Ideas in Development

To the extent that incentive deals result in net new job creation or bring jobs to communities that need them the most, they may indeed justify the use of public monies.

To the extent that incentives are used to fill niches in certain sectors, such as high tech or auto, that result in greater agglomeration economies, the state or local government may be getting an adequate return on its public dollar.

In short, attracting a worthy corporation that provides good jobs and benefits is a great boon to any community.

Costs

There are some considerable dangers associated with using tax and non-tax incentives to attract businesses. ¹

First, there are the political dangers. An intensified debate over the wisdom of this bidding-for-business approach is heating up in some places. Although rare, lawsuits by businesses angry over other companies being favored by the government’s largess, along with the growing use of performance contracts and other accountability mechanisms by state and local governments, are just two signals of a  backlash against these subsidy programs.

Second, “bidding for business” is risky. Often the promised jobs do not appear, and sometimes the company relocates from the community that initially recruited it.

Third, the game is not always voluntary and can become quite costly. Companies threatening to leave a community can spark an escalating bidding war between jurisdictions. Likewise, higher expectations on the part of companies, coupled with powerful political pressures on elected officials, can launch the cost of an incentive package into an inflationary spiral.

Fourth, predatory forms of competition are breaking out as well. Some states and localities have focused their attraction efforts on economically troubled areas, which have been hit hard by industrial restructuring, demographic changes, rising crime rates, rising business costs or risks.

Fifth, providing incentives to one firm creates a demand for incentives among other firms. This is known as the “reverse potato chip rule”—when it comes to incentives, it’s hard to give away just one.

Sixth, giving away too much of a government’s tax base can lead to underfunding of critical services, the imposition of additional taxes onto other businesses and citizens, the creation of built-in structural deficits, and the imposition of yearly, ad hoc, and confusing tax changes and user fees to bring the budget into balance. As a result, tax certainty, elasticity, balance, progressivity and revenue adequacy may be affected negatively.

Seventh, excessive reliance on bidding-for-business prospects also has intangible costs. For one, this strategy can lead to an overly reactive, non-strategic approach to economic development that wastes funds on potential prospects that are not in a community’s long-term interest. It can misplace spending priorities and cause the neglect of needed investments in other development strategies that may be potential windows of opportunity—such as foreign exports, tourism, small business development, downtown renovations, manufacturing modernization, and university and R&D-driven development.

What Are The Key Questions In Using These Incentives Wisely?

Although the costs of competing for businesses via incentives can be quite costly, states and localities continue to use incentives because they seem to work.

Yet, there are a number of reasons to be cautious about using incentives to promote job creation. Four fundamental questions surround the use of tax and non-tax incentives as a tool for attracting jobs.

Do incentives end up subsidizing economic activity that would have taken place anyway?

The data needed to judge this issue typically is inadequate or uncollected. First of all, many projects are shrouded in secrecy—only the company’s management and its accountants know why one spot was picked and what difference the incentive package made in the calculation. Second, the multiplier assumptions chosen to promote a project can make any prospect a “winner,” and are infrequently evaluated after the fact. Third, rarely is some sort of experimental model used that could act as a “control” and demonstrate “if not for this X (incentive), Y (business location) would not have happened.”

Can government really create new jobs?

Mainstream economic theory ² suggests that government efforts to foster net new job creation—as opposed to attracting jobs from somewhere else—will only occur if there is “market failure” and it is effectively addressed. Examples of such market failures include high transaction and information costs, externalities, lack of competition and discrimination. It is unlikely that the sorts of well-heeled industrial plums that most governments seek are suffering from any of the types of market imperfections that tax incentives, free land, or subsidized loan terms could remedy. Hence, these sorts of packages, from a national perspective, represent pure “windfalls” that only increase the value of shareholder assets. (However, they may allow an area to attract a company from somewhere less fortunate, create local employment and foster a higher level of growth that aids the local real estate industry.) ³

Paul Courant, the chairman of the University of Michigan’s Department of Economics, describes the rationality of most incentive programs with the following story: “Basically the subsidies are analogous to what might go on if a locality decided to engineer a gold rush on land that had no gold. The local government could go out and buy the gold on the open market, and incur the costs of transporting and burying it. The gold could then be worth digging up, but in the end all that would be available would be the value of the gold. The costs of transport, burying, and digging would be lost forever.” ⁴ He argues that this is what happens with most attraction efforts that rely primarily on incentives. They use scarce public capital to entice footloose firms that would be expanding anyway. In his view, this is especially true of most capital subsidies. As Courant summarizes, “The policies may well affect economic variables, but their certain costs exceed their maximum potential benefits.” ⁵

However, if the factors of production do not show the typical diminishing marginal returns, if there is genuine structural unemployment in the jurisdiction, if taxes are higher than the value of the benefits that the services provided, or if some other level of government is paying for the subsidy, then the subsidy may pass a cost-benefit test and even, in some cases, correct market distortions. Courant further notes that this critique does not apply if the government is trying to re-distribute economic activity to areas of individuals that are falling behind. But “only when distributional considerations are adduced or one or more of the assumptions do not hold (of the perfect market), can there be a cost-effective role for local development policy.” ⁶

Are incentives really more effective than other strategies for promoting job growth?

Although some evaluations of development programs like small business initiatives have been undertaken using controlled experimental design, ⁷ nowhere has such a methodology been used in assessing recruitment incentives. Likewise, incentive studies rarely use standardized approaches that could allow researchers and policymakers to compare the effectiveness of different programs and incentive packages.

Finally, studies of the estimated effects of tax abatements and other cuts on the various outcome measures associated with business location and business activity seldom factor in the role of government spending that could aid firms. Those that do still demonstrate a large variation in outcome data, which suggests that whether government spending fosters economic development depends on the quality of government services, how well they meet industry needs and how appropriate their mix.  (See past articles on this blog for current examples, facts and figures)

Are incentives a cost-effective development strategy?

The basic question here is: do incentives, over time, generate more fiscal and development benefits than they cost?

Ideally, in performing such an analysis, one also should weigh the “opportunity costs” of not investing these dollars in other ways. This can be done by asking the question: Which development strategy pays back more and over what period? For example, despite the continued willingness of states and localities to recruit large plants across state lines, overwhelming evidence suggests that the majority of new jobs comes from expansions and new business start-ups. Moreover, small businesses account for the lion’s share of these new jobs. So, while some states will need to rely more on recruitment strategies than others, are certain states investing too much in this strategy? Likewise, research also suggests that few of the recruitment prospects go to the regions of a state that need employment the most. Recruitment, hence, may be an appropriate approach for only certain areas — other communities may not stand a chance in the highly competitive recruitment arena.

Economist Timothy Bartik from the Upjohn Institute for Employment Research points out that “areas that have declined in employment and population will also have greater fiscal benefits from job growth. Such areas will have underutilized public infrastructure and services. Adding jobs or preventing further decline may require little additional public spending. In rapidly growing areas, additional job growth will require investments in roads, schools and other infrastructure. Case studies have indicated that such infrastructure investments often exceed the tax revenues from new job growth.” ⁸ Thus, new plant sittings in rapidly growing areas must meet much tougher cost/benefit tests. ⁹

Can incentives attract jobs? Of course, they can (whether these are net new jobs, in national terms is another question). The better question is: Are the jobs worth it? Has the state attracted the kinds of “prize” that fit its economic needs and future opportunities? Does the deal make sense in cost/benefit terms?