Cities should stop playing poker with tax dollars

Melvin L. Burstein | Senior Vice President and General Counsel

Published July 1, 1995  | July 1995 issue

About six months ago, when playing poker with a group of friends, I told them that Art Rolnick, the Minneapolis Fed's director of research, and I were working on an essay for the bank's 1994 Annual Report that would criticize competition among states to attract businesses by using preferential taxes and other subsidies. One of my friends said, "Do me a favor, Mel, don't publish your essay for a few months. I'm in the process of talking to Golden Valley, St. Louis Park, Plymouth and a couple of other suburbs in the area about getting public funding for a larger office and warehouse facility in exchange for moving my company and its 25 employees from Crystal [Minnesota]. It sounds like your essay could kill my chances."

Our essay, "Congress Should End the Economic War Among the States," was published at the end of March. My friend didn't get the funding, but not because of our essay. St. Louis Park had funds available but he lost out to a new motel.

Most people are familiar with examples of states competing with one another through the use of preferential economic incentives to attract and retain businesses. Perhaps most well known is state competition for sports franchises, such as St. Louis competing with Los Angeles for the Rams, and New Orleans competing with Minneapolis for the Timberwolves.

However, economic competition also exists at other levels of government. The 1995 World Investment Report of the United Nations Conference on Trade and Development will include a report that discusses the prevalence and economic wisdom of such competition among countries. Perhaps not as conspicuous, but undoubtedly more prevalent than either competition among states or countries, is the kind my poker buddy was hoping would pay for his company's new facility—intrastate competition among cities.

In our essay, Art and I argued that competition among states for businesses through general tax and spend policies, that is, policies that apply to all businesses, is beneficial. Such competition helps lead all states to provide the amount of public goods their citizens are willing to pay for, something that states would find difficult to accomplish without such competition. However, when states compete using economic incentives to attract specific businesses, it is harmful to the overall economy of the nation.

To illustrate, consider the case where no business relocates because each state goes on the offensive to lure businesses away from other states, but defensive strategies prevail; incentives given to local businesses keep them from leaving. While each state could claim a victory of sorts (for no state loses a business), clearly all states are worse off than if they had not competed. Competition has simply led states to give away a portion of their tax revenue to local businesses; consequently, they have fewer resources to spend on public goods, and the country as a whole has too few public goods.

Next consider the case where some businesses relocate. There appears to be no net loss to the overall economy; jobs that one state loses another gains. Yet on closer examination we can see that this is worse than a zero-sum game. As in the case with no relocations, there will be fewer public goods produced in the overall economy because, in the aggregate, states will have less revenue.

In all cases, states negotiate with imperfect information. A state probably will not know of businesses' willingness to move, how long they will stay in existence and how much tax revenue they will generate. Assuming all states are so handicapped, they will, on average, end up with fewer jobs and tax revenues than they had anticipated, and at times the competition may not even be worth winning. For example, Pennsylvania bidding for a Volkswagen factory in 1978 gave a $71 million incentive package for a factory that was projected to eventually employ 20,000 workers. The factory never employed more than 6,000 and was closed within a decade. Even when a company meets its commitment, it may accept a new offer from another community as soon as possible. For example, the city of Grand Forks, N.D., granted a tax break to a company that would agree to stay for at least five years. After five years the company accepted a new offer and is moving a short distance across the North Dakota border to Crookston, Minnesota.

Although our essay speaks of competition among states, we note that it should apply as well to competition among local governmental units. Moreover, cities play a pivotal role in the process of interstate competition. However, many of the economic incentives used by cities often come through state programs. A Minnesota Marketing and Incentives Survey distributed by the governor in July identifies the following kinds of incentive tools used by the state of Minnesota: grants to communities for business loans, direct business loans, loans to businesses through local/regional organizations, grants to businesses, loan guarantees, equity investments, job training, funding for infrastructure in support of business development, and procurement programs/targeting for small business.

When Art and I embarked upon our essay, it was not clear to us that competition among the states for businesses through the use of preferential incentives was bad economics. It took a good deal of analysis and discussion to satisfy ourselves that it did not make economic sense. But I simply cannot understand how anyone could reach a different conclusion in the case of intrastate competition among cities. Using Minnesota as an example, intrastate competition among cities, on its face, seems so perverse as to be indefensible, particularly when state funds are used to support the competition. Just as our essay calls for Congress to end the economic war among the states, state legislatures should prohibit such self-destructive competition among their local governmental units. And like Congress, the legislatures have the power to do so.

At least 300 cities and other governmental units in the state of Minnesota have development agencies. Although they may attract some businesses from out of state, as often as not they are probably competing with one another. As evidenced by the experience of my poker buddy, the competition often involves contiguous communities and would not result in bringing new jobs into the area. It simply makes no sense for the state of Minnesota to encourage Golden Valley to compete with Plymouth or Crystal, for example, particularly if a community development effort in one of the cities has a direct adverse effect on adjoining communities.

For example, often the economic preferences offered by a city include tax increment financing (TIF). That is, the added real estate taxes, which are supposed to result from the new business or business expansion, are applied to subsidize the company's land cost. During the years the TIF is in place, the school district in which the business is located may not get any portion of the taxes, even though the school district may include other cities that competed for the business. In the rare instance when the community development effort actually creates new jobs in the area, it could also increase the student population of the school district while diverting funds from the school district. None of this makes economic sense, particularly if the state is an active participant in this self-destructive competition.

As I indicated, one of the incentives offered by the state of Minnesota is funding for job training. Does it make sense for the state to encourage a business with a skilled work force to move to another city in the state, by offering funds to train workers in that city to replace those workers lost in the move?

Just like the players in my poker game, cities have to wager increasing amounts of money if they wish to stay in the game. However, there are two important differences: First, the poker players wager their own money, but the cities wager the public's; second, the poker player who wins the pot immediately knows the size of the pot and that he has at least recovered his wager, but the city that wins a business may not know the size of the pot for many years or if it will ever recover its wager. Worse yet, the city may have to continue wagering public money long after the game is over.

It is time for state legislatures to end this mindless competition.

For more on this issue see: The Economic War Among the States