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The Economic War Among the States: An Overview

The pros and cons of the debate

June 1, 1996


Chris Farrell Contributing Economics Editor, BusinessWeek
The Economic War Among the States: An Overview

States and localities must capitalize on the vulnerability of opponents by having a set of pro-active business investment tools.
—Graham S. Toft, "The New Art of War"

From the states' point of view each may appear better off competing for particular businesses, but the overall economy ends up with less of both private and public goods than if such competition was prohibited.
—Melvin L. Burstein and Arthur J. Rolnick, "Congress Should End the Economic War Among the States"

Long the nation's backwater, the Southeast has emerged as a formidable economic region over the past decade. Cheap land and cheap labor played a part in the region's renaissance. But so did an aggressive industrial policy pursued by state and local governments from Virginia to Georgia. Lure industry with generous incentives. Woo foreign manufacturers. Train workers. Promote exports. In the Southeast between 1985 and 1995, nonfarm employment rose at a 2.5 percent annual rate vs. 1.8 percent for the nation as a whole. No wonder state governments around the country are using economic development incentives to attract business and jobs to their borders.

Problem is, costs are soaring in the battle for business. Micron Technology received some $80 million from the state of Utah to build a chip plant in Provo. Alabama captured a Mercedes Benz factory with a package worth over $250 million. Blue Water Fibre received about $80 million in inducements from Michigan for a paper-recycling mill and its 34 employees—a subsidy of $2.4 million per job. The arms race for jobs and income is spiraling out of control, and alarmed researchers at the Federal Reserve Bank of Minneapolis have called on Congress to end the internecine conflict.

Welcome to an incendiary political and economic debate: Are development incentives good or bad? Proponents say incentives create a business-friendly, entrepreneurial climate; promote local job opportunities and worker training; enhance private sector productivity and competitiveness. Opponents charge that these giveaways divert government money from supporting traditional public goods like education, frequently cost far more than any realized benefits, misallocate resources and make everyone worse off. Inflaming the politically charged debate is the fact that the dispute touches on some of the most contentious issues in U.S. history: Are the states laboratories of innovation or barriers to economic union? What is the proper boundary between the public and private sectors? Industrial policy or laissez faire?

Although states are highly creative with their incentive programs, they can be grouped into three broad categories: tax incentives, financial aid and employment assistance. Tax incentives range from credits for jobs created to exemptions from corporate taxes to property tax abatements. Financial aid includes everything from tax-exempt bonds to loan guarantees. Employment assistance typically means the state will train a company's workers, often at a nearby community or technical college. "The economic development field used to be a real amateur place," says Peter K. Eisenger, author of The Rise of the Entrepreneurial State: State and Local Government Development Policy in the United States. "But state and local governments have developed real professionals, people who know how to put deals together, who know how to create public and private partnerships."

State competition for business is nothing new, of course. In the early years of the Republic, Massachusetts, New Jersey, Georgia and other states courted business with a variety of subsidies to spur growth in their underdeveloped economies. Many scholars trace modern economic development policies to the Great Depression years, when Mississippi and other southern states solicited out-of-state businesses with offers of generous tax relief and ample public capital. In the immediate post World War II decades, as tax revenues swelled and state governments expanded, politicians doled out financial goodies to favored companies and industries. For instance, in 1959 five states had state industrial finance authorities, public agencies which guarantee loans to industrial borrowers and loan state funds to business. By 1963, the number had swelled to 19 states, according to a study by Roger Wilson, policy analyst at the Council of State Governments.

Still, today's bitter battle for business originated in the 1970s. The energy crunch, brutal global competition and high unemployment drove state governments to take action, especially in the old industrial belt states of the Northeast and Midwest. State and local public officials extended and refined their development efforts in the 1980s, in part because the federal government cut back on revenue sharing for financial and philosophical reasons. Now, the lethal combination of highly mobile firms, slow growth and relentless corporate downsizings is intensifying the war between the states for big business and the jobs they bring. The average number of state incentive programs has more than doubled to 24 over the past two decades, according to Regional Financial Associates Inc., an economic consulting firm. In a survey of over 200 manufacturing, retailing and distribution companies by KMPG Peat Marwick LLP, 73 percent of the respondents were more likely to be offered incentives last year than five years before. At the same time, recruitment subsidies are increasingly lavish. In 1980, Tennessee snared a new Nissan plant at a public cost of about $11,000 per job created; in 1993, Alabama got the new Mercedes Benz factory for an average subsidy per promised job of some $168,000. "The reality and perception is that business has become more mobile than it once was," says Timothy Bartik, economist at the W.E. Upjohn Institute for Employment Research. "As some areas use incentives the pressure grows on other areas to also use incentives."

Flourishing, yes. But do incentives work? Given the deep philosophical split over the issue, opponents and proponents disagree in many ways. But the crucial, somewhat overlapping, differences seem to be these:

Are states overpaying for business?

Critics charge that in high-profile, multimillion dollar bidding wars for auto plants, steel mills and other large enterprises, the victor typically overpays to win. Economists call it the "winner's curse"—in an auction with many bidders the winner is often a loser. In 1978, Pennsylvania spent some $70 million convincing Volkswagen to build a factory with its promised 20,000 jobs; yet the plant employed around 6,000 workers and shut down within a decade as the troubled German automaker consolidated operations. Even in the countless smaller deals that don't generate headlines, states may pay huge sums for fewer jobs and less tax revenue than expected. Business has learned how to strike the best deal for itself by playing states off each other. Bartik estimates the average annual cost per job from incentive programs is about $4,000, a high "hurdle" rate for states to exceed in order to get a positive return on their investment. Perhaps most important, many economists argue that even if states don't overpay, the nation as a whole loses because "beggar-thy-neighbor" competition isn't creating net new jobs, but simply shifting jobs from one state to another.

To be sure, some recent economic studies suggest that these programs may have a positive, albeit small, job impact in manufacturing. Sophia Koropeckyj, economist at Regional Financial Associates, found that adding one incentive program increased the relative growth in manufacturing employment by 0.4 percentage points over a decade. She obtained similar results using average per worker spending targeted toward attracting manufacturing companies between 1990 and 1995—an additional dollar in spending per worker on economic development programs will increase relative manufacturing growth by 0.4 percent. A study by Mark M. Spiegel, senior economist at the Federal Reserve Bank of San Francisco, and Charles A.M. de Bartolome, economist at the University of Colorado, suggests a positive relationship between state spending on development per worker and state manufacturing employment growth between 1990 and 1993—in general, states that spent more had better manufacturing job creation than those that didn't. The economists calculate that if a state development agency increased its annual expenditure per worker by $10 over the current mean of $10.67, then manufacturing jobs in that locality would increase by more than 1 percent per year. Other experts point out that business incentive programs could be creating new jobs, and not just simply redistributing work among different states, to the extent they generate work in high-unemployment areas.

What's more, economic development programs are a way of keeping government responsive to the evolving needs of both capital and labor. Indeed, in the global economy, states aren't just competing with each other, but with nations equally eager to lure investment and jobs to their borders.

Do incentives misallocate resources?

Generous tax breaks may induce executives to make uneconomic business decisions, which would make the economy worse off. In 1991, Minnesota offered Northwest Airlines a financial package roughly worth $700 million—with about half the money tied to Northwest building maintenance facilities in Duluth and Hibbing. But was it a good business decision to build two facilities in a cold climate? (Northwest has since decided to scale back its commitment.) Still, surveys of business executives usually show that state subsidies only come into play after businesses have satisfied themselves that the competing areas meet their labor, market, transportation and infrastructure needs.

Far more serious is the charge that the more money state and local governments pour into business incentives the less money they have for public services. To economists, government's economic role is to produce "public goods," such as education, libraries and infrastructure. Government does what private enterprise can't, either because customers can't be excluded from using services or charged market prices for what they consume. In an era of tight budgets and tax rebellions, state governments shouldn't be chasing smokestacks, but concentrating scarce resources on opening libraries, repairing roads, and restoring vitality to the public school system and safety to public streets.

Advocates counter that the concern is exaggerated. Indeed, economic development programs often end up nurturing traditional government functions. For example, they can accelerate infrastructure projects. In many parts of the country, community colleges and technical institutes, the bricks and mortar of the nation's technical training system, have grown along with business incentives. Tax revenue lost from tax competition is at least partly offset by increased taxes from other sources.

Is industrial policy a big mistake?

Government has a lousy record in picking business winners. State governments are throwing billions of taxpayer dollars to attract plants of industrial behemoths from other states or countries. Yet most new jobs come from existing firms in all kinds of industries within a state, many of them small- to medium-sized companies. Public policies geared toward streamlining the tax code and investing in the workforce would benefit all businesses rather than a favored few.

In addition, more than ever before economic wealth is being created by research, discovery and innovation as the Industrial Era gives way to the Information Age. In our high-tech economy, the most dynamic and innovative firms aren't basing their location decisions on minimizing tax burdens or other costs, according to David Birch, Anne Haggerty and William Parsons, consultants at Cognetics Inc. and authors of Entrepreneurial Hot Spots: The Best Places to Start and Grow a Company, 1995. What does matter? A skilled labor pool. Good universities. A major airport. Quality of life. Indeed, if there is any pattern, fast-growing companies are shifting to higher, rather than lower, cost areas.

Yet the entrepreneurial states, despite many stumbles and learning bumps, have achieved notable successes. Business incentive programs are merely part of a wide array of pragmatic policies state and local governments are using to stimulate innovation and growth. States are experimenting, trying to see what works, acting as the laboratory of economic policy. Government activism played a key role in building some of America's leading technology centers from Austin, Texas, to Salt Lake City, Utah, to central Florida. State and local governments forged close alliances with business and educators, offered low cost capital and seed grants, subsidized worker training and pushed through infrastructure projects. Some economists, such as Paul Romer of Stanford University, argue that when thinking about the forces propelling growth, the important economic divide is between ideas and things, not public and private goods. Growth comes from innovation and the transformation of things into more valuable goods, and ideas have elements of both public and private goods. Perhaps to ensure vigorous growth tomorrow, governments should take an activist role in creating hospitable conditions for individuals, companies and industries to pursue new ideas and techniques.

The controversies run deep. Nevertheless, there do seem to be some broad areas of agreement. For one thing, financial disclosure is far too sparse. To improve accountability, many experts advocate state and local governments better disclose the true cost of their incentive programs, and establish mechanisms for tracking the performance of their investments over time. "If I could redo the whole policy area, rather than say you couldn't do incentives, I would mandate a cost-benefit analysis in every case," says David S. Kraybill, regional economist at Ohio State University. "The most effective reform would be informing citizens and policymakers what the costs and the benefits are." Another idea with widespread support is strategically targeting incentives toward areas with high unemployment and depressed economic activity. And there is little disagreement that too much public money is being showered on multinational corporations and major league sport franchises—big ticket investments with questionable payoffs—and not enough investment in meeting the business needs of in-state entrepreneurs and upgrading worker skills.

One final area of agreement: No state can stop using development incentives in a world of fierce domestic and international competition. To do so unilaterally would be politically and economically suicidal. At the Minneapolis Fed, general counsel Melvin L. Burstein and director of research Arthur J. Rolnick call on Congress, which has the power to regulate interstate commerce under the Commerce Clause of the Constitution, to "prevent states from using subsidies and preferential taxes to attract and retain businesses." Only the federal government can bring this type of competition to an end. Many constitutional scholars agree that Congress has the power to stop "beggar-thy-neighbor" competition, and there is support for congressional action among numerous participants in the economic development business. Yet many are skeptical. In today's era of "new federalism," the trend is for the federal government to expect the 50 states and 80,000 local units to assume greater responsibilities and for citizens to expect their state and local government to be more responsive to economic turmoil and job anxiety. A congressional ban on preferential business incentives would limit states' freedom to act. Yes, but prohibition proponents point out that federal action would encourage states to focus on their growing public responsibilities and make sure they back them with sufficient funds.

But there is an enormous range for action between an outright federal ban and checkbook competition. Figuring out the right course of action is what this conference is all about.

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.