their own labor market policies, as well as those of the national government, may be limiting economic growth and development in their respective states.

Where Does Noise Fall on People? Evidence from the Atlanta Airport

Spatial heterogeneity of the determinants of airport noise is explored using houses sold near the Atlanta airport. Ordered probit locally weighted regressions (OPLWR) produce results substantively different than those using standard ordered probit. We find notable differences in the signs and magnitudes of the parameter estimates for different individual observations using OPLWR. For example, using a standard ordered probit model, the coefficient estimate for the connection between the percentage of neighborhood households headed by a Hispanic and noise is double the average of the OPLWR estimates. Moreover, while the standard ordered probit point estimate is positive, 37 percent of the estimates using OPLWR are negative. Even in relatively small areas, the OPLWR results imply that the standard ordered probit model can generate biased estimates due to ignored heterogeneity among individual houses.

Is the International Border Effect Larger than the Domestic Border Effect? Evidence from U.S. Trade

Many studies have found that international borders represent large barriers to trade. But how do international borders compare to domestic border barriers? We investigate international and domestic border barriers in a unified framework. We consider a data set of exports from individual U.S. states to foreign countries and combine it with trade flows between and within U.S. states. After controlling for distance and country size, we estimate that relative to state-to state trade, crossing an individual U.S. state’s domestic border appears to entail a larger trade barrier than crossing the international U.S. border. Due to the absence of governmental impediments to trade within the United States, this result is surprising. We interpret it as highlighting the concentration of economic activity and trade flows at the local level.

Do Large Banks Have Lower Costs? New Estimates of Returns to Scale for U.S. Banks

The number of commercial banks in the United States has fallen by more than 50 percent since 1984. This consolidation of the U.S. banking industry and the accompanying large increase in average (and median) bank size have prompted concerns about the effects of consolidation and increasing bank size on market competition and on the number of banks that regulators deem “too–big–to–fail.” Agency problems and perverse incentives created by government policies are often cited as reasons why many banks have pursued acquisitions and growth, though bankers often point to economies of scale. This paper presents new estimates of ray-scale and expansion-path scale economies for U.S. banks based on non-parametric local-linear estimation of a model of bank costs. Unlike prior studies that use models with restrictive parametric assumptions or limited samples, our methodology is fully non-parametric and we estimate returns to scale for all U.S. banks over the period 1984–2006. Our estimates indicate that as recently as 2006, most U.S. banks faced increasing returns to scale, suggesting that scale economies are a plausible (but not necessarily only) reason for the growth in average bank size and that the tendency toward increasing scale is likely to continue unless checked by government intervention.

Biofuel Subsidies: An Open Economy Analysis

This paper explores optimal biofuel subsidies in a general equilibrium trade model. The focus is on the production of biofuels such as corn-based ethanol, which diverts corn from use as food. In the small-country case, when the tax on crude is not available as a policy option, a second-best biofuel subsidy may or may not be positive. In the large-country case, the twin objectives of pollution reduction and terms-of-trade improvement justify a combination of crude tax and biofuel subsidy for the food exporter. Finally, we show that when both nations engage in biofuel policies, the terms-of-trade effects encourage the Nash equilibrium subsidy to be positive (negative) for the food exporting (importing) nation.

The Effects of Recessions Across Demographic Groups

The burdens of a recession are not spread evenly across demographic groups. The public and media, for example, noticed that, from the start of the current recession in December 2007 through June 2009, men accounted for more than three quarters of net job losses. Other differences have garnered less attention, but are just as interesting. During the same period, the employment of single people fell at more than twice the rate that it did for married people, while black employment fell at one-and-a-half times the rate that white employment did. To have a more complete understanding about what recessions mean for people, this paper examines the different effects of this and previous recessions on employment experiences across a range of demographic categories: sex, marital status, race, age, and education level.

The Role of Location in Evaluating Racial Wage Disparity

A standard object of empirical analysis in labor economics is a modified Mincer wage function in which an individual’s log wage is specified to be a function of education, experience, and an indicator variable identifying race. We analyze this approach in a context in which individuals live and work in different locations (and thus face different housing prices and wages). Our model provides a justification for the traditional approach, but with the important caveat that the regression should include location specific fixed effects. Empirical analyses of men in U.S. labor markets demonstrate that failure to condition on location causes us to (i) overstate the decline in black-white wage disparity over the past 60 years, and (ii) understate racial and ethnic wage gaps that remain after taking into account measured cognitive skill differences that emerge when workers are young.

The Revenue Performance of Casinos after a Smoking Ban: The Case of Illinois

Recent state-wide smoking bans are likely the most significant regulations imposed on the casino gaming industry. We explore the effects that the Illinois state smoking ban has had on Illinois casino revenue and attendance as well as casino tax revenue. Our empirical methodology extends and enhances that of previous literature in that we observe a natural experiment in comparing the performance of Illinois casinos with out-of-state casinos (no smoking ban) that share a market with Illinois casinos. Estimates suggest that revenue and admissions at Illinois casinos declined by more than 20 percent ($400 million) and 12 percent, respectively. Calculations reveal that casino tax revenue to state and local governments declined by approximately $200 million.

Poverty, Political Freedom and the Roots of Terrorism in Developing Countries: An Empirical Assessment

This paper finds that political freedom has a significant and non-linear effect on domestic terrorism, but this effect is not significant in the case of transnational terrorism. Some of our other novel findings are that while geography and fractionalization may limit a county’s ability to curb terrorism, the presence of strong legal institutions deters it.

Foreign Aid as Counterterrorism Policy

This paper presents a model where foreign aid bolsters a developing country’s proactive counterterrorism efforts against a resident transnational terrorist group. In stage 1 of the game, the donor country allocates resources to terrorism-fighting tied aid, general assistance, and defensive actions at home. The recipient country then decides its proactive campaign against the common terrorist threat in stage 2, while the terrorists direct their attacks against the donor and recipient countries in stage 3. Terrorists’ choices in the final stage provide a solid microfoundation for the terrorists’ likelihood of success function. In stage 2, greater tied aid raises the recipient country’s proactive measures and regime instability, while increased general aid reduces these proactive efforts and regime instability. In stage 1, a donor’s homeland security decisions are interdependent with its aid package to a recipient country, hosting resident transnational terrorists. This interdependency has gone unrecognized to date.

Toxic Exposure in America: Estimating Fetal and Infant Health Outcomes

We examine the effect of toxic exposure on U.S. infant and fetal mortality rates between 1989 and 2002 from toxic pollution released by facilities reporting to the Toxic Release Inventory (TRI). Unlike previous studies, we control for toxic pollution from mobile sources and from non-TRI reporting facilities. We find significant adverse effects of TRI exposure on infant mortality. There is evidence that health effects vary across media: air and water having a larger impact than land pollution. And, within air, we find that releases of carcinogens are particularly problematic for infant health outcomes. We estimate that the average county-level decreases in TRI concentrations between 1988 and 2002 saved in excess of 13,800 infant lives.

U.S. Commercial Bank Lending through 2008:Q4: New Evidence from Gross Credit Flows

What was hiding behind the aggregate commercial bank loans through the end of 2008? We use balance sheet data for every insured U.S. commercial bank from 1999:Q1 to 2008:Q4 to construct credit expansion and credit contraction series and provide new evidence on changes in lending. Until 2008:Q3 net credit growth was not dissimilar to the 1980 and 2001 recessions. However, between the third and fourth quarter credit contraction grew larger than credit expansion across all types of loans and for the largest banks. With the inclusion of 2008:Q4 data our series most resemble the intensification of the Savings and Loan crisis. <p><a href=\"/econ/contessi/2009_011_appendix.pdf\" class=\"icon-pdf\">Appendix</a></p>

Are Children "Normal"?

In his classic work on the economics of fertility, Becker (1960) suggests that children are likely “normal.” We examine this contention. Our first step is documenting an empirical regularity about the cross section of non-Hispanic white married couples in the U.S.: When we restrict comparisons to similarly-educated women living in similarly-expensive locations, completed fertility is positively correlated with the husband’s income. The empirical evidence is consistent with a simple model of household location and fertility choice, with children being “normal.” But this evidence does not settle issues of causality. In an effort to sort out causal effects, we undertake a rather specialized empirical exercise to analyze the localized impact on fertility of the mid 1970s increase in world energy prices—an exogenous shock that substantially increased men’s incomes in the Appalachian coal-mining region. Empirical evidence for that population indicates that fertility is increasing in men’s income.

Subprime Mortgage Design

This paper offers evidence on the design of subprime mortgages as bridge-financing products. We show that the viability of subprime mortgages was uniquely predicated on the appreciation of house prices over short-horizons. High rates of early prepayments on subprime mortgages are suggestive of the use of prepayments as an exit option. This paper argues that high early defaults on post-2004 originations can be explained when one considers high early prepayment rates for pre-2004 originations.

Subprime Loan Quality

This paper is an exploration of subprime mortgages over the cohorts from 2000 through 2006, especially those prior to 2004. In particular, this study contrasts subprime originations during the “boom years” of 2004-2006 with originations during an “early period” of 2000-2002. We develop a counterfactual technique to determine how originations during the early period would perform in a different environment, namely, the environment faced by originations in 2004, 2005, and 2006. We find that representative originations during the early period of 2000-2002 would not have performed significantly better than representative originations in 2004, 2005, and 2006. This result is robust to counterfactual exercises for originations with different LTVs. We conclude that mortgages of early cohorts were no less vulnerable to the environment faced by cohorts of 2004-2006.

The Interplay Between Preemptive and Defensive Counterterrorism Measures: A Two-Stage Game

A two-stage game depiction of counterterrorism is presented, where the emphasis is on the interaction between the preemptive and defensive measures taken by two targeted countries facing a common threat. The preemptor is likely to be the high-cost defender with the greater foreign interests. A prime-target country may also assume the preemptor role. The analysis identifies key factors – cost comparisons, foreign interests, targeting risks, and domestic terrorism losses – that determine counterterrorism allocations. The study shows that the market failures associated with preemptive and defensive countermeasures may be jointly ameliorated by a disadvantaged defender. Nevertheless, the subgame perfect equilibrium will still be suboptimal owing to a preemption choice that does not fully internalize the externalities.

City Business Cycles and Crime

We explore the influence of city-level business cycle fluctuations on crime in 20 large cities in the United States. Our monthly time-series analysis considers seven crimes over an approximately 20-year period: murder, rape, assault, robbery, burglary, larceny, and motor vehicle theft. Short-run changes in economic conditions, as measured by changes in unemployment and wages, are found to have little effect on city crime across many cities, but property crimes are more likely to be influenced by changes in economic conditions than are more violent crimes. Contrary to the deterrence hypothesis, we find strong evidence that in many cities more arrests follow an increase in crime rather than arrests leading to a decrease in crime. This is true especially for the more visible crimes of robbery and vehicle theft and suggests that city officials desire to remove these crimes from the public’s view.

Local Price Variation and Labor Supply Behavior

In standard economic theory, labor supply decisions depend on the complete set of prices: the wage and the prices of relevant consumption goods. Nonetheless, most of theoretical and empirical work ignores prices other than wages when studying labor supply. The question we address in this paper is whether the common practice of ignoring local price variation in labor supply studies is as innocuous as has generally been assumed. We describe a simple model to demonstrate that the effects of wage and non-labor income on labor supply will typically differ by location. We show, in particular, the derivative of the labor supply with respect to non-labor income will be independent of price only when labor supply takes a form based on an implausible separability condition. Empirical evidence demonstrates that the effect of price on labor supply is not a simple “up-or down shift” that would be required to meet the separability condition in our key proposition.

The Dynamic Interaction of Order Flows and the CAD/USD Exchange Rate

We explore the relationship between disaggregated trading flows, the Canada/U.S. dollar (CAD/USD) market and U.S. macroeconomic announcements with a novel data set of unprecedented breadth and length. Foreign financial trading flows appear to demand liquidity, contemporaneously driving the CAD/USD while commercial trading flows seem to be price sensitive, providing liquidity in response to exchange rate movements. Despite strong contemporaneous correlations with trading flows, exchange rate returns are generally not predictable, except for some intriguing success at long horizons. This failure contrasts with much, but not all, previous research on the topic. While two types of CAD trading flows and the CAD/USD appear to be cointegrated, such structure is probably spurious. There appear to be structural breaks in the order-flow-exchange rate VECM systems in 1994-1996 and 1998-1999. <a href="http://research.stlouisfed.org/econ/cneely/Data_Appendix_The_Dynamic_Interaction.pdf">Data Appendix</a>.

Income and Lottery Sales: Transfers Trump Income from Work and Wealth

The effect of income on lottery expenditures has generally been studied using an aggregate measure of income, usually personal income. Reasons exist for thinking that lottery expenditures do not respond equally to all sources of income. This paper examines lottery consumption and income from three sources, namely income from earnings, wealth, and transfer payments. Using county-level data for seven states and controlling for demographic and other characteristics, we find that each source of income has a different effect on lottery ticket expenditures. A noteworthy finding is that purchases are most strongly influenced by changes in transfer payments. Several policy implications follow from our results.

Urban Crime and Labor Mobility

We present a model of crime where two municipalities exist within a metropolitan statistical area (MSA). Consistent with the literature, local law enforcement has a crime reduction effect and a crime diversion effect. The former confers a spillover benefit to the other municipality, while the latter a spillover cost. If the net spillovers are positive (negative), then the respective Nash enforcement levels are too low (high) from the perspective of the MSA. When we allow for Tiebout type mobility, labor will move to the location offering lower disutility of crime (including the tax burden). To attract labor, both jurisdictions would like to reduce crime in their municipality. Interestingly, this could raise or reduce enforcement compared with the immobility case. If it was too high (low) under immobility, it will be raised (reduced) further under mobility. In the symmetric case, neither can gain any labor, but the competition for it pushes the jurisdictions further away from the efficient outcome. Thus, mobility is necessarily welfare reducing. Next, we consider asymmetry in the context of differences in efficiency of enforcement. The low cost municipality has the lower crime damage (inclusive of the tax burden) and attracts labor. Mobility is necessarily welfare reducing for the high cost municipality and for the MSA, but it has an ambiguous effect on the low cost municipality. Finally, we extend the model and allow residents to choose between productive and criminal activities. We conclude that to the extent that enforcement increases the number of criminals (“replacement effect”), jurisdictions have an incentive to reduce their enforcement levels relative to the no-occupational choice case. Additionally, the equilibrium levels of enforcement are more likely to be overprovided in the presence of occupational choice.

Human Capital Externalities and Adult Mortality in the U.S.

Human capital is now widely recognized to confer numerous benefits, including higher incomes, lower incidence of unemployment, and better health, to those who invest in it. Yet, recent evidence suggests that it also produces larger, social (external) benefits, such as greater aggregate income and productivity as well as lower rates of crime and political corruption. This paper considers whether human capital also delivers external benefits via reduced mortality. That is, after conditioning on various individual-specific characteristics including income and education, do we observe lower rates of mortality in economies with higher average levels of education among the total population? Evidence from a sample of more than 200 U.S. metropolitan areas over the decade of the 1990s suggests that there are significant human capital externalities on health. After conditioning on a variety of city-specific characteristics, the findings suggest that a 5 percentage point decrease in the fraction of college graduates in the population corresponds to a 14 to 36 percent increase in the probability of death, on average. Although I am unable to identify the precise mechanism by which this relationship operates, it is certainly consistent with the idea that interactions with highly educated individuals - who tend to exhibit relatively healthy behaviors - encourage others to adopt similar behaviors. Evidence of a significant inverse relationship between aggregate human capital and smoking, conditional on personal characteristics, in a sample of 226 U.S. metropolitan areas is also consistent with this hypothesis.


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