This paper summarizes what we know about eight issues for public
policy toward economic development incentives. The evidence supporting
many statements made here can be found in the references listed at the
1. Benefits vs. costs of incentives.
The issue isn't whether economic development incentives can work; empirical
evidence suggests they can. The issues are whether benefits of incentives
outweigh costs, and how benefits and costs are affected by local conditions
and incentive design.
Empirical research on taxes and business location suggests that state
and local taxes have a statistically significant effect on business
location decisions. Local job growth has significant effects on the earnings
of local residents.
But do the earnings benefits justify the costs of incentives? Incentives
are costly per job created. The effect of taxes on business location is
modest. Many location and expansion decisions are unchanged by incentives.
The cost of incentives to businesses whose location decisions are unchanged
exceeds the taxes from businesses whose location decisions are changed.
When one considers all the evidence, the costs to local residents (in
higher taxes or lower services to pay for incentives) from an "average"
economic development incentive program are of similar size to the earnings
benefits for local residents. This implies that the average incentive
program does not make sense in a low-unemployment area. If unemployment
is low, local residents can easily find jobs, and the earnings benefits
from greater employment rates will overstate the social benefits of new
Economic development incentive programs are more likely to pass a benefit
cost test if (1) local unemployment is high, so the new jobs are needed
by local residents; (2) the jobs pay higher wages; (3) more of the jobs
go to local residents.
Targeting some firms for greater incentives than others may be rational.
Such targeting should not, however, be based on political pressure or
media attention. Targeting should be based on which firms are likely to
provide greater social benefits at lower incentive costs. Reasonable targets
include firms that provide greater social benefits because they pay higher
wages, or are more likely to employ local residents.
Because large new branch plants attract media attention, there is political
pressure to target incentives at these plants, and not smaller or existing
firms. A more rational basis for targeting incentives is toward firms
that provide greater social benefits at lower incentive costs. Firms that
provide greater social benefits, and therefore might be targeted for greater
incentives, include firms paying higher wages and firms that hire the
local unemployed or disadvantaged.
Incentives could also be more cost-effective if targeted to firms that
are more responsive to incentives. This type of targeting is more questionable.
Research has not provided clear evidence of the types of firms or industries
that are most responsive to incentives. Economic development officials
lack sufficient information on particular firms to tell whether an incentive
will prove decisive.
3. Rules vs. discretion.
Economic development incentives should be distributed with more reliance
on rules and less on discretion. The balance between rules and discretion
should vary for different incentives. For example, job training and infrastructure
incentives should be customized to individual firm needs and therefore
must be partly discretionary. On the other hand, most financial incentives
could be folded into the state and local tax code.
It is more efficient and fairer to provide similar incentives to all
firms providing similar social benefits per dollar of incentive. Formulas
or rules for distributing incentives can help do this. In theory, a benefit-cost
analysis of each firm could do a better job of evaluating the social benefits
from the firm's increase in employment. In practice, some simple rules
may do reasonably well at matching the larger incentives to the firms
offering greater social benefits. Formulas and rules help a state or local
government maintain its bargaining position against political pressure
to increase the bid for a particular company.
Financial incentivestax abatements or credits, subsidized loanscould
be governed by rules by being incorporated into the regular tax code.
Firms could be entitled to a "New Jobs Tax Credit" that based
the amount of the credit on factors such as the firm's increase in employment,
the wage rate paid by the new jobs and who gets the jobs.
Job training incentives or infrastructure assistance will be more useful
if customized to the needs of the particular firm. Therefore, these programs
should not be designed as entitlements, although there should be guidelines
on which types of firms are to be helped and how.
4. Incentives vs. small business assistance.
Customized government assistance to particular businesses does not always
represent an "incentive" designed to attract businesses and
increase job growth. Small business assistance programs provide customized
services to small businesses to improve their productivity. Such services
to small business include help with job training, technology, exporting,
financing and business management. These programs are efficient if they
increase business productivity by more than their costs.
There are many possible private "market failures" that adversely
affect small businesses, including: inefficiently low job training; poor
information on management, technology and exporting; and problems in obtaining
financing. Many economic development programs seek to address these problems,
either through government directly providing services, or encouraging
a private organization to provide services. Evidence from surveys, and
comparisons of assisted and unassisted firms, suggests such assistance
can be effective.
Small business assistance programs should not be confused with incentive
programs that are solely justified by their effects on local job growth.
Small business assistance programs can be efficient even if they do not
increase local job growth. For example, suppose a small business assistance
program provides training to help disadvantaged individuals start new
restaurants. Suppose these new restaurants compete so successfully with
other local restaurants that they drive them out of business. Even if
total local employment is unchanged, the local restaurant sector will
be more productive, because presumably the restaurants that survived had
better food or lower prices. If the greater productivity of the new restaurants
exceeds the costs of training new restauranteurs, then local consumers
are better off.
5. The timing of incentives.
Both economic efficiency and theories of public decision-making suggest
that better decisions will be made if incentives are required to be provided
upfront. "Clawback" provisions should be attached to these upfront
incentives, allowing some incentive funds to be recovered if the promised
jobs do not arrive or later disappear.
Because empirical evidence suggests that business executives heavily
discount future cash flows, incentive dollars provided 10 years or more
in the future have little effect on business location decisions. Furthermore,
allowing politicians to give away the future tax base of their jurisdiction
is likely to encourage profligate use of incentives.
6. The zero-sum game argument.
The theoretical case for economic development incentives being
a zero-sum or negative sum gamethat is, for rational competition
among state and local governments inevitably leading to economic inefficiencyis
weak. The national concerns about economic development incentives should
be twofold: (1) For political reasons, governors and mayors often do not
pursue the general interest of their jurisdiction, resulting in inefficient
use of incentives; (2) economic development competition among states and
local governments is making it harder for these jurisdictions to redistribute
money or services to low- and moderate-income groups.
If one assumes that each state or local government serves the interests
of all its residents, and that these governments can use many tax instruments,
economic development competition should be efficient. Competition should
bid business taxes down to equal the marginal cost of providing businesses
with public services, plus the marginal environmental and congestion costs
created by the business, minus the marginal social benefit the business
provides by creating jobs. Such a business tax system is economically
This competition might lead to some expansion of national output, employment
or wage rates. Subsidies for employment and capital in many jurisdictions
might increase total national employment and capital stock. (This is more
likely if greater incentives are provided in high-unemployment areas,
which have the greatest social benefits from job growth.) Support for
higher wage industries and firms might increase wages nationally. The
provision of information and training to small businesses could increase
One problem with this argument for the efficiency of economic development
competition is that governors or mayors may not pursue the interests of
all local residents. Governors or mayors in low-unemployment areas may
offer large incentives, though the benefits for local residents are small,
to help land developers. Governors or mayors may use long-term tax abatements
to pass the costs of incentives on to their political successors. Governors
or mayors may favor the large branch plants that get media attention over
helping smaller businesses.
A second problem is that economic development competition is making
it harder for state and local governments to redistribute public services
or money to low-income households. Traditionally, state and local fiscal
systems have been designed so that businesses and upper-income households
pay a bit more in taxes than they receive in public services, and low-income
households receive more in public services than they pay in taxes. The
mobility of businesses and upper-income households has limited but not
eliminated this redistribution. The increased mobility of businesses and
economic development competition is making redistribution more difficult
for state and local governments.
7. The feasible federal role.
The federal government cannot eliminate economic development competition
among states and local governments. The federal government can encourage
a more rational competition. Federal policy could discourage discretionary
financial incentives and encourage economic development policies that
would have greater national benefits, for example, policies to encourage
growth in high-unemployment areas or increase labor productivity. But
greater federal intervention in economic development could also discourage
state and local experiments, and hurt distressed areas.
As long as state and local governments can design their own business
tax systems and mix of public services, they can use such power to attract
new businesses. Federal policy might more feasibly be used to penalize,
through withholding federal grants, discretionary financial assistance
given to particular branch plants, but not to similar businesses. Federal
policy could encourage and support economic development incentives in
high-unemployment areas, where the social benefits are greater. Federal
policy could encourage experiments with small business assistance, which
may increase productivity. Finally, federal policy could support more
consistent information on and evaluation of state and local economic development
policies. Better information on the size and effects of incentives, and
other economic development policies, should put pressure on state and
local governments to adopt more rational policies.
The problem is that federal intervention could also eliminate some important
experiments in economic development policy. A federal policy to discourage
discretionary incentives might discourage them everywhere, including high-unemployment
states and cities. Furthermore, federal intervention could discourage
job training, infrastructure and small business assistance programs that
could help increase productivity.
8. Incentives, federalism and redistribution.
The problems of economic development competition reinforce the argument
that the federal government should have primary responsibility for redistributional
policies. Current proposals to turn over responsibility for welfare and
Medicaid to the states are going in the wrong direction.
The traditional wisdom in public finance is that income redistribution
should be a federal responsibility, because mobility of households and
businesses makes this task difficult for state and local governments.
This traditional wisdom seems more sensible as business has become more
footloose and economic development competition intensifies. The problem
with turning over welfare and Medicaid to the states is that states have
strong incentives, for economic development reasons, to cut funds for
welfare and Medicaid. Taxing businesses to finance welfare and Medicaid
does not make sense for a state's economic development.
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.
Bartik, Timothy J. "The Market Failure Approach to Regional Economic
Development Policy," Economic Development Quarterly 4,
(November 1990): 361-370.
Bartik, Timothy J. Who Benefits from State and Local Economic
Development Policies? Kalamazoo, Mich.: W.E. Upjohn Institute for
Employment Research, 1991.
Bartik, Timothy J. "Jobs, Productivity, and Local Economic Development:
What Implications Does Economic Research Have for the Role of Government?" National Tax Journal 47, No. 4 (December 1994): 847-61.
Bartik, Timothy J. "Strategies for Economic Development," Management Policies in Local Government Finance, 4th Edition,
J.R. Aronson and E. Schwartz, eds., International City/County Management
Association Press, forthcoming.