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ESSAYS ON ISSUES

THE FEDERAL RESERVE BANK
OF CHICAGO

DECEMBER 1988
NUM BERlfi

Chicago Fed Letter
B idding for business
States compete for business. The stakes
are high and the game is rough. Among
the bargaining chips that states can
use, selective tax incentives and fiscal
inducements are favorites.
Competition among local and state
governments can sometimes result in a
bidding frenzy. For example, 25 states
(and an untold number of localities)
offered generous packages of tax
abatements, special services, and im­
provements to infrastructure in an at­
tempt to land General Motors’ Saturn
auto facility. State governors made
personal visits to GM headquarters and
appeared on national television to
plead their cases in public.
In another instance, the State of Illinois
reportedly offered a package worth
over $80 million in its successful effort
to bring the Chrysler/Mitsubishi
Diamond-Star auto production facility
to the Bloomington/Normal area. The
value of this package has become a
matter of keen interest because the pri­
vate investment at that site was only
expected to be $500 million.

This letter looks at the value of these
abatements and inducements—
Let’s
call them tax breaks and be done with
it. What evidence we find is so uncer­
tain and so difficult to assess, we con­
clude that any case for tax breaks for
relocating or expanding business is un­
proved at best.
The community’s perspective

In granting tax incentives, states and
localities expect that the return will be
greater than the cost. This benefit may
not be achieved. To the extent that tax
breaks and fiscal inducements merely
reshuffle rather than reduce the overall
tax burden, state and local govern­
ments may be doing more harm than
good.1
LTnlike general competition between
localities in providing appropriate
public services at a reasonable price,
selective tax breaks do not necessarily
redress any inefficiencies in the delivery
of public services. Accordingly, the
capricious and uncertain assignment of
tax burdens—the hallmark of a selective

incentives program—may actually repel
businesses that have a long-term per­
spective on community investment.
And, it is just that type of commercial
neighbor that can be most valuable to
a community.
From a community’s perspective, the
appropriate way to evaluate its incen­
tive program is to ask whether the
benefits to the community exceed the
costs. There has not been adequate
research to measure the effectiveness of
these programs in general for every
community. Yet, given what is known,
along with careful attention to the logic
behind the programs, there are basic
questions that public policy makers
must answer before engaging in a costly
and widespread program of selective
industry fiscal inducements.
Are tax breaks a good lure?

A steady stream of studies on the re­
lationship between overall state and
local tax burdens and business growth
has emerged over the past 35 years.

These selective incentive policies must
be distinguished from more general ef­
forts to make a state’s overall fiscal and
tax structure favorable to business and
development. Such incentive packages
are offered by state and local govern­
ments to individual companies, or in­
dustries, and not on a uniform basis to
all businesses within the community.
They are selectively negotiated by
public officials in hopes of snaring ad­
ditional business activities that will pay
a return on investment in terms of
added jobs, income, and tax revenues.
As one commentator has noted, the re­
sulting competition to attract industry
has become a dog-eat-dog, Indianaeal-Ohio affair.

S tate loans fo r
building construction

SOURCE: S i t e

S e le c tio n

State financing aid fo r
existing plant expansions

Tax exem ption o r
moratorium on land and
capital im provem ents

a n d I n d u s t r i a l D e v e l o p m e n t , C onw ay Publications.

State provides free
land for industry

M o s t e a rly stu d ie s su g g e ste d th a t tax es
w e re n o t r e la te d to s ta te a n d lo c a l e c o ­
n o m ic g r o w th .' A c c o rd in g ly , p o lic y
a d v ic e w a rn in g lo c a l c o m m u n itie s
a g a in s t th e use o f ta x b re a k s b e c a m e
w id e s p r e a d .3
H o w e v e r, as th e s o p h is tic a tio n o f
stu d ie s in c re a s e d , n e w e v id e n c e seem s
to in d ic a te th a t, a t th e m a r g in , tax es
c a n in d e e d h e lp a t t r a c t b u sin esses to
specific lo c a litie s. S tu d ie s o f firm lo ­
c a tio n d ecisio n s w ith in a m e tro p o lita n
a r e a h a v e su g g e ste d th a t, o n c e th e
su p p ly o f p ro p e r ly z o n e d a n d a v a ila b le
la n d is a c c o u n te d for, lo c a l ta x e s b e ­
c o m e im p o r t a n t in sitin g d e c isio n s o f
m a n u f a c tu r in g p la n ts .4 In d e e d , stu d ie s
c o n s id e rin g th e lo c a tio n o f e c o n o m ic
g ro w th h a v e su g g e s te d t h a t ta x b u r ­
d en s, ta x s tru c tu r e , a n d th e c h o ic e
a m o n g ty p es o f s ta te a n d lo c a l p u b lic
e x p e n d itu re s a n d serv ices c a n a ll b e
sig n ific a n t in lo c a tio n d ecisio n s.
T h e se fin d in g s re - o p e n e d d e b a te
a m o n g a n a ly s ts o f s ta te a n d lo c a l fiscal
in c e n tiv e s p o licy . B u t, w h ile it seem s
th a t tax es d o m a tte r , th is h a r d ly im ­
plies th a t tax es a re a sig n ific a n t c o n ­
s id e ra tio n fo r e a c h in v e s tm e n t
d e c is io n .5 Q u e s tio n n a ire s d ir e c te d a t
p la n t o r c o m p a n y officials h a v e b e e n
used to d e te r m in e th e e x te n t to w h ic h
re lo c a tin g o r in v e s tin g b u sin ess w o u ld
h a v e u n d e r ta k e n th e in v e s tm e n t w ith ­
o u t th e selectiv e ta x b re a k . R e sp o n se s
c e rta in ly a re in flu e n c e d b y th e f irm ’s
r e lu c ta n c e to b ite th e h a n d t h a t feeds
it. B u t, n o n e th e le ss, th e su rv e y fin d in g s
su g g est th a t th e success ra te o f in c e n ­
tive p ro g r a m s te n d to b e v e ry lo w .1
’
F irm s w ill u n fa ilin g ly ask fo r in c e n tiv e s
i f th e y a re a v a ila b le , b u t s ta te a n d lo cal
c o m m u n itie s fin d it d iffic u lt to d is tin ­
g u ish th o se firm s t h a t ask fro m th o se
firm s t h a t n e e d .
F o r th is re a s o n , th e d e b a te h a s sh ifte d
to ask w h e n a n d w h e re se le c tiv e ta x
b re a k s w ill be effective. M o re im p o r ­
ta n tly , it is n o t c le a r w h e th e r th e s ta te
a n d lo c a l officials w h o g r a n t b re a k s at
th e ir o w n d is c re tio n c a n d is tin g u ish
s itu a tio n s in w h ic h ta x b re a k s a re su c ­
cessful in g a in in g n ew b u sin ess fro m
those in w h ic h ta x a b a te m e n t c o u ld
h a v e b e e n a v o id e d . C le a rly , ju d g m e n ts
o n th e n e t b en efits o r costs o f fiscal in ­

d u c e m e n t p ro g r a m s w ill d e p e n d o n
su c h c o n sid e ra tio n s.

c o s t-b e n e fit a n a ly s is w o u ld r e q u ir e th a t
su c h costs b e c o n sid e re d .

T h e m a in c o n se q u e n c e o f a lo w success
r a te is th a t sta te s a n d lo c a l c o m m u n i­
ties m u s t h e a v ily d is c o u n t th e jo b s a n d
in c o m e th a t a re sa id to re s u lt fro m i n ­
c e n tiv e p ro g ra m s , in d e c id in g w h e th e r
o r n o t to e n g a g e in a b r o a d p o lic y o f
selectiv e ta x b re a k s.

F in a lly , a c o m m u n ity p o lic y o f selectiv e
ta x b re a k s m a y f u r th e r c ro w d o u t p o ­
te n tia l b u sin e ss in v e s tm e n ts t h a t w o u ld
o th e rw ise o c c u r in th e a b s e n c e o f th e
p ro g r a m . S o m e p o te n tia l firm s m a y
feel t h a t a c o m m u n ity w ith la r g e scale
in c e n tiv e p ro g r a m s c a n n o t b e c o u n te d
o n fo r a s ta b le a n d e ffic ie n t fiscal c li­
m a te in w h ic h to c o n d u c t b u sin ess. ( O f
c o u rse , a b u sin e ss t h a t h a s a lr e a d y d e ­
c id e d to lo c a te o r re in v e s t in a c o m ­
m u n ity w ill a sk fo r a ta x a b a te m e n t if
it is a v a ila b le o r i f th e y b e lie v e th e y c a n
e x tr a c t a su b sid y —to d o o th e rw ise
w o u ld n o t be a r a t io n a l e c o n o m ic r e ­
sp o n se b y th e firm .)

Do breaks crowd out as they
bring in?
E v e n i f a ta x b re a k d o es p ro m o te in ­
v e s tm e n t, d ir e c t e c o n o m ic b e n e fits c a n
b e w h o lly o r p a r tly offset if e x istin g
b u sin esses o r re s id e n tia l a c tiv itie s a re
c ro w d e d o u t o f th e c o m m u n ity , o r i n ­
v e s tm e n ts b y lo c a l b u sin esses a re d is ­
c o u ra g e d . F o r e x a m p le , w h e n th e ta x
b re a k p o lic y allo w s th e in c o m in g firm
to g a in a c o m p e titiv e a d v a n ta g e o v e r
a lo c a l firm e n g a g e d in th e sa m e serv ice
o r p r o d u c t, it m a y th e re b y d riv e a w a y
in v e s tm e n t d o lla r fo r d o lla r.
M o s t e v id e n c e o f this effect is a n e c ­
d o ta l. F o r e x a m p le , a m a k e r o f h y ­
d ra u lic e q u ip m e n t, A b e x C o rp o ra tio n ,
D e n iso n D iv isio n , a n n o u n c e d p la n s to
close a C o lu m b u s, O h io , fa c ility in th e
la te 1970s. T h is w as in re sp o n se to a
g e n e ro u s ta x b re a k b y th e C o lu m b u s
C ity C o u n c il to its d ir e c t c o m p e tito r,
L. S c h u le r G M B H , o f W e st G e rm a n y ,
to lo c a te a fa c ility in C o lu m b u s .7 T o
th e e x te n t t h a t s ta te a n d lo c a l g o v e rn ­
m e n ts c a n n o t fo resee su ch situ a tio n s,
ta x u n ifo rm ity r a t h e r th a n selectiv e ta x
b re a k s is a b e tte r p o lic y c h o ic e to
m a in ta in th e c o m m u n ity ’s sta b ility .
E v e n w h e n p o te n tia l firm s d o n o t
c o m p e te d ire c tly in fin a l m a rk e ts w ith
e x istin g c o m m u n ity firm s, th e y d o
c o m p e te in th e c o m m u n ity fo r o th e r
fa c to rs o f p ro d u c tio n , su c h as la b o r a n d
in f ra s tru c tu re . W e d o n o t k n o w th e
e x te n t to w h ic h “ in v ite d ” busin esses
ra ise som e lo c a l fa c to r costs to th e p o in t
w h e re o th e r a c tiv itie s a re c ro w d e d o u t
o f th e c o m m u n ity . T h e ta x re lie f a n d
g e n e ro u s u p g ra d in g o f in f ra s tru c tu re
th a t w as o ffered to V o lk sw a g e n to lo ­
c a te its p ro d u c tio n fa c ility in N ew
S ta n to n , P e n n s y lv a n ia , w as lo u d ly p r o ­
te ste d b y so m e lo c a l b u sin e ssm e n w h o
fo resaw th e ir ta x b u rd e n s b e in g h ik e d
w ith o u t a tt e n d a n t b en efits. A c a re fu l

M o re o v e r, a firm ’s p r io r a sse ssm e n t o f
th e ta x p o lic y o f a c o m m u n ity w ith a n
e x te n s iv e in c e n tiv e p r o g r a m m a y also
re c o g n iz e th a t its o w n fu tu r e ta x b u r ­
d e n w ill d e p e n d o n th e d e v e lo p m e n t
d e c isio n s o f th e n e x t g o v e r n m e n t in of­
fice. F u tu r e officials m a y g r a n t ev en
la r g e r b re a k s to th e n e x t fo o tlo o se i n ­
v e sto r, th e r e b y in c re a s in g th e ta x b u r ­
d e n o n th e c o m m u n ity ’s e x istin g
businesses.
O p in io n s o b ta in e d fro m m a n y c o m p a ­
nies in d ic a te th a t, w h e n assessing a
c o m m u n ity , firm s lo o k fo r a lo n g - te rm
re c o rd o f fiscal s ta b ility a n d efficien cy
in p ro v id in g p u b lic services. S u c h a
fiscal c lim a te w ill in s u re t h a t a la r g e
p riv a te in v e s tm e n t w ill n o t b e u lt i­
m a te ly so u re d b y d e te r io r a tin g p u b lic
serv ices o r u n e x p e c te d a n d u n d e s ira b le
c h a n g e s in ta x p o licy .

Are gains in business activity
long-term?
I n e v a lu a tin g p o te n tia l b e n e fits, c o m ­
m u n itie s m u s t also re c o g n iz e th a t
p ro m ise s o f lo n g - te rm jo b s a n d fu tu r e
in v e s tm e n ts b y in c o m in g firm s d o n o t
a lw a y s m a te ria liz e . A m id s t m u c h f a n ­
fa re , V o lk s w a g e n ’s a ss e m b ly p la n t in
N e w S ta n to n , P e n n s y lv a n ia , o p e n e d in
1978. I t s h u t d o w n in 1988. A u to p r o ­
d u c tio n b y C h ry s le r C o r p o r a tio n a t
A M C ’s fo rm e r p la n t in K e n o s h a ,
W isc o n sin , w ill cea se th is D e c e m b e r
fo llo w in g a tw o -y e a r ru n . T h e S ta te o f
W isc o n sin w ill p r o b a b ly re c o u p its in ­
v e s tm e n t b e c a u se C h ry s le r h a s r e ­
s p o n d e d to p u b lic o p in io n o r p u b lic

n e e d s (m a n y o th e r c o m p a n ie s a re n o t
so resp o n siv e).
U n lik e m a n y E u r o p e a n c o u n trie s,
s ta te s in th e U .S . h a v e b e e n slow to
a d o p t “ c la w b a c k ” p ro v isio n s, w h ic h
a llo w c o m m u n itie s to re g a in su b sid ie s
w h e n p ro m ise d jo b s a re n o t re a liz e d
fro m firm s re c e iv in g p u b lic su b sid ies.
H o w e v e r, o n e re c e n t c o u rt d e c isio n
(s u b je c t to re v ie w ) h a s p la c e d lim its o n
th e a b ility o f a firm to close a p la n t a n d
re lo c a te o p e ra tio n s w h e n th e firm h a d
b e e n a re c ip ie n t o f a su b s id iz e d lo a n to
e x p a n d in its o rig in a l lo c a tio n .8 O th e r
ju d ic ia l tests a re n o w in p ro g re ss.

Administrative costs
I n a d d itio n to a n s w e rin g th ese
q u e stio n s, c o m m u n itie s m u s t c o n sid e r
th e h ig h a d m in is tr a tiv e co sts o f in c e n ­
tiv e p ro g ra m s . T h e c o m m u n ity m u st
s tu d y w h o w ill b e fa v o re d b y ta x b re a k s
a n d sp e c ia l serv ice in d u c e m e n ts ; w h a t
th e costs a n d b e n e fits a re o f e a c h ty p e
o f fa c ility ; w h o w ill be b e n e fitte d in th e
c o m m u n ity ; a n d w h o w ill b e h u r t. I t
m u s t also a n a ly z e w h a t p u b lic services
a n d fa c ilitie s w ill n e e d to b e e x p a n d e d
b e c a u se o f th e in v e s tm e n t a n d to w h a t
d e g re e it c a n b e e x p e c te d to e x p a n d
e m p lo y m e n t a n d p o p u la tio n .

Conclusions
C o m m u n itie s a re u su a lly a w a re o f th e
d ir e c t costs a n d b e n e fits o f a tt r a c t in g
b u sinesses w ith ta x b re a k s a n d o th e r
fiscal in d u c e m e n ts . T h e lo st ta x r e ­
v e n u e s o r re sh u ffle d ta x b u rd e n s a re
h ig h ly v isib le fro m new s a c c o u n ts o f
p la n t n e g o tia tio n s b e tw e e n s ta te offi­
cials a n d b ig -n a m e c o rp o ra tio n s . T h e
a tt e n d a n t b e n e fits o f e m p lo y in g th e
u n e m p lo y e d a re re a d ily a c c e p te d a n d
h ig h ly v a lu e d by th e g e n e ra l p u b lic .
B ut, b e y o n d th ese o b v io u s c o n s id e r­
a tio n s, a b r o a d c o m m u n ity p o lic y o f
selectiv e tax b re a k s c a n b e risky. T h e
success r a te o f ta x in c e n tiv e p ro g ra m s
in a c tu a lly in d u c in g firm s to re lo c a te
o r e x p a n d is d iffic u lt to g a u g e fo r b o th
th e g e n e ra l p u b lic a n d p u b lic officials
alik e. I n a d d itio n , th e e x te n t to w h ic h
in c e n tiv e p ro g r a m s crow d, o u t o th e r
p o te n tia l in v e s tm e n t, th e re b y c re a tin g
u n c e rta in ty as to th e c o m m u n ity ’s fiscal
sta b ility a n d busin ess c lim a te , is h a r d
to assess.

B e tte r e c o n o m ic a n a ly sis a n d in f o rm a ­
tio n o n th e se im p a c ts w ill b e re q u ire d
b e fo re th e u tility o f in c e n tiv e s p o lic y
c a n b e d e te r m in e d fo r e v e ry c o m m u ­
n ity . M e a n w h ile , g iv e n th e p o te n tia l
p itfa lls, p u b lic officials sh o u ld b e c a u ­
tio u s in m a k in g selectiv e in c e n tiv e
p ro g ra m s -ta x b re a k s a k e y sto n e o f
s ta te a n d lo c a l d e v e lo p m e n t p o licy .
— W illia m A. T e s ta
a n d D a v id R . A lla rd ic e *
1

' This article does not argue th a t general
competition between state-local govern­
ments in providing low-cost, high-quality
public services, financed through a wellstructured tax system, should be discour­
aged. See J o h n Shannon, “ Interstate T ax
C ompetition T h e Need For a New
L o o k ” ; an d “T a x Competition: Is W h a t ’s
Good For the Private Goose Also Good
For the Public G an d er?” , in Reform Or Re­
venue, Symposium, N ational T ax
Association/Tax Institute of America,
Arlington, VA., M a y 19-20, 1986, Vol.
X X X I X , No. 3.
2 T h e seminal works in this area are: C.C.
Bloom, State and Local Tax Differentials and
the Location o f Manufacturing, Studies in
Business an d Economics, T h e University
o f Iowa, No. 5, 1956; an d J o h n Due,
“ Studies of State and Local T a x Influences
on the Location of Indu stry ” , National Tax
Journal, ol. 14, J u n e 1961, pp. 163-173.
3 See G ary C. C ornia, William A. Testa,
an d Frederick D. Stocker, Stale-Local Fiscal
Incentives and Economic Development, A cad­
emy F or C o n tem porary Problems,
Columbus, O hio, 1978; and Michael
Kieschnick, Taxes and Growth: Business In­
centives and Economic Development, Council of
State Planning Agencies, Washington,
D.C., 1981. "
1 See R o b e rt J . N ew m an and Dennis H.
Sullivan, “ Econometric Analysis of Busi­
ness T a x Im pacts on Industrial Location:
W h a t Do Wc Know, and H ow Do We
K n o w It?” , Journal o f Urban Economics, Vol.
23, pp. 215-234.
’ J a m e s A. Papke has constructed a
micro-simulation model which estimates
the after-tax rates of return for h y p o th e t­
ical capital investments at alternative sites.
All else is held constant except for state
and local tax effects, their interaction with
each other, and their interaction with the
federal tax system. A 1985 study am ong
sites in 15 states revealed that there w r i t
significant differences in after-tax rates of
return for a hypothetical investm ent which

was p a ttern ed after the S atu rn C o rp o ­
ration subsidiary of G M . However, and
not surprisingly, the state where the in­
vestment was finally located, Tennessee,
did not have the most favorable profit rate
(based on tax structure an d incentives
alone). See J a m e s A. Papke, The Taxation
o f the Saturn Corporation: Intersite
MicroAnalytic Simulations, C enter For T ax
Policy Studies, P u rdue L’niversity, West
Lafayette, Ind., M a r c h 1985.
6 F o r example, a recent study by George
W. Morse an d M ich ael C. F a rm e r found
that, ou t of 23 investm ent decisions in ru ­
ral O hio communities, in only one was the
deciding factor found to have been the tax
ab ate m en ts according to on-site interviews.
However, all 2.3 companies received tax
abatements.
See R og er J . V au g h n , “A New Look at
State T a x Incentives” , The Entrepreneurial
Economy, J u l y 1984, pp. 8-9. U n d e r New
York City's “J o b Incentives P ro g r a m ,”
tens o f millions o f dollars in exemptions
an d abate m ents were gran ted to New York
firms in an a tt e m p t to a tt r a c t and retain
firms. V a u g h n cites, as an example of an
incentive th a t was prob ably a give-away,
a ten-year, 3>8 million bonus to Tiffany’s
for the reh ab o f two floors of its building
at 57th St. an d 5th Avc. in New York City
(arguably one of the most valuable pieces
o f real estate in the country even w ithout
the tax incentive).
7 Columbus Dispatch, T hu rsd ay, S eptem ber
7, 1978. p. 3.
8 T he case involves the City of Duluth,
M innesota versus T riang le C orporation,
Stamford, C onnecticut and its a tte m p t to
move D iam on d Tool an d Horseshoe Co.
For reference to o th er judicial challenges
see “ Factory T ow ns S tart T o Fight Back
Angrily W h en Firms Pull O u t ” , W all Street
Journal, M a r c h 8, 1988.

K a r l A. S ch eld , S en io r V ic e P resid en t a n d
D ir e c to r o f R e s e a rc h ; D a v id R . A lla rd ice, V ice
P r e s id e n t a n d A ssistan t D ir e c to r o f R e s e a rc h ;
E d w a r d G. N ash , E d ito r.
C h i c a g o F e d L e t t e r is p u b l i s h e d m o n t h l y b y t h e
R esea rc h D e p a r tm e n t o f the F e d e ra l R eserv e
B a n k o f C h ic a g o . T h e view s e x p re s s e d a r e th e
a u th o r s ' a n d a re n o t necessarily those o f the
F e d e ra l R eserv e B a n k o f C h ic a g o o r th e F e d e ra l
R e se rv e S y stem . A rticles m a y b e re p r in te d if the
s o u r c e is c r e d i t e d a n d t h e R e s e a r c h D e p a r t m e n t
is p r o v i d e d w i t h c o p i e s o f t h e r e p r i n t s .
C h i c a g o F e d L e t t e r is a v a i l a b l e w i t h o u t c h a r g e
from th e P u b lic In fo rm a tio n C e n te r. F ed eral
R eserv e B a n k o f C h ic ag o , P .O . Box 834, C h ic ag o ,
I l l i n o i s 6 0 6 9 0 , o r t e l e p h o n e ( 3 1 2 ) 3 2 2 - 5 1 11.

ISSN 0895-0164

Manufacturing activity in the nation edged up only 0.2 percent in September,
fueling speculation that the economy is beginning to slow down. The nonelectrical
machinery industry, reflecting the strength in business equipment, continued to
post solid gains, as did the transportation equipment industry. However, pro­
duction of consumer durables (except autos) and nondurables declined along with
basic metal materials, such as steel.
Manufacturing activity in the Midwest fared slightly better than the nation, rising
0.3 percent in September after experiencing no growth in August. Midwest man­
ufacturing was aided by a relatively strong performance in its primary metals and
electrical equipment industries, when compared to those industries nationally.

Chicago Fed Letter
mm
F E D E R A L R E SE R V E BA NK O F C H IC A G O
P u b lic In fo rm a tio n C enter
P .O . B o x 834
C h ic ag o , Illin o is

60690

(312) 322 -5 1 1 1

04

2SOI

ARCHIVES

CHI

RECORDS MANAGEMENT

N O T E : T h e M M I is a com posite index o f 17
m an u factu rin g industries an d is constructed from
a w eighted com bination o f m onthly h o u rs worked
an d kilow att hours d a ta . See “M idw est M a n u ­
facturing Index: T h e C hicago F ed ’s new regional
econom ic in d icato r,” Economic Perspectives, F ederal
R eserve B ank o f C hicago, Vol. X I, N o. 5,
S ep tem b er/O cto b er, 1987. T h e U n ited States
represents the F ederal Reserve B oard ’s In d ex o f
In d u strial P roduction, M anu factu rin g .


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102