The Region

Doing battle over the incentives war: Improve accountability but avoid federal noncompete mandates

Graham S. Toft - President, Indiana Economic Development Council Inc., Indianapolis, Indiana

Published June 1, 1996  |  June 1996 issue

Thesis: The hyper-competitive economic environment now facing the United States equally affects business and state and local decision-makers. Economically prosperous jurisdictions will be those that give strategic and energetic attention to their competitive business climate as well as their investment incentives. Both must be considered with strict rate of return/accountability discipline, but in the context of local initiative, free of federal mandates.

Interjurisdictional tax and incentive competition is a perennial and intractable problem. In recent years, large state incentive packages for major industrial projects have attracted media attention and raised the ire of economic theorists. On Sept. 20, 1995, over 100 Midwest economists called for an end of the economic war between the states. They claimed that government-sponsored selective business subsidy programs, such as direct grants and targeted tax abatements, are used by Midwest states to lure businesses away from nearby states. According to the economists, these programs fail to promote healthy and even-handed statewide economic development because they: "(1) unfairly penalize existing businesses and labor through higher taxes to subsidize relocating firms; (2) target relocating firms that, according to empirical academic research, add little, if anything, to net job creation; (3) serve only a small portion of the firms that need tax and regulatory relief; (4) are minor factors in plant location decisions of most firms; (5) give unfair advantage to large firms with administrative capabilities to negotiate the "best" deal with governments; and (6) represent state-level industrial policies that attempt to pick winners and losers through political rather than economic process, with all the potential for political abuse that this implies."

This fair field with no favors solution may make sound economic sense in a noncompete world. However, states and localities find themselves in an increasingly competitive environment in which unilateral declarations, multistate compacts, federal mandates, corporate codes of conduct or academic admonitions make little sense. The harsh realities of this war continue unabated as illustrated by the 1996 State of the State addresses of several governors: Florida Gov. Chiles proposed to expand the budget of Enterprise Florida, the state's economic development flagship, to attract and keep good high-wage, high-value jobs; Kentucky's Gov. Patton proposed a new tax incentive program "to share half the cost of skills upgrade training"; Oklahoma Gov. Keating proposed a series of tax cuts and credits for businesses that contract with other Oklahoma businesses, hire Oklahoma college graduates or are engaged in value-added processing; and Virginia's Gov. Allen proposed performance grant legislation to two semiconductor manufacturing facilities expected to create nearly 10,000 jobs. The list goes on. Earlier documentation by Greg Leroy in No More Candy Store reinforces the extent, and in some cases extremes, to which jurisdictions engage in incentives wars.

This article makes the case for well-disciplined incentives policy and practice as the only practical response. The call for federal intervention to protect the states from hurting themselves and the national economy makes little sense. Rather, subnational units of government should be allowed to compete in a marketplace where they can "... capitalize on the vulnerability of opponents by having a set of pro-active business investment tools" (James D. Laughlin and Graham S. Toft, The New Art of War). While this marketplace is far from perfect, the entry prices offered by states will not escalate out of control, especially as they take up a disciplined/rate of return approach in response to mounting public demand for accountability and no new taxes. Albeit, the federal government can take several constructive steps to level the playing field without adding mandates.

For the purposes of this article, state and local incentives refer to tax concessions, financial aid and development finance tools that attract, expand or retain investment. Beneficiaries of incentives include individuals, firms and nonprofits.

The case for incentives

When a business makes a location decision, it does so in at least two stages. First, it narrows down to a few states or geographic regions based on various site location criteria, such as proximity to markets. Incentives play a lesser role here, but are considered to the extent that states without an attractive incentives program may not even make the first cut. At the second stage, a short list of sites from within the candidate states are compared. By this stage any of a short list of sites usually meets location requirements. Here the incentive package can tip the balance in favor of one site over two or three comparable sites. It is difficult to imagine federal intervention being able to alter this competitive process because:

  1. Business investment is as much global as it is domestic. Foreign states and cities are becoming tough competitors, either directly in project bids or indirectly by raising the stakes in general. Furthermore, trade agreements are often silent on the matter, making cross-national competition accepted.

  2. Our governors, legislators and mayors may not be in a position to enter into compacts on behalf of their jurisdictions. Business, labor and civic leaders often band together into organized local economic development organizations that choose to take charge of the destiny of their communities. Some have a major say in how their community should respond to a business prospect. This new localism is spreading across the country like wildfire.

  3. Given national policy trends in favor of devolution, attempts to control the direction of local initiative by senior levels of government would seem politically unpalatable.

  4. In the majority of cases, incentives do not lure businesses away from another state, but rather assist with moves within a city, substate region or state. These intrastate relocations are motivated by market conditions, not incentives.

  5. Incentives serve the useful purpose of compensating the business prospect for the fact that certain costs of doing business are higher than in competitor jurisdictions. Such higher costs may have resulted from poor tax and regulatory policies of prior administrations. Outlawing incentive use can place a burden on today's leaders, who want to redress the errors of the past by aggressively reinvesting in the locale.

  6. The argument that incentives wars are a zero-sum game deserves closer examination. It is based on the premise that the same investment will have the same economic impact in any economic setting. But the value of a firm to a locality can be greater than its value in other settings. Unique local interfirm dependencies and rivalries can, according to cluster strategists, upgrade economic vitality and competitiveness. The very same investment can have widely different economic multipliers—that is, different indirect effects in terms of supplier-buyer relationships among local/regional firms, different demands for local consumer goods and public services, and different stimuli upon economic activity such as employment of disadvantaged workers. For example, Timothy Bartik, in Who Benefits from State and Local Economic Development Policies?, demonstrates that incentives in higher-unemployment areas can have higher returns than in low-unemployment areas. This is born out in Puerto Rico, The Section 936 Debate by Elliot Abrams and Jimmy Wheeler who show that rather than being denounced as corporate welfare by its critics, Section 936 tax incentives in Puerto Rico have functioned like an enterprise zone program, inducing private sector investment and employment in a significantly disadvantaged area.

    The Midwest industrial renaissance serves as a second example of the positive-sum game. Ironically, most of the 100 Midwest economists referred to earlier belong to universities that have been beneficiaries of a remarkable economic turnaround since the rustbelt days of the early/mid '80s. Without bidding for and attracting foreign investment, especially Japanese transplants, the Midwest would not only have been worse off for jobs, but have missed out on the demonstrable effect that foreign production and management practices have had on U.S. auto firms. Indeed, incentives can be used strategically to upgrade the economy in ways that would not have happened otherwise.

  7. The ultimate market test of the impact of incentives is what they do to bond ratings. Little evidence is available to date that would indicate serious fiscal problems resulting from incentives misuse.

Competing successfully in the war

Given the harsh realities of interjurisdictional competition, James Laughlin and I, in The New Art of War, have proposed six principles of good practice based on two notions: (1) that incentives be treated like any other public expenditure, that is, as an investment choice evaluated on a reasoned risk-reward basis and (2) that, given the public's sour mood toward government, incentives be designed and administered according to strict standards of accountability. These principles call for determining and deciding upon an acceptable rate of return, specifying outcomes and compensating the firm on performance, and requiring tight development agreements, which include clawback provisions.

Furthermore, incentives are intended for situations where targets are understood, that is, where goals have been clearly specified. Most jurisdictions fail to tie their incentives to a well-considered strategic development plan. Incentives are a tool for proactively shaping growth. Deserved criticisms of their use frequently refer to cases where the jurisdiction is attempting to shoot anything that flies, claim anything that falls.

Successful incentive programs also require regular evaluation and personnel training. Where impacts are poorly measured and evaluated, a jurisdiction deserves the wrath of the public and the media when it comes time for reelection, incentives budget requests or public acceptance of a package in support of a major new business coming to town. Since incentives are complex, and crafting development agreements are critical to the success of each package, routine staff and public official training is essential.

What can the federal government do?

Given that outlawing incentives would be anti-competitive, arbitrary, anti-local and biased against jurisdictions with a legacy of prior development problems, what can the federal government do?

  1. Get its own fiscal house in order. Over and above incentives, smart states and localities know that a strong governmental balance sheet is a prerequisite to creating a competitive business climate. Businesses make location decisions for the long haul. They want to know they are locating in areas where fiscal problems and unfunded liabilities will not create future tax surprises. With increasing global choice for mobile investments, this applies as much to nations as to states and localities. Also, from the perspective of competitive strategy, does the $5 trillion public debt make the United States more vulnerable to factors outside its control?—approximately $550 billion of U.S. Treasuries are held by foreign central banks alone, including 40 percent in Japan.

  2. By example, reduce corporate welfare in the federal tax code. Like the states, federal tax policy has become de facto industrial policy. Tax codes are replete with exemptions, allowances, credits, rate reliefs and tax deferrals that target particular types of firms or industries for special treatment. Cleanup of these preferential treatments at both federal and state levels is a far greater challenge than eliminating state and local incentives.

  3. Eliminate major federal job subsidy programs. While the price per job created for large state economic development projects has escalated in recent years (now in the range of $20,000 to $160,000 per job), some federal programs are well above that, particularly those that seek to retain existing jobs. A recent report for the International Trade Commission puts the costs of American trade protectionism (anti-dumping and countervailing orders) at $420,000 per job. The job retention costs of agriculture price supports are also well above what states are willing to pay.

  4. Eliminate place-based subsidies to states and localities. Programs that provide financial aid to places run the risk of adding fodder to interlocal bidding wars. For example, Indianapolis' recent success at retaining a long-term corporate citizen, American Trans Air at a price of $18.7 million, came after warding off a Floridian contender assisted by federal aid. For another example, the U.S. Department of Housing and Urban Development has approved the use of community development block grant funds for below market-rate loans to businesses in nonentitlement communities on a competitive basis. Potentially, this pits a HUD-favored small town against one without federal aid at a time when capital markets are flush and all low-interest subsidies to business are questionable

All four recommendations fall directly under federal control. Each would significantly enhance the abilities of subnational units of government to compete on a level playing field, without undue interference with states rights to freely compete in a global marketplace.

Conclusion

Barring significant disruptions to worldwide growth and trade, cities, substate regions and states will increasingly become the locus of competitive advantage. Capital markets are now fully global and very efficient. It makes little sense for a national government to tie the hands of subnational units of government in seeking to attract investments to their areas. This is economic war, and states and localities need the flexibility to play it smart according to their economic strengths.

It makes little sense for 100 Midwest economists, mostly free market advocates, to argue in favor of the federal government curtailing competition, especially when the Midwest has been the beneficiary of strategic incentive practices by states over the '80s and '90s.

Incentives are a cost of doing business. They can and should be managed in a strategic and disciplined way so as to maximize upgrades to and synergies in the local/regional economy, while ensuring acceptable rates of return to taxpayers.

Down the road it is conceivable that one or two states may adopt the contrarian strategy of competing without incentives. This tactic would hinge on having extremely efficient and fair tax and regulatory policies—something even more difficult to accomplish than a disciplined approach to incentives. But for the majority of states, an invisible hand will contain the bidding wars. The public will continue to demand no new taxes and greater accountability from government. At the same time, devolution of responsibilities by the federal agencies will add to the increasing demands for state resources. These factors, together, force economic development in the opposite direction of escalating incentives. Thus, the best federal intervention would be to eliminate preferential treatment within its existing tax and expenditure programs, while avoiding another mandate on the states.

This paper, published by the Minneapolis Fed for "The Economic War Among the States," a conference held in Washington, D.C., on May 21-22, 1996, is reprinted in this issue of The Region.

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