New strategies for inner-city economic development by: Porter, Michael E

THE ROLE OF THE PRIVATE SECTOR

Many skeptics question whether the private sector is best suited, willing, or able to tap into inner cities' advantages and play a leading role in the economic revitalization of these areas. They point to the past (and, to some extent, current) behavior by the private sector--departures of companies, poor treatment of workers, and damage to the environment--and argue that the private sector is part of the problem, not the solution. Given the track record of outsiders, both in government and the private sector, such skepticism is understandable. However, if this skepticism leads to an isolationist, statist approach to economic development, inner cities will continue to decline. As Robert Kennedy once said, "To ignore the potential contribution of private enterprise is to fight the war on poverty with a single platoon, while great armies are left to stand aside."(n35)

Why Aren't Market Forces Working Better?

Many people have asked, "If inner cities truly have important competitive advantages, why isn't the market working?" There are at least three answers that have been underscored by interviews both inside and outside the inner city.

First, there are many misperceptions and biases about inner cities and their opportunities--what economists call information imperfections. Fed by media coverage, many see inner cities as combat zones devoid of economic activity and populated by people with no ambition, skills, or resources. Crime is indeed a severe problem in certain inner-city areas, but not all. For example, Boston's Dorchester neighborhood is widely perceived as a high-crime area, when in fact the rates of violent crime and overall felony crime are 20% below the Boston average.(n36) Such perceptions, which are often wrong or exaggerated, severely retard investment and business development in areas with obvious market opportunities.

Second, many of the inner city's competitive advantages have been diluted, if not overturned, by poor policies and leadership, whereas disadvantages remain. For example, the advantage of strategic location has often been dissipated by inadequate infrastructure investments and maintenance. Until the many disadvantages of inner cities as business locations are addressed, disadvantages will continue to outweigh advantages for many companies.

Finally, there is limited and garbled communication between entrepreneurs and companies, on the one hand, and advocates for inner cities (e.g., CBOs, foundations, and government) on the other. Advocates for inner cities often feel that companies are not doing enough for their communities, whereas businesspeople feel victimized by what they perceive to be unreasonable demands and expectations. The result is often tension, if not outright hostility, and business investment and growth are deterred. A few companies in politically sensitive or regulated industries will respond to pressure or mandates, but the effort will backfire by driving away other investors.

Inner cities, like other areas, must compete for investment and jobs. The best (and only) way to develop the economies of inner cities is to make them attractive and welcoming places in which to invest and do business, both for residents and nonresidents. We see some hopeful signs that attitudes about business in inner cities are improving.

Will the Private Sector Step Forward?

Yes, it will--not because it is forced to, but because inner cities can offer attractive markets, advantageous locations, and good employees. In response to more attention to these advantages, there is clear evidence (cited earlier) that the private sector is already investing in inner cities,(n37) and the trend is building momentum. With improvements in the inner-city business environment and continued changes in perceptions, inner-city business development can accelerate.

There have been few efforts to engage the private sector through business-to-business activity, despite many organized, successful efforts to involve corporations in inner-city issues, such as housing and education. This is not due to lack of interest on the part of the private sector for programs that make economic sense. In fact, we believe so strongly in the need for better linkages between the private sector and the inner-city economy that we have founded a new organization, the Initiative for a Competitive Inner City, to develop programs to involve companies, professional service firms, and graduate business schools in assisting and creating inner-city companies in cities around the country. This effort includes close contact with local government and CBOs. Many companies--among them Bank of America, The Boston Consulting Group, Citibank, John Hancock, Lotus Development Corporation, Pacific Gas & Electric, Staples, and Textron--are actively involved. Additionally, more than 30 of the nation's leading graduate business schools have created or expanded programs linking students and faculty with inner-city companies.(n38) The response gives us confidence that the business community is ready to try new approaches to urban problems, based on sound, economically driven strategies. An important role of the initiative is to lower the barriers to inner-city business development by dispelling myths about inner cities that hold back investment, publicizing successful companies, developing strategies to help enhance the competitive advantages and ameliorate the present disadvantages of inner cities, and improving communication between the private sector and inner-city advocates. The time is right for a proliferation of such efforts, in which business development is the central goal.

THE BUSINESS ENVIRONMENT IN THE INNER CITY

As business locations, inner cities suffer many disadvantages: discrimination against residents and entrepreneurs, high taxes and utility costs, difficulty in finding affordable insurance, crime, poorly maintained logistical infrastructure, burdensome regulations and permitting requirements, environmental pollution, and a weak education and training system.

The inner city's disadvantages as a business location must be seen as an economic problem and addressed as part of an economic strategy. Too often, addressing weaknesses such as a poorly trained workforce or deficient logistical infrastructure is approached with only the social welfare of residents, not the needs of business, in mind. For example, inner-city training programs often fail to screen applicants--and even give priority to the least prepared residents in the name of fairness. Employers are then disappointed with the graduates.

Second, attempting to offset disadvantages with operating subsidies to businesses is futile. A more effective approach is to address the impediments to doing business directly. There is no substitute for reducing unneeded regulatory hurdles, simplifying permitting, and reorienting environmental cleanup requirements.

Third, our research indicates that many of the inner city's disadvantages are not inherent but are the result of poor strategies and obsolete public policies. There are many best practices nationwide that could be adopted in every inner city, as will be discussed further.

THE ROLE OF GOVERNMENT

Many past and present government programs have defied economic logic, distorted incentives, and failed to ease racial tensions. To quote a senior federal official, "We've put a great deal of money into inner-city economic development, and have had very few successes."(n39) At the local level, state and city governments bear significant responsibility for the disinvestment by the private sector in inner cities by failing to maintain and improve schools, neglecting infrastructure, failing to provide for public safety, raising taxes excessively, and creating a morass of costly regulations.

However, this critique does not imply that all government efforts have been harmful; nor do we advocate that government should simply abandon the inner city and allow private initiatives to take over. The issue is not the importance of a continuing government role but exactly what that role should be. There is a continuing, vital role for government in inner-city economic development--a role focused not on direct intervention and heavy reliance on operating subsidies to attract companies, but on creating a favorable environment for business (e.g., improving the public school system, training workers, upgrading infrastructure, streamlining regulation).

Crime Prevention

Crime, with its associated fears and costs, is one of the greatest barriers to inner-city economic revitalization. Although we believe that the perception of crime is greater than the reality, our surveys reveal the costs of the reality of crime to inner-city business activity. In Boston and Atlanta, 75% and 55%, respectively, of inner-city-based companies we surveyed said that crime and security issues were serious problems.(n40) In Atlanta, employers cited break-ins/vandalism, employee theft, and extra insurance and security costs as their three biggest problems.(n41) In another case, the Shops at Church Square, an inner-city strip shopping center in Cleveland, spends $2 per square foot more than a comparable suburban center, because it has a full-time security guard, more lighting, and continuous cleaning. Its overall costs are thus raised by more than 20%.

There is a great deal businesses can do to mitigate the problem. Although prudent security measures are a part of the solution, we have heard again and again that, as one business owner put it, "If you become part of a neighborhood by hiring locally and participating actively in the community, the crime issue becomes virtually nonexistent."(n42)

Ultimately, however, government must play a leading role, and there are signs of real progress. For example, New York City and a handful of other cities are adopting highly successful police force management and crime-fighting techniques that disproportionately benefit high-crime inner-city areas. The results have been dramatic: Although major crime has declined modestly across the country, in New York City it has fallen dramatically in the past few years (17.5% in 1995 alone) to levels not seen since the early 1970s.(n43)

Discrimination

It is clear that discrimination has kept African Americans and other people of color from the educational and economic opportunities afforded many other groups in American society. The current economic weakness of inner-city communities, together with the human capital deficits that plague them, in many ways reflects the legacy of discrimination. It is also clear from our research that discrimination remains a serious problem.

However, the problems of inner cities go beyond discrimination to many factors that magnify its effects. Although continuing to work to eliminate discrimination, we must move forward with a positive strategy to address other parts of the inner-city problem. Our experience has been that a sound economic strategy based on improving competitiveness is a positive step forward that emphasizes mutual benefits and brings people together.

Affirmative Action and Government Set-Aside Programs

A central tool employed to counter discrimination has been affirmative action, which has created opportunities for minorities in a number of occupational and educational fields. In the area of business-related affirmative action programs, such as minority preferences for government contracts, further steps are needed to better tailor these programs to jobs and wealth creation for residents of distressed communities, instead of targeting minority entrepreneurs regardless of income levels and whom they employ. To quote President Clinton: "We need to do more to help disadvantaged people in distressed communities, no matter what their race or gender."(n44)

Some have argued that, since minority-owned firms are more likely to hire inner-city residents than are White-owned companies, inner-city economic development efforts should focus exclusively on assisting minority-owned firms, regardless of their location.(n45) Our research confirms that minority-owned companies do indeed hire a greater proportion of inner-city residents, and we are enthusiastic supporters of minority-owned businesses. However, promoting only minority-owned businesses will not be sufficient, as the record of recent decades clearly indicates. There is a need for broader strategies that will stimulate inner-city job creation by all types of companies. Our research reveals that there are many White-owned businesses in or near inner cities that are providing many thousands of good jobs to inner-city residents.(n46) Rather than accept as a given that few White-owned businesses in inner cities will hire local residents, we need a strategy to increase their local hiring.

Business development programs also need to be refined to promote sustainable businesses, not just guarantee companies a market. Many such programs have dulled motivation and retarded cost and quality improvements. These pitfalls are not just true for minority set-asides; similar problems afflict business incentive programs around the world. It is not surprising, therefore, that a 1988 General Accounting Office report found that, within six months of graduating from the Small Business Association's (SBA's) purchasing preference program, 30% of the companies had gone out of business. An additional 58% of the remaining companies claimed that the withdrawal of the SBA's support had a devastating effect on their business. Companies benefiting from set-asides must demonstrate movement toward self-sufficiency to retain them, so that incentives are more aligned with creating sustainable, profitable businesses. By linking such incentives to distressed communities and limiting their duration, we are confident the current attacks against preference programs would diminish significantly.

The Role of Subsidies

Public funds (subsidies) will be necessary to revitalize inner cities, but they must be spent in support of an economic strategy based on competitive advantage, instead of distorting business incentives with futile attempts to lure businesses that lack an economic reason for locating in inner cities. It is appropriate for government funds to be used to prepare a site for business by assembling parcels of land, improving infrastructure, performing environmental remediation, and providing better public safety. However, the businesses that then locate in inner cities should not receive ongoing operating subsidies, or they are unlikely to become sustainable in the long run.

The Proper Use of Tax Incentives

Both at federal and state level, various tax incentives have been employed to support economic development in designated depressed areas, often called enterprise zones. Although we support measures that make inner cities more competitive (and higher taxes than exist in the surrounding region are often a significant disadvantage(n47)), the record of enterprise zones is not encouraging. Again and again, businesses that locate in an area because of tax breaks or other artificial inducements, rather than genuine competitive advantages, prove not sustainable. Research is accumulating from around the world that few businesses make location decisions based on tax incentives--especially the modest ones commonly associated with enterprise zones.(n48) Thus the bulk of tax breaks goes to businesses that would have been operating in the enterprise zone anyway. Enterprise zone incentives can be perverse in a number of other ways. They often fail to encourage the hiring of residents of the depressed area and to promote entrepreneurship by residents.(n49) Tax breaks that do not rest on making a profit are also dangerous, because they encourage uneconomic investments.

Training

Unfortunately, the existing job training system in the United States is ineffective. Training programs are fragmented, overhead intensive, and disconnected from the needs of industry and recipients.(n50) Many programs provide poor training for nonexistent jobs in industries with no projected growth; for example, a study of the Job Training Partnership Act showed that young men who had dropped out of school and enrolled in the program earned 8% less than those who were given no training.(n51)

Inner-city job training programs have an especially difficult challenge, because they have to overcome many inner-city residents' low education levels and poor work skills. However, there are a number of extraordinary programs such as the National Foundation for Teaching Entrepreneurship, which has helped thousands of inner-city youth start businesses. Boston's One With One and Project Protech, the Bidwell Training Center in Pittsburgh,(n52) Detroit's Project: HOPE,(n53) and Jobs for Youth in various cities are just a few examples of other organizations doing an outstanding job in training and placing inner-city residents in good jobs in nearby clusters. Additionally, outlined in my Harvard Business Review article(n54) were a number of strategies both to engage the private sector to create and certify training programs, which could be built around industry clusters in the inner city and in the nearby regional economy, and to tap into existing private-sector training programs, especially corporate ones.

Access to Capital

The issue of access to capital provides an especially illuminating example of appropriate versus inappropriate government intervention. Most government efforts have focused on the creation of government loan pools and quasi-public financing entities that have produced fragmentation, market confusion, and excessive overhead costs, resulting in many uneconomic investments.

The only viable solution is to harness market forces and the resources of the private capital markets. In the area of debt financing, we argue that mainstream financial institutions must be engaged through direct incentives, such as transaction fees, to cover high overhead costs associated with small transactions and partial loan guarantees that mitigate some--though not all--of the risk. Additionally, increased disclosure of inner-city business loans would motivate efforts by private-sector lenders.

Regarding equity capital, our proposal is to eliminate the tax on capital gains and dividends from long-term equity investment in inner-city-based businesses (or subsidiaries) that employ a minimum percentage of inner-city residents. This proposal would, we believe, maintain a focus on genuine profit and result in new equity capital from a wide range of sources flowing into inner cites. The cost, which is likely to be modest, would be decisively outweighed by tax revenues from higher employment of inner-city residents.(n55)

Deregulation

Given the history of exploitation in inner cities, some advocates resist any reform. Although I strongly oppose needless, inefficient, and destructive government regulation, I do not favor scrapping laws that govern workplace health, safety, and compensation. Instead, my primary focus is on the astounding number of rules, permits, and regulations that have accumulated at the federal, state, and especially city government levels over many years.(n56) It is truly ironic that the areas in the United States that are most in need of business development are the most overregulated.

Merely registering and legally operating a small business in an inner city is daunting. For example, according to Steve Mariotti, the founder of National Foundation for Teaching Entrepreneurship, which teaches entrepreneurship to "at-risk" inner-city youth:

The minority entrepreneur usually ends up being his own lawyer and accountant.... The paperwork, cost, and confusion . . . drive would-be entrepreneurs away from certainty and down a slippery slope. They develop contempt for the government, because they no longer see it as their ally. That drives people into the underground economy, where there are no contracts. Matters of dispute are settled with gun or a beating.... Once an entrepreneur moves into the balkanized--and chaotic--underground economy, growing the business is not a viable option.(n57)

Absurd laws and regulated monopolies also plague inner-city entrepreneurs. According to a leading magazine for entrepreneurs, "about 10% of all jobs in this country require some sort of license, and many of those are low-skill, entry-level occupations such as taxicab driving, working as a street vendor, cosmetology, trash hauling, and recycling. The licensing process in these fields is often onerous and . . . preserves existing monopolies at the expense of those least able to defend themselves."(n58)

Regulation also affects larger businesses and CBOs. Alan Hershkowitz, a senior scientist with the National Resources Defense Council, who is working with the Banana Kelly CDC to develop a proposed paper recycling project in the South Bronx, speaks for a large number of developers and businesspeople we have interviewed: "There is usually a lengthy, labyrinthine permitting process in cities."(n59) Another example shows that for-profit businesses are not the only victims. Rev. Calvin Butts of the Abyssinian Development Corporation in Harlem laments, "If we could sit down with the city and have an ordinary negotiation, we could easily build twice the number of [housing] units, and I assure you it would cost a lot less."(n60)

The regulatory process can be streamlined, as the case of Massachusetts illustrates. There, Governor William Weld's administration is reviewing all 20,000 pages of the 26-volume Code of Massachusetts Regulations. By January 1, 1997, it plans to rescind 19% and modify 44% of the 1,600 regulations on the books, fundamentally modifying the way the state regulates itself and its citizens.(n61)

In the area of zoning, antiquated laws reflect an economy that has not existed for decades. For example, large swaths of land in New York City remain zoned for manufacturing and industrial usage, despite the fact that few such businesses remain. This land should be rezoned to allow residential and retail development.

Finally, it is ironic that current environmental policy (especially the Federal Superfund law), intended to foster cleanup of the nation's estimated 200,000 to 500,000 vacant urban industrial sites, has instead hampered such efforts. According to Henry L. Henderson, Chicago's environmental commissioner, "The shadow of crushing liability and the fear of lenders made it impossible for small businessmen to get loans to develop urban properties."(n62) Liability and cleanup laws must be modified so that lenders, developers, and businesses will return to the inner city. We are pleased to see that more than half the states have passed legislation or developed policies to reduce the liability threat inherent in such properties and institute reasonable cleanup requirements. Congress is considering a host of similar proposals. Similarly, the Clinton administration initiated a $10 million grant program last year to fund cleanup and has modestly relaxed the Superfund law that governs hazardous-waste cleanups.(n63)

Government as a Marketer

In the area of economic development, a critical role of government is to act as a marketer--courting, welcoming, and assisting companies. From hundreds of interviews with businesses, government officials, and others across the country, we have unfortunately found that government rarely plays this role in inner cities. For example, the CEO of a major Oakland corporation that was deciding whether to expand its plant in Oakland or open a new one in Houston recounted a story we have heard variations of many times across the country. In Houston, he was met at the airport by city officials, shown appropriate parcels of land, and given all required permits and waivers on the spot. By contrast, he was frustrated that neighborhood groups and city government in Oakland had stymied his attempts to win approval to expand his existing plant because of concerns over more traffic.(n64)