DRI-162 for week of 2-1-15: It Happens Every Season

An Access Advertising EconBrief:

It Happens Every Season

The Super Bowl has come and gone. And with it have come stories on the economic benefits accruing to the host city – or, in this case, cities. The refrain is always the same. The opportunity to host the Super Bowl is the municipal equivalent of winning the Powerball lottery. Thousands – no, hundreds of thousands of people – descend on the host city. They focus the world’s attention upon it. They “put in on the map.” They spend money, and that money rockets and ricochets and rebounds throughout the local economy with ballistic force, conferring benefits left, right and center. We cannot help but wonder – why don’t we replicate this benefit process by bringing people and businesses to town? Why wait in vain on a Super Bowl lottery when we can instead run our own economic benefit lottery by offering businesses incentives to relocate, thereby redistributing economic benefits in our favor?

It happens every winter. In fact, publicity about economic development incentives (EDIs) is always in season, for they operate year-round. Nowadays almost every state in the union has a government bureau with “economic development” on its nameplate and a toolkit bulging with subsidies and credits.

For years, the news media has mindlessly repeated this stylized picture of EDIs, as if they were all repeating the same talking points. Both the logic of economics and empirical reality vary starkly from this portrait.

EDIs In a Nutshell

The term “EDIs” is shorthand for a variety of devices intended to make it more attractive for particular businesses to relocate to and/or operate in a particular geographic area. The devices involve either taxes or subsidies. Sometimes a business will receive an outright grant of money to relocate, much as an individual gets a relocation bonus from his or her company. Sometimes a business will receive a tax credit as an inducement to relocate. The tax credit may be of specified duration or indefinite. Sometimes the business may receive tax abatement – property tax abatements are especially favored. Again, this may be time-limited or indefinite. Sometimes the tax or subsidy is implicit rather than explicit. Sometimes businesses will even receive production subsidies in excise form; that is, a per-unit subsidy on output produced.

Various forms of implicit or in-kind benefit are also offered. These include grants of land for production facilities and exemption from obligations such as payment for municipal services.

These do not exhaust the EDI possibilities but the list is representative and suggestive.

A Short, Sour History of EDIs

Proponents of EDIs indignantly reject the charge that their ideas are new. On the contrary, government favors to business trace back to the early years of the republic, they insist.

It is certainly true that the early decades of the 19th century saw a boom – today, we would call it a “bubble” – in the building of canals, primarily as transportation media. The Erie Canal was the most famous of these. Although the canals were privately owned, they were heavily subsidized and supported by government. Are we surprised, then, that the canal boom went bust, sinking most of its investors like sash weights? Railroads are traditionally given credit for spearheading U.S. economic development in the 19th century, and the various special favors they won from state and local governments are legendary. They include subsidies and extravagant rights of way on either side of their trackage. But economist Robert Fogel won a Nobel Prize for his downward revision of the importance of railroads to the economic growth of 19th-century America, so there is less there than meets the mainstream historical eye.

The modern emphasis on EDIs can be traced back to the state industrial finance boards of the 1950s. These became more active in the late 1960s and 70s when the national economy went stagnant with simultaneous inflation and recession. Like European national governments today, state and local governments were trying to steal businesses from each other. They lacked central banks and the power to print money, so they couldn’t devalue their currencies as European nations are now doing serially. Instead, they used selective economic benefits as their tools for redistributing businesses in their favor. And, like Europe today, they found that these methods only work as intended when employed by the few. When everybody does it simultaneously, they cancel each other out. One state steals Business A from another, but loses Business B. How do we know whether that state has gained or lost on net balance? We don’t, but in the aggregate nobody wins because businesses are simply being reallocated – and not for the better. Of course, we haven’t yet stopped to consider whether the state even gained from wooing Business A in the first place.

We can look back on many celebrated startups and relocations that were midwived by EDIs. In Tennessee, Nissan got EDI subsidies for relocating to the state in 1980. Later, GM built its famous Saturn plant there. In both cases, the big selling point was the large number of jobs ostensibly created by the project. We can get some idea of the escalation in the EDI bidding sweepstakes by comparing the price-tag per job over time. The Nissan subsidies cost roughly $11,000 per job created. At this price, it is hard to envision an economic bonanza for the host community, but compare that to the $168,000 per job created that went to Mercedes Benz for relocating to Alabama in 1993. In 1978, Volkswagen promised 20,000 jobs for the $70 million it got for moving to Pennsylvania, but ended up delivering only about 6,000 jobs before closing the plant within a decade.

There is every reason to believe that these results were the rule, not the exception. Economists have identified the phenomenon known as the “winner’s curse,” in which winning bidders often find that they had to bid such a high price to win that their benefits were eaten up. Economists have long objected to the government practice of setting quotas on imported goods because the quota harms domestic consumers more than it benefits domestic producers. Moreover, governments customarily give import licenses to politically favored businesses. Economists plead: Why not open up the licenses to competitive bid? That would force would-be beneficiaries of the artificial shortage created by the quota to eat up their monopoly profits in the price they pay for the import license. Then taxpayers would benefit from the revenue, making up for what they lose in consumption of the import good. This same principle prevents cities from benefitting when they “bid” against other cities to lure firms by offering them subsidies and tax credits – they have to offer the firm such lucrative benefits to win the competition against numerous other cities that any benefits provided by the relocating business are eaten up by the subsidy price the city pays.

The Economics of Business Location

The general public probably envisions an economic textbook with a chapter on “economic development” and tips on how to lure businesses and which types of business are the most beneficial, as well as tables of “multiplier” benefits for each one.

Not! The theory of economic development is silent on this subject. The only applicable economic logic is imported from the theory of international trade. The case of import quotas provided on example. The specter of European nations futilely trying to outdo each other in trashing the value of their own currencies is another; international economists use the acerbic term “beggar thy neighbor” to characterize the motivation behind this strategy. It applies equally to states and cities that poach on businesses in neighboring jurisdictions, trying to lure them across state or municipal boundaries where they can pay local taxes and provide prestigious photo opportunities for politicians.

What about the Keynesian theory of the “multiplier,” in which government spending has a multiple effect on income and employment? Even if it were true – and all major Keynesian criticisms of neoclassical theory have been overturned – it would apply only under conditions of widespread unemployment. It apply only to national governments that can control policies for the entire nation and have the power to control and alter the supply of money and credit and rates of interest. Thus, the principle would be completely inapplicable to state and local governments anyway.

Economists believe that there is an economically efficient location for a business. Typically, this will be the place where it can obtain its inputs at lowest cost. Alternatively, it might be where it can ship its output to consumers the cheapest. If EDIs cause a business to locate away from this best location by falsely offsetting the natural advantages of another location, they are harming the consumers of the goods and services produced by the businesses. Why? The business is incurring higher costs by operating in the wrong location, and these higher costs must be compensated by a higher price paid by consumers than would otherwise be true. That higher price combines with the subsidies paid by taxpayers in the host community to constitute the price paid for violating the dictates of economic efficiency.

Why do economists obsess over efficiency, anyway? The study of economics accepts as a fact that human beings strive for happiness. In order to attain our goals, we must make the best use of our limited resources. That requires optimal consumer choice and cost minimization by producers. When government – which is a shorthand term for the actions of politicians, bureaucrats and lower-level employees acting in their own interests – muck up the signaling function of market prices, this distorts the choices made by consumers and producers. Efficiency is reduced. And this effect is far from trivial. A previous EconBrief discussed an estimate that federal-government regulations since 1949 have reduced the rate of economic growth in the U.S. by a factor of three, implying that average incomes would be roughly $125,000 higher today in their absence.

EDIs are a separate issue from regulation. They are more recent in origin but growing in importance. In 1995, the Minneapolis Federal Reserve published a study by economists Melvin Burstein and Arthur Rolnick, entitled “Congress Should End the Economic War Between the States.” At about the same time, the United Nations published its own study dealing with a similar phenomenon at the international level.

Borrowing once again from the theory of international trade, these studies view production in light of the principle of comparative advantage. Countries (or states, or regions, or cities, or neighborhoods, or individual persons) specialize in producing goods or services that they produce at lower opportunity cost than competitors. Freely fluctuating market prices will reflect these opportunity costs, which represent the monetary value of alternative production foregone in the creation of the comparative-advantage good or service. Free trade between countries (or states, regions, cities, neighborhoods or persons) allows everybody to enjoy the consumption gains of this optimal pattern of production.

Burstein, Rolnick, the U.N., et al felt that politicians should not be allowed to muck up free markets for their own benefit and said so. That debate has continued ever since in policy circles.

The Umpires Strike Back: EDI Proponents Respond 

Responses of EDI proponents have taken two forms. The first is anecdotal. They cite cases of particular successful EDI regimes or projects. The cited case is usually a city like Indianapolis, IN, which enjoyed a run of success in luring businesses and a concurrent spurt of economic growth. A less typical case is Kansas City, KS, which languished for several decades in prolonged decay with a deserted, crumbling downtown area and crime-ridden government housing projects and saw its tax base steadily disintegrate. The city subsidized a NASCAR-operated racing facility on the western edge of its county, miles away from its downtown base. It also subsidized a gleaming shopping and entertainment district slightly inward of the racetrack. Both NASCAR and the shopping district have benefitted from these moves, and politicians have claimed credit for revitalizing the city by their efforts. A recent Wall Street Journal column described the policy has having revamped “the city and its reputation.”

The second argument consists of a few studies that claim to find a statistical link between the level of spending on EDIs and the rate of job growth in states. Specifically, these studies report “statistically significant” relationships between those two variables. This link is cited as justification for EDIs.

Both these arguments are extremely weak, not to say specious. It is widely recognized today that most investors are foolish to actively manage their own stock portfolios; e.g., to pick stocks in order to “beat the market” by earning a rate of return superior to the average rate available on (say) an index fund such as the S&P 500. Does that mean that it is impossible to beat the market? No; if millions of investors try, a few will succeed due to random chance or luck. Another few will succeed due to expertise denied to the masses.

Analogous reasoning applies to the anecdotal argument made by EDI proponents. A few cities are always enjoying economic growth for reasons having nothing to do with EDIs – demographic or geographic reasons, for example. With large numbers of cities “competing” via EDIs, a few will succeed due to random chance. But this does not make, or even bolster, the case for EDIs. Indeed, the use of the term “competition” in this context is really false, because cities do not compete with cities – only concrete entities such as businesses or individuals can compete with each other. It is really the politicians that are competing with each other. And this form of competition, quite unlike the beneficial form of competition in free markets, is inherently harmful.

This sophisticated rebuttal is overly generous to the anecdotal arguments for EDIs. Even if we assume that the EDIs produce a successful project – that is, if we assume that Saturn succeeds at its Tennessee plant or NASCAR thrives in Kansas City, KS – it by no means follows that one company’s gains translate into areawide gains in real income. A study by the late Richard Nadler found no gains at all in local Gross Domestic Product for Wyandotte County, in which Kansas City, Kansas resides, years after NASCAR had arrived. The logic behind this result, reviewed later, is straightforward.

The studies claiming to support EDIs lean heavily on the prestige of statistical significance. Alas, this concept is both misunderstood and misapplied even by policy experts. Its meaning is binary rather than quantitative. When a relationship is found “statistically significant,” that means that it is unlikely to be completely random or chance but it says nothing about the quantitative strength or importance of the relationship. This caveat is especially germane when discussing EDIs, because all the other evidence tells us that EDIs are trivial in their substantive effect on business location decisions.

For decades, intensive surveys have indicated that business executives select the optimal location for their business – then gladly take whatever EDIs are offered. In other words, the EDI is usually irrelevant to the actual location decision. But executives seal their lips when it comes to admitting this fact openly, because their interests lie in fanning the flames of the Economic War Between the States. That war keeps EDIs in place and subsidizes their moves and investments.

Thus, a statistical correlation between EDIs and job growth is not a surprise. But no case has been made that EDIs are the prime causal mover in differential job growth or economic growth among states, regions or cities.

Perhaps the best practical index of the demerits of EDIs would be the economic decline of big-spending blue states in America. These states have been high-tax, high-spending states that heavily utilized EDIs to reward politically favored businesses. This tactic may have improved the fortunes of those clients, but it has certainly not raised the living standards of the populations of those states.

If Not EDIs, What? 

It is reasonable to ask: If EDIs do not govern the wealth of states or cities, what does? Rather than offer selective inducements to businesses, governments would do better to offer across-the-board inducements via lower tax rates to businesses and consumers. Studies have consistently linked higher rates of economic growth with lower taxes on both businesses and individuals throughout the U.S.

Superficially, this strikes some people as counterintuitive. The word “selective” seems attractive; it suggests picking and choosing the best and weeding out the worst. Why isn’t this better than blindly lower taxes on everybody?

In fact, it is much worse. Government bureaucrats or consultants are not experts in choosing which businesses will succeed or fail. Actually, there are very few “experts” at doing that; the best ones attain multi-millionaire or billionaire status and would never waste their time working for government. Governments fail miserably at that job. Better to allow the experts at stock-picking to pick stocks and relegate government to doing the very, very few things that it can and should do.

States and municipalities typically operate with budget constraints. They cannot create money as national governments can and are very limited in their ability to borrow money. So when they selectively give money to a few businesses with subsidies or tax credits, the remaining businesses or individuals have to pay for that in higher taxes. If lower taxes for a few are good for that few, then it follows that higher taxes for the rest must be bad for the rest. And this means that even if the subsidies promote success for the favored business, they will reduce the success of the other businesses and reduce the real incomes of consumers. In other words, the “economic development” promoted by government’s “subsidy hand” will be taken away by government’s “tax hand.” What the government giveth, the government taketh away. Oops.

Lower taxes for everybody work entirely differently. They change the incentives faced at the margin, causing people to work, save and invest more. The increased work effort causes more goods and services to be produced. The increased saving makes more financial resources available for investment by businesses. The increasing investment increases the amount of capital available for labor to work with, which makes labor more productive. This increased productivity causes employers to bid up wages, increasing workers’ real incomes.

Lest this process sound like a free lunch, it must be noted that unless the increased incomes are self-financing – that is, unless the increased incomes provide equivalent tax revenue at the lower rates – government will have to reduce spending in order to fulfill the conditions for stability. Since modern government is wildly inflated – heavily bureaucratized, over-administered and over-staffed as well as obese in size – this should not present a theoretical problem. In practice, though, the willingness to achieve this tradeoff is what has defined success and failure in economic development at the state and local level.

Markets Succeed. Governments Fail

EDIs fail because they are an attempt by government to improve on the workings of free markets. Free markets have only advantages while governments have only disadvantages. Free markets operate according to voluntary choice; governments coerce and compel. Voluntary choice allows people to adjust and fine-tune arrangements to suit their own happiness; compulsion makes no allowance for personal preference and individual happiness. Since human happiness is the ultimate goal, it is no wonder that markets succeed and governments fail.

Free markets convey vast amounts of information in the most economical way possible, via the price system. Since people cannot make optimal choices without possessing relevant information, it is no wonder that markets work. Governments suppress, alter and distort prices, thereby corrupting the informational content of prices. Indeed, the inherent purpose of EDIs is exactly to distort the information and incentives faced by particular businesses relative to the rest. It is no wonder, then, that governments fail.

Prices coordinate the activities of people in neighborhoods, cities, regions, states and countries. In order for coordination to occur, people should face the same prices, differing only by the costs of transporting goods from place to place. Free markets produce this condition. Governments deliberately interfere with this condition; EDIs are a classic case of this interference. No wonder that governments, and EDIs, fail.

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