1996-1997 Essay Contest Topic

Should states be permitted to use targeted incentives to recruit businesses?

Background Information

The Economic War Among the States

An Overview

Imagine: You are a top economic adviser to the governor of a Ninth District state. Your state's economic development agency actively recruits businesses to the state by offering special incentives, such as a tax break or a loan at a below-market interest rate, to companies planning to relocate or expand. Recently, however, some economists and politicians have spoken out against this use of public funds, saying that it wastes money which could be better spent on public goods, such as highways and education. On the other hand, many argue that special incentives are a form of community investment that helps states develop their economies. In response to this debate, Congress is considering a bill that would prohibit states from using incentives that benefit a specific company. Your governor has been called to testify before a congressional committee on this issue and must decide whether to support the prohibition of incentives or oppose it. Your job is to research the controversy and present the governor with a position paper that recommends whether to support the bill.

Background information

Should states be permitted to use targeted incentives to recruit businesses?

States and local governments are spending enormous amounts of money to lure businesses into their region. Consider the following examples in the Ninth District. A county board committed itself to a deal of over $1 million to bring an airline maintenance facility to Sawyer, Mich. Deadwood, S.D., offered actor Kevin Costner's company $7 million to build a casino in their town—almost $6,000 per capita. Northwest Airlines received a financial package roughly worth $700 million to build two airplane repair facilities in an economically depressed region of Minnesota. Montana made a $5.5 million loan to Pasta Montana for building a plant in Great Falls. Of course, some regions spend less than the examples listed here. While some of these efforts may prove successful, some fall short when the recruited business doesn't live up to expectations—or worse yet, fails completely and closes. Are economic incentives worth it?

Even if a state answers "no" to that question and wants to drop out of the bidding war, it would be politically difficult and perhaps costly for the state to stop offering incentives while other states continue to do so. Such a state might lose the bidding war by default and businesses might look elsewhere. If the state's business climate is healthy and inviting, it might be able to overcome the lack of government handouts. However, few states so far seem willing to try.

Incentives have been challenged in court, most notably by William Maready, a trial lawyer in Winston-Salem, N.C., who argued that the use of public funds to subsidize private companies was against the Constitution of North Carolina. A Superior Court judge ruled in favor of Maready; however, the state's Supreme Court overturned the ruling and declared that incentives contribute to the "general economic welfare" of the state and are an appropriate use of public funds.

Another way to end the "economic war" would be to have Congress pass a law that prohibits targeted incentives—the root of this year's Essay Contest question. Below are the basic arguments behind the cases for and against targeted incentives.

The case for targeted incentives

Supporters of incentives argue that they enhance the local economy and nurture traditional government functions. While opponents claim that incentives take money away from producing public goods, supporters counter that this concern is exaggerated. Instead, supporters emphasize that incentives help boost the local economy, including the indirect effects that incoming businesses have on the economy. For example, a new plant will boost employment in a community by the number of people it hires plus the number of jobs needed to supply materials and services for the plant and its employees. Furthermore, incentives can help accelerate infrastructure projects and expand community colleges and technical institutes.

Some incentive supporters argue that incentives should be used to provide equity; states can use incentives as a tool to help revitalize a depressed economy or support a particular industry. Businesses generally don't consider the effects on the local economy when they make their location decisions, but states and local governments do. States can direct investment to the areas that need it most. The effect of investment in an economically depressed area can have a greater effect than the same investment in healthy area. Even if there is a small loss in efficiency, it is offset by gains in equity.

Another argument is that some government cooperation is usually necessary for major private projects, whether or not there is competition among states. Take, for example, the Mall of America in the Twin Cities. Roads and utilities, among other things, needed expansion so that the Mall of America could be built. Government cooperation was necessary to make these changes.

Aside from economic considerations, incentives can be administered with "clawbacks"—clauses that protect governments if a company does not meet the requirements of a bargain. For example, if the incoming business doesn't employ a certain number of people within an agreed time frame, its tax reduction could be eliminated or it may be required to repay its incentives to the state. Incentive supporters argue that even though some bad agreements are made, this isn't a reason to prohibit a practice that, if done right, could benefit society.

In general, incentive supporters say that the costs and benefits of each incentive expenditure must be evaluated carefully, but if administered appropriately, they can be a profitable investment in a state's economy.

The case against targeted incentives

Those who oppose targeted incentives argue that incentives cause inefficiency and waste. They argue that subsidies and preferential taxes distort prices and disrupt the free market. Incentives encourage companies to locate where they are subsidized the most, not where they would perform most efficiently. For example, a corn milling plant might decide to locate in a non-agricultural state because it could receive special treatment from the state, such as a decrease in taxes. Since the company would be located far from its source of raw materials, the result would be an inefficient use of resources. In addition, when one company pays less taxes, competitors are placed at a disadvantage. In this case the market will not support the most efficient company, but the one that received special treatment.

In addition, incentive opponents contend that economic incentives do not create new jobs or businesses, they only move them from state to state. They say incentives are at best a "zero-sum" game: The total number of jobs or businesses stays the same nationwide. Meanwhile, however, millions of dollars pass from the government into private hands in this process, resulting in a net loss for taxpayers.

The loss of efficiency combined with the lack of net growth explain why incentive opponents say the situation on a national level is actually a "negative-sum" game. Incentives decrease efficiency with no national gain of jobs or growth.

Most incentive opponents support general competition between states, where states appeal to businesses with such attractions as low taxes for all companies, high quality infrastructure and an effective education system. It is preferential taxes and targeted incentives that they oppose.

Toolbox of concepts

The following economic concepts will help you evaluate the debate over economic incentives.

Opportunity cost

Almost everything has a cost. When economists talk about the cost of a good or service, however, they mean something different than noneconomists. For example, when economists calculate the cost of a car, they include both the money used to buy the car and the loss of income that the money would have earned if it hadn't been spent. This sort of price includes the loss of what could have happened, and is called the "opportunity cost" of a decision, often defined as the "best alternative forgone." Even decisions that don't involve money have opportunity costs. For example, if you walk to a store that is giving away free mugs, you don't pay money for the mug, but you lose the time that it takes to walk to the store and back. Depending on what you could have done during this time, the opportunity cost of the mug could be more sleep, extra wages or many other things.

When a government spends money on targeted incentives for businesses, it forgoes the benefits it could have received from the next best use of that money. For example, the money could have been put in a savings account to earn interest, or spent on a public good, such as education.

Cost-benefit analysis

Cost-benefit analysis is the examination of a public project and the evaluation of its total costs and benefits to all concerned. The most important part of cost-benefit analysis is the identification and quantification, if possible, of all the effects of the project. These effects can include changes in production, changes in prices, environmental effects, shifts in income distribution and other social or economic effects. Changes are considered not only for their present effects, but their long-term implications as well. The negative and positive aspects of these changes are then evaluated to determine if the project is worthwhile.

A cost-benefit analysis of a deal with a business that involves incentives can determine if the benefits are worth the costs. The state may ask the following questions: How many jobs will the incoming business create? What effect will the deal have on other sectors of the economy? What are the opportunity costs of giving the business a tax break?

Market failure

Market competition usually determines the most efficient use of scarce resources. However, there may be times when the market produces an inefficient result, called a market failure. They occur when noncompetitive behavior exists, public goods are underproduced or externalities—external costs or benefits—are present. When market failures occur, government intervention is sometimes used to correct them. Government has the capacity to discourage noncompetitive behavior, such as monopolies, produce public goods and adjust for externalities.

In the case of an externality, part of the cost or benefit of a good falls on a third party. Since the company producing or buying a good doesn't account for all costs and benefits of the good, the market will not allocate resources efficiently.

For example, the process of manufacturing widgets creates air pollution. Unless the government taxes companies for emitting pollutants into the air, the local widget company won't consider the environmental and health costs borne by its neighbors in determining how many widgets to produce. It will probably produce too many widgets. Once all costs of pollution are included, the company will produce the number of widgets that most efficiently uses resources.

Incentive opponents argue that by using incentives, state governments keep markets from operating at their optimal levels. They say that since there isn't a market failure to be corrected, the government shouldn't interfere in the decisions of the free market and distort the allocation of resources by offering incentives.

On the other hand, some incentive supporters argue that government is fixing a market failure when it uses incentives. For example, when a business locates in a state, benefits are realized by the entire state, not just the business. Since the business wouldn't take those external benefits into account, the state should step in. Some also contend that there sometimes isn't enough information available for businesses to determine where to locate. States can bridge this gap in part by recruiting businesses that are well-suited for the state.

Still, incentive opponents claim that it is difficult to prove that there is a market failure, and they contend that the market generally makes better decisions than the government about which companies are best for its state.

Challenge

As an economic adviser to the governor, your are responsible for presenting him or her with a recommendation on whether or not to support a congressional bill that will ban the use of targeted economic incentives. Evaluate the pros and cons of targeted economic incentives with economic concepts, such as efficiency, opportunity cost, market failure and externalities.

Now it's time for you to read what economists and journalists have written about the issues and talk to economic development agencies and business leaders who would be affected by this bill if it were developed in real life. Then place your pen on the paper or your fingers on the keyboard and argue whether states should be allowed to use targeted economic incentives to recruit businesses.

 
Latest Articles
Federal Reserve Consumer Help