When States Compete to Attract Businesses

When States Compete to Attract Businesses
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Free-market fans often hold romantic notions about "competitive federalism": the idea that states and localities will cut taxes and trim regulations to attract businesses, reducing the size of government and expanding freedom for all. But as a new Mercatus Center working paper from Christopher J. Coyne and Lotta Moberg shows, the reality of luring companies to a jurisdiction is often much more cynical.

The key fact is that not all businesses are equally mobile. If I've spent 20 years building up a small store with a loyal customer base, I have an enormous preference for staying in place. By contrast, once I make a decision to relocate -- or if my business grows and I want to open another shop -- I'll probably be open to suasion as to where I should go. And if I'm, say, a Hollywood studio deciding where to film a movie that's set in a generic suburb, I might have very little preference for one place over another aside from tax rates.

What happens is that states and localities focus on these businesses, giving them special tax breaks rather than lowering rates across the board. If you view this situation from on high, the problems are obvious: It's unfair for the new business in town to pay lower taxes than its competitor across the street, and game theory suggests that all jurisdictions would be better off if they got together and agreed to stop this. From the point of view of a local official, though, it can be very difficult to tell what the best course of action is.

Let's say our jurisdiction gives a tax break worth $1 million to a company that opens a new location employing 100 people. We could do some basic arithmetic and conclude that we spent $10,000 for each job. We'd be wrong, though, because that method ignores the question of what would have happened without the tax incentive.

If the business would have moved in anyhow, we've made a huge mistake: The jobs were ours either way, but this way we're out a million bucks. On the other hand, if the business wouldn't have moved in, we got ourselves a great deal: 100 more people are now employed here and paying income and sales taxes, and presumably the business is paying some taxes even with the special break. We still might say we "spent" $10,000 per job by giving the tax break, but that number is meaningless, because the actual alternative was no jobs and no taxes. Call it unfair if you want, but it's not hard to see why this would be attractive to local politicians.

It gets especially difficult when a program gives tax breaks to many different businesses, some of which come for the tax breaks and some of which would have come without them. What do real-world data say about these arrangements, and what are the longer-term effects? That's where the new paper comes in handy.

As the authors note, governments do not always evaluate their incentive programs carefully -- and when evaluations take place, researchers are never sure what would have happened without the program, and different assumption produce radically different results. One Michigan program, for example, cost $1,653 per job if we assume that all new jobs at subsidized firms resulted from the program, but $45,000 per job without that assumption. A Minnesota program might have cost $5,000 per job, or maybe more like $30,000.

Meanwhile, studies that might inform the assumptions we make -- those that, for example, look to see whether businesses move in when legislators make a low-tax "enterprise zone" -- tend to arrive at results that are mixed at best. In one survey, only 24 percent of enterprise-zone businesses cited the tax break as an important reason for their decision, suggesting that you need to subsidize at least four businesses to affect one decision.

The authors also make two arguments regarding the longer-term effects of these programs.

First, they say these tax breaks "contribute to the misallocation of resources because they divert them from the uses that market actors value the most." Without these programs, businesses would simply choose the best location rather than looking for bribes, and with all businesses located at the best location we'd all be better off. Further, while governments often try to woo businesses in a strategic way to spur economic growth, there's no reason to believe they're better at this than the market. And even when it comes to the very simple goal of focusing tax incentives on the companies whose location and staffing decisions are most "elastic," there are reasons to doubt that lawmakers get it right. (There are limits to this last point: Almost by definition, a company that's moving or opening a new location is more persuadable than a company that isn't, so at least at this basic level the incentives are better targeted than an across-the-board tax cut.)

Second, the authors note that these programs lead to cronyism -- government actors pick winners and losers, and typically spend most of their effort making life easier for big companies. Over time, two-way relationships take hold and warp government policy, with connected businesses supporting friendly candidates and spending increasing amounts of money on lobbying.

The authors' solution is not to rule out tax cuts entirely, but "to end the use of discriminatory policies toward private market actors. ... Policymakers need to make a commitment to a generality norm whereby no company or industry receives preferential treatment over others." Getting there from here will be tough. But one of their suggestions -- cooperation between states to roll these programs back -- might a good place to start.

It's not a competitive move in itself, but it may be the only way to create a "competitive federalism" we can be proud of.

[Update: I should also note this recent Council on Foreign Relations paper, which we linked in our White Papers & Research section a week ago. It suggests a more active role for the federal government in fighting these subsidies.]

Robert VerBruggen is editor of RealClearPolicy. Twitter: @RAVerBruggen

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