Introduction

Over the last four decades, deindustrialization, automation, trade with China, the rise of the tech economy, and industry concentration have all contributed to the country’s regional divergence in economic prosperity. A 2019 Brookings report found that 90 percent of growth in high-tech jobs happened in just five metropolitan areas–Boston, San Francisco, San Jose, Seattle, and San Diego. In other words, wealth and prosperity are becoming increasingly concentrated in a few metro areas, while most of the nation is scrambling to stay competitive.

Until the early 1980s, America’s growth was a story of regional convergence. The American middle class resided across all of America. In the 1960s, the list of top 25 richest cities included Rockford, Illinois; Milwaukee, Wisconsin; Ann Arbor, Michigan; Des Moines, Iowa; and Cleveland, Ohio. In 1978, per capita income in metropolitan Detroit was virtually identical to that in the metropolitan New York City area; by 2019, per capita income in metro Detroit was just half of that in the New York metro.¹ Today, all 25 richest cities are on the coasts, including the Washington region. The Washington region experienced a particularly robust economic growth between 1980 and 2010, largely due to increased federal spending. However, following the Great Recession, the Washington region has lagged behind its major metropolitan peers.² In 1989, the Washington metropolitan area had the third highest per capita income in the nation, but by 2019, it had slipped to 13th place.

The region’s close proximity to the federal government serves as a double-edged sword. For several decades federal spending has been a boon for region’s growth. In fact, even in the heart of the Great Recession, the region was sheltered from the worst effects. However, reductions in federal spending following the Great Recession, both in payroll and contracting, resulted in no growth in 2013 and smallest job growth rate among nation’s largest 15 metropolitan areas in 2014.³

The economic development community is in broad agreement that the region needs to replace its historic dependence on federal spending with private sector-driven investments in order to increase the region’s GDP and create more employment. The mounting federal deficit and the U.S.’s waning economic supremacy in the world indicate that federal spending can no longer be a reliable driver for the region’s next wave of economic growth. The arrival of President Biden’s administration has altered this calculus and the federal government may favor the region longer than expected. In part because of COVID-19 pandemic, the Biden administration passed a series of Roosevelt era-type big government spending measures with the $1.9 trillion American Rescue Plan and also possibly the “one-in-a-generation” $2 trillion infrastructure and climate plan. Big government spending is usually good for the region, but it remains to be seen how long these expenditures will flow to the Washington metropolitan area.

This report identifies industries that the District of Columbia should target with tax incentives in order to increase business expansion, employment, and annual payroll growth – thus increasing GDP. I analyze the District’s economic development incentives using the Panel Database of Incentives and Taxes (a comprehensive economic incentives database) and examine how effectively the District and surrounding jurisdictions in Virginia and Maryland⁴ target tax incentives to sectors with local comparative advantages. Regions have a comparative advantage in industries where there is a concentration of workers and industry infrastructure. Following the common wisdom that tax incentives are best put to use in export-base industries because they create additional employment, this paper also investigates in which export-base industries the District has a comparative advantage. The District has a local comparative advantage in several export-base industries including Information and Professional, Scientific, and Technical Services. As such, D.C. would maximize economic growth and the effectiveness of tax incentives by targeting these specific industries.

The District’s industry profile

Washington, D.C. is a federal district that, together with cities in northern Virginia and southern Maryland, makes up the greater Washington metropolitan area. As such, the status of the District’s economic performance is best understood when examined both as part of the greater metropolitan area and also as a standalone city.

The Washington region was never a manufacturing hub like Detroit or New York; it was never a transportation hub like Chicago, Los Angeles, Memphis, or Atlanta; nor an energy hub like Houston. Rather, it has been and continues to be a hub for federal research laboratories and agencies such as the National Institutes of Health (NIH), the United States Food and Drug Administration (FDA), Department of Agriculture (USDA), Department of Energy (DOE), Department of Health & Human Services (HHS), the National Institute of Standards and Technology (NIST), National Aeronautics and Space Administration (NASA), National Science Foundation (NSF), and the Department of Defense (DOD), including the Pentagon and the Defense Advanced Research Projects Agency (DARPA).⁵

In addition to high employment in public agencies, the Washington region is well-positioned for today’s knowledge economy, with over half a million people employed in the Professional, Scientific, and Technical Services industry. Another 100,000 or so are employed in the Information sector, and another 100,000 in the Finance and Insurance (See Graph 1). In fact, in sheer headcount, with 228,060 total computer and mathematical occupations (2017), Washington-Arlington-Alexandria metropolitan area already has a booming information technology cluster that ranks second only to New York-Newark-Jersey City. By some counts, the BioHealth Capital Region (Maryland/Virginia/Washington D.C.) also boasts the fourth largest biotech cluster (behind Boston, San Francisco, and New York).

D.C., Virginia, and Maryland have created different clusters in relation to the federal government

Northern Virginia and Maryland have taken advantage of proximity to the federal government in different ways than D.C., affording us the opportunity to compare different economic development strategies across these neighboring jurisdictions.

Montgomery County, Maryland, has fostered a biotech cluster in the I-270 corridor by leveraging its proximity to the National Institutes of Health (NIH). Northern Virginia has fostered an information communication technology cluster using its proximity to the U.S. Department of Defense.⁶ Bryant Foulger, a Montgomery County, Maryland-based real estate executive, puts it simply, “They’ve [Virginia] got the death sciences; we’ve [Maryland] got the life sciences. The death sciences dwarf the life sciences, when you look at government spending.”

Today, Northern Virginia is the economic powerhouse of the region, with a job base greater than the District or Maryland. Virginia’s long-term economic strategy orchestrated by the Virginia Economic Development Partnership and the statewide commitment to creating a business-friendly environment have earned it the first place on America’s Top States for Doing Business in 2019.

The District has also emerged as a vibrant economy. It is home to 177 foreign embassies and the headquarter to many international organizations, trade unions, non-profits, lobbying groups and professional associations. But, when large corporate headquarters expand or relocate to the Washington region, they almost always choose Northern Virginia over Maryland or the District. The District is confined in space to just 68 square miles and has strict building height restrictions.⁷ Additionally, the District’s economic development policies suffer from short-term planning with tendencies to change rapidly with political cycles. For example, although not directly related to economic development, the way that the District completely and suddenly changed the structure of commercial property taxes in 2019 created instability for the business community. The District needs a long-term strategy that carefully targets export-base industries for which the District has a comparative advantage.

Between 1998 and 2015, many industries have been growing in the Washington metropolitan area, including Accommodation and Food Services and Educational Services. Conversely, Manufacturing, Retail Trade, and Wholesale Trade were declining sectors across every jurisdiction. The District’s highest growth sector has been in Educational Services (72 percent) and Accommodation and Food Services (67 percent); and, the highest decline sector has been Manufacturing (-38 percent) and Retail Trade (-21 percent) (Appendix C).

Targeting industries that make up the largest portion of the economy is one way of increasing economic development, as those industries have already built a skilled workforce and have existing infrastructure and suppliers in the region, allowing other businesses to start up at lower costs. The largest industries (by employment) in Washington, D.C. are Professional, Scientific, and Technical Services (75,591 people), Public Administration (61,097 people), and Health Care and Social Assistance (37,860 people) (Graph 2).⁸ In the following section, I show which industries would be most effective to target with tax incentives by evaluating how effectively the District leverages local comparative advantages in business incentives compared to Baltimore and Virginia Beach, two representative cities for neighboring jurisdictions in Maryland and Virginia, respectively.

Targeting industries of local comparative advantage

To maximize economic development, incentives should be targeted toward industries where the District already has a skilled workforce and infrastructure, allowing it an advantage over other metropolitan areas. A region is said to have a local comparative advantage if it is capable of producing a good or service at a lower opportunity cost than other regions. In other words, a region has a comparative advantage if it already has a skilled workforce and infrastructure for a specific industry in place, allowing companies to form and expand with relative ease using already existing talent and services. Businesses can minimize average total costs by sharing suppliers, storage centers, and logistics, especially for highly specialized industries. Because costs are lower when there are existing clusters of skilled workers and infrastructure, it is easier for new businesses to form and expand, contributing to economic growth.

Certain urban centers have high distributions of skills and occupations in a specific industry. For example, New York City is the financial capital and Los Angeles is the entertainment capital of the United States. As such, these cities have a comparative advantage in financial and entertainment industries, respectively. When cities’ have infrastructure and talent within specific industries, it lowers supply costs and increases the knowledge pool, forming an environment conducive to innovation for both startups and corporations. These advantages feed off of each other, translating to more investment and more job creation. To increase economic development, cities should use tax incentives to target and expand industries where they have a comparative advantage.

A standard way to identify and measure comparative advantages is through Location Quotients (LQ). An LQ compares the industrial activity of a region to that of the country as a whole. When a city has a high location quotient in a specific industry, there is likely an industrial cluster present that:

• Increases the productivity of existing businesses;
• Increases innovation, productivity, and growth of that sector; and
• Stimulates new business formation.⁹

I use three different measures of local comparative advantage: (1) Establishment expansion LQ; (2) Average earnings per worker LQ; (3) Employment LQ¹⁰:

• Establishment expansion LQ measures growth: to what extent the region’s specific industry is growing compared to national trends.
• Average earnings per worker LQ measures to what extent the region’s average industry earnings are growing compared to national trends; this is a good proxy for the quality of jobs.
• The employment LQ measures to what extent the region’s employment levels are growing compared to national trends; this is a good proxy for the quantity of jobs.

Graph 3 shows LQ and the level of incentives given by the District, Virginia Beach, and Baltimore.

Tax incentives would maximize economic growth by targeting industries in which there is a local comparative advantage, as measured here by location quotients (LQ). A region’s local comparative advantages would be considered well-targeted with incentives if the trend line is positively sloped, meaning that industries in which there are local comparative advantages (show by a LQ greater than one) are receiving higher levels of incentives.

Well-targeted business incentives can set in motion a virtuous cycle: the region’s industrial clusters are bolstered by business incentives (co-locating of firms in the same industry), attracting even more business expansions/relocations; as a result, the city’s economy grows and the government reaps greater tax revenues. As shown in Graph 3, all three metro areas have a positively sloped trend line in Average earnings per worker LQ. This suggests that incentives are correlated to good paying jobs. However, the trend line for Establishment Expansions LQ and Employment LQ appears to be negatively sloping for Virginia Beach and Baltimore. This suggests that incentives are not correlated with expansions and job creation. The negative correlation may be reflective of the fact that political rather than economic factors are driving the region’s incentive-granting strategies. Another possibility is that the business incentives are being exploited by firms because the government fails to keep them accountable.

The District has much stronger industry representation in Professional, Scientific, and Technical Services and Education Services than Virginia Beach or Baltimore has in any industry. The District’s unique industry status is shown with some industries highly overrepresented and some completely underrepresented (Graph 2). For example, the District has a high local comparative advantage in Professional, Scientific, and Technical Services, and no comparative advantage in the Manufacturing sector.¹¹ While both Baltimore and Virginia Beach have industries that are not represented, the differences are not as stark as in the District (they have no industries with such strong LQs as some in D.C.), and they do not offer tax incentives to every industry like the District does.

The District’s tax incentives are more generous than those of Baltimore and Virginia Beach. Across all industries, the District’s tax incentives hover around 0.15 to 0.45 (tax incentives translate to 15 to 45 percent discount on tax liabilities for an average recipient firm). In both Virginia Beach and Baltimore, the range is between 0 and 0.2 (between 0 and 20 percent discount on tax liabilities).

The District offers tax incentives to all industries studied here, in contrast to Virginia Beach and Baltimore who target only specific industries. In both Virginia Beach and Baltimore, business incentives are offered selectively in industries which are export-base or for which the region has a comparative advantage. These include Transportation and Warehousing for Virginia Beach and Manufacturing for Baltimore. By contrast, the District offers incentives across all sectors. Research suggests that a more targeted approach, specifically giving tax incentives to export-base industries in which the District has a comparative advantage, could be both more cost-effective and impactful for D.C., maximizing the economic development created by public dollars.

Targeting industries of local comparative advantage in export-base industries

Research consistently shows that business incentives targeted at export-base industries yields the best return on investment.¹² The idea is simple: export-base industries have higher job multipliers. For example, the highest multipliers are in high-tech sectors, particularly in local economies with a presence of high-tech clusters. It is estimated for every high-tech job, somewhere between two or three jobs (such as in nurses, teachers, hairdressers) are created in the local labor market. High tech sectors in the District include some in which the District has comparative advantages that are also export-base including Professional, Scientific, and Technical Services and Information.

The District does not specifically target export sectors over non-export sectors, in contrast to both Baltimore and Virginia Beach. Graph 4 re-plots Graph 3 but color-codes export (orange) vs. non-export (blue) industries. In the District, there is no correlation between industries receiving generous incentives and industries that are export-base. Both Professional, Scientific, and Technical Services and Information are export–base industries, but the former gets low and the latter gets high business incentives. Both Construction and Real Estate and Rental and Leasing are non export-base industries but the former gets low and the latter gets high business incentives.

The District has several sectors for which it has a strong comparative advantage, but does not specifically target those industries or export-base industries in its tax incentive policy. Specifically, four sectors (e.g., Sectors with Establishment Expansions LQs greater than two) are worth highlighting: Professional, Scientific, and Technical Services, Information, Other Services (except Public Administration), and Educational Services. Only the first two are export-base industries. The District’s highest (proportionally) business incentives, however, target a non-export base industry: Real Estate and Rental and Leasing, for which it has a modest comparative advantage. The District offers generous business incentives in some export-base industries, such as in Manufacturing, Finance and Insurance, and Other Services (except Public Administration). But it offers low business incentives in other export-base industries, such as: Management of Companies and Enterprises, Transportation and Warehousing, and Professional, Scientific, and Technical Services. One sector where the District effectively targets its comparative advantage is in Information, which gets second highest business incentives. An opportunity in the future for the District is to align its comparative advantages in Professional, Scientific, and Technical Services, an export-base industry, with business incentives.

In contrast, both Baltimore and Virginia Beach target export-base industries. Baltimore specifically targets Manufacturing and Professional, Scientific, and Technical Services. Baltimore has a legacy Manufacturing industry and has successfully restructured itself into a service-oriented economy.¹³ Once a major industrial town, Baltimore has a diversity of manufacturing clusters focused on steel processing, shipping, auto manufacturing, and transportation. But the city experienced deindustrialization in major manufacturing, heavy industry, and the rail industry. In the process, Baltimore shed tens of thousands of low-skill, high wage “middle class” jobs. The consequences of deindustrialization are still palpable in that Baltimore relies on a low-wage service economy, which accounts for over 30 percent of jobs in the city. The silver lining to their story is the major shift to a service-oriented economy with John Hopkins Hospital and John Hopkins University emerging as the city’s major employers. Baltimore’s business incentives target both the old (Manufacturing) and the new (Professional, Scientific, and Technical Services).

Virginia Beach specifically targets three export-base industries: Transportation and Warehousing, Manufacturing, and Professional, Scientific, and Technical Services. Virginia Beach is Virginia’s largest city, and boasts a skilled workforce and a business-friendly environment, defined here as low taxes and a local government committed to working with businesses. The city’s highest comparative advantage is for Professional, Scientific, and Technical Services and Accommodation and Food Services and it aligns its local comparative advantages and incentive-granting strategy.

Policy recommendations

Research suggests that the District would benefit in the future if it aligns its local comparative advantage in export-base sectors with tax incentives.

1. The District should increase its business incentives in select export-base industries where it has a comparative advantage. From the analysis provided in this report, two industries emerge as most promising: Information and Professional, Scientific and Technical Services. By increasing business incentives in these industries, the District will effectively lower costs of business operation within select industries, which will then attract more of these businesses and promote more expansions. This will increase the amount of jobs and the tax base of the region. In addition, by targeting export-base industries, the jobs created will in turn create more jobs in service and other adjacent industries. As such, targeting sectors of local comparative advantage is the most efficient use of incentive dollars to promote economic development.

2. The District should reduce or eliminate its business incentives flowing into non export-base industries or industries in which it lacks a local comparative advantage. The most immediate way to reform the District’s business incentives is by reducing or eliminating those that flow into non export-base industries.¹⁴ Over the years, the untargeted nature of business incentives, particularly in non export-base industries, such as in Real Estate and Rental and Leasing has politicized economic development incentives. A five-part special investigation by WAMU in 2013 found that the elected officials in the District received more than $2.5 million in campaign cash from groups receiving the subsidies; in return, elected officials approved $1.7 billion in tax breaks and discounted land deals between 2000 and 2010. Business incentives work best when economic rather than political factors drive policy.

3. The District could benefit from spatially targeting its business incentives around industrial clusters, or areas of concentrated economic activity, where highest job multipliers are likely to be found. Specific areas where industry clusters are most vibrant are usually also the places where the job multipliers are the greatest, meaning that business incentives are likely to generate the best results for the least money. Usually, industry clusters form around a major research institutions, such as NIH, FDA, NASA, or large firms. As of 2020, four of the Fortune 1000 companies had their headquarters in the District; Fannie Mae (24^th), Danaher (161^st), Carlyle Group (713^th), and FTI Consulting (906^th). These research institutions and large firms serve as a seedbed for many startups and spinoffs through employee entrepreneurship or academic entrepreneurship. While much of the economic activity in the District is centered around downtown, there may be additional pockets in the city worth expanding. For example, JLABS @ Washington, DC was created as a collaboration between Johnson & Johnson Innovation and the Biomedical Advanced Research and Development Authority (BARDA) at Children’s National Hospital to leverage their proximity to other research organizations. Its vision is laid out as follows, “Its proximity to federal research institutions and agencies, universities, and academic research centers aims to enable the new Children’s National campus to leverage the rich ecosystem of public and private sectors to help bolster biohealth, medical device, and life science innovation.”¹⁵

4. The District’s possible exception to the export-base best practice may apply to the education sector. Although the education sector is generally considered a non export-base sector, it could be considered export-base in the District because of the number of out-of-state students that enroll in major universities like Georgetown University, George Washington University, American University, and Catholic University of America (there are at least 20 degree-granting universities with a main campus in DC listed in Appendix E). Moreover, given increasing demand for postgraduate professional degrees, many universities are increasingly establishing satellite campuses in DC for immersive MBA, law, or public policy programs (there are at least 63 degree-granting universities listed in Appendix E). This trend may be the explanation for why the District registered such high growth in this sector (Appendix C) and high comparative advantage (Appendix D). As these universities are often large employers, they may warrant tax incentive targeting along with Professional and Scientific Services and Information.

Summary

This report has compared incentive-granting strategies in three representative metro areas for the metropolitan region: the District, Virginia Beach, and Baltimore. The District does not appear to have a comprehensive incentive-granting strategy with a long-term perspective that specifically aligns its comparative advantages in export-base industries. The report brings to attention this discrepancy and recommends targeting export-base industries in which the District has a local comparative advantage, including Information and Scientific and Professional Services.

Appendices

1. Author’s calculations based on U.S. Bureau of Economic Analysis data on personal income by metropolitan area.
2. Author’s calculations based on U.S. Bureau of Economic Analysis data on personal income by metropolitan area. See https://www.bea.gov/data/income-saving/personal-income-county-metro-and-other-areas
3. See https://sfullerinstitute.gmu.edu/wp-content/uploads/2017/01/roadmap_for_the_washington_regions_future_economy_123115.pdf
4. The two metro areas (NORFOLK-VIRGINIA BEACH-NEWPORT NEWS VA-NC and BALTIMORE, MD) are compared to the WASHINGTON, D.C. I otherwise specify when referring to the entire Washington metro area.
5. These government research labs and agencies invest vast amounts of resources to produce research for the public good. Inventions from government-funded research are often ripe for commercialization, and have included the internet, AI, GPS, MRI machines, hybrid corn, jet aircraft, and microwaves.  In the 1990s, the Washington metropolitan region was home to prominent IT companies MCI, AOL, NexTel, Teligent and Wintel, as well as hundreds of small and medium IT businesses.
6. Northern Virginia is the largest data center market in the world and also the busiest internet intersection in the nation, with up to 70 percent of all internet traffic flowing through its data centers every day.
7. Maximum height for buildings is 130-160 feet depending on the area.
8. See more at https://datausa.io/profile/geo/washington-dc#tmap_ind_num_emp
9. Porter, M. E. (2014, August 1). Clusters and the New Economics of Competition. Harvard Business Review. https://hbr.org/1998/11/clusters-and-the-new-economics-of-competition.
10. Location Quotient, in this paper, is constructed using information on establishment expansions from the Statistics of U.S. Businesses.   Establishment expansion refers to “establishments that have positive first quarter employment in both initial and subsequent years and increase employment during the time period between the first quarter of the initial year and the first quarter of the subsequent year.” Employment includes all paid employment consisting of both full- and part-time employees who are on the payroll, including salaried officers and executives of corporations. Not included are sole proprietors and partners of unincorporated businesses.
11. Professional, scientific, and technical services (NAICS: 54) has an Employment LQ of 2.87 and an Establishment Expansions LQ of 2.64, though its Average earnings per worker LQ is only 1.01. By contrast, the Manufacturing (NAICS: 23) sector has no comparative advantage. Its Establishment Expansions LQ is 0.1; Average earnings per worker LQ is 0.96; Employment LQ is 0.2.
12. In total, seven of sixteen “Super sector” industries are designated as export-base: (1) manufacturing; (2) transportation and warehousing; (3) information; (4) finance and insurance; (5) Professional, scientific, and technical services; (6) Management of companies and enterprises; (7) Arts, entertainment, and recreation.
13. Manufacturing is the most difficult sector to accurately capture incentives. Of 19 aggregated manufacturing sectors, the incentive mean was 0.023, with a low of 0.011 and a high of 0.046.
14. The non-export base industries are: (1) Construction; (2) Wholesale Trade; (3) Retail Trade; (4) Real estate and rental and leasing; (5) Administrative and support and waste management and remediation services; (6) Educational services; (7) Health care and social assistance; (8) Accommodation and food services; (9) Other services (except public administration). Business incentives in these industries introduce risks of a displacement effect where larger corporations with knowledge of corporate tax laws and its loopholes can take advantage of the policy at the cost of smaller mom-and-pop shops.
15. See: https://jlabs.jnjinnovation.com/locations/jlabs-washington-dc