Winning battles, rather than the war, on economic development subsidies


Arthur J. Rolnick | Senior Vice President and Director of Research, 1985-2010

Published July 1, 2000  | July 2000 issue

With the publication of its 1994 Annual Report, the Federal Reserve Bank of Minneapolis took a formal position in the debate surrounding the use of public subsidies for private businesses. Readers of the fedgazette know this bank has opposed such preferential treatment, arguing that only Congress—under its power within the Commerce Clause of the Constitution—has the ability to address this issue on a national scale. Since that time, we have taken a fairly active role in this debate.

Most recently, we have taken a close look at economic development programs and policies from Montana to the Upper Peninsula of Michigan in the April and July issues of the fedgazette, including an informal survey of economic development officials in the Ninth District.

During the course of research for these articles, a few comments and themes came up repeatedly from local development practitioners, and deserve some discussion.

Incentives to businesses are a good thing because they create new jobs for local citizens. Yes, from a purely local point of view, that can be true. Attracting or retaining jobs for a particular community—if those jobs would ultimately end up somewhere else—makes sense. To a degree, communities must engage in these subsidy battles as long as such business incentives are the norm. While it might be noble and principled, unilateral withdrawal from the incentive competition is tantamount to community martyrdom.

Nevertheless, the benefits of these battles are often overstated. To justify the use of incentives, cities quickly point to the number of business expansions and new jobs they've created with the use of incentives. Those same cities, however, have also been on the losing end of that incentive competition. Rarely is a larger scorecard kept, one that tallies both wins and losses over time and geographic space. Neither do cities thoroughly assess whether economic expansion would have occurred in some fashion without the use of incentives.

These individual local skirmishes also are not an end game. The war is large scale and long term, and it is at this level that the use of incentives is ultimately ineffective and unproductive. If Rapid City, S.D., for example, lures a company from Sioux Falls, S.D., that may be good for Rapid City, but what has the state of South Dakota gained? And if Sioux Falls attracts a company from Fargo, N.D., what is the benefit to the country? Perspective matters in this debate; the broader a perspective you take, the more this economic war becomes a zero-sum game, at best.

Business incentives are a good way to counter-balance a poor business climate. While seemingly a pro-business stance, in fact incentives compound a poor business climate. The best way to counter a poor business climate is to change that climate across the board, rather than grant exemptions from it for a few lucky businesses.

When people talk about a poor business climate-be it local or state-they generally mean that business taxes are too high. The answer to this problem is not to give preferential treatment to certain businesses, but to reduce the tax burden for all businesses. Indeed, incentives exacerbate a poor business climate by requiring existing businesses to bear the cost of incentives given to a handful of companies-some of whom might be their competitors.

Incentives aren't the deciding factor in business locations—they aren't the "deal closers"—so why all the fuss? Quite simply, you can't have it both ways: If preferential subsidies don't matter, then why use them? Studies show that, on average, this assertion is true and incentives are not, in the end, the deal closers. But this only suggests that there is a fair amount of bluffing going on among companies and their suitors.

If most bargaining is just a ruse, then public funds merely go to encourage and reward the practice. In the end, finite public resources will have been used to facilitate private economic activity that would have occurred anyway, and the public loses.

As long as incentives are an ingrained part of the "location market," what's the harm if everyone provides them? Three reasons:

  • If one company gets preferential treatment, it is unfair to existing businesses, some of whom may be competitors with the newcomer.

  • While incentives are often not the deciding factor in location decisions, as previously discussed, they sometimes do affect the end location and result in an inefficient outcome.

  • Taking the broader perspective, the economic bidding war consumes finite resources that should be used for public goods like schools, roads and public protection. If there were no economic bidding war, there would be more revenue for the basic public goods, or a lower overall tax burden.

If you take away incentive tools, rural areas will not be able to compete with larger metropolitan areas. This argument presupposes that rural areas, on average, are faring well in the economic bidding war. Most evidence and opinion suggests they are not. Rural development professionals regularly point out that they are easily and often outbid by larger cities and metro areas with more resources, particularly for larger business projects. Somewhat ironically, many nonetheless believe that rural areas would be the losers in ending the competition over incentives.

Such a viewpoint—that incentives help stem rural loses—is patronizing to rural areas, and assumes that the only reason a company would move to a small town is because of preferential incentives. If rural areas are luring businesses to their locations, it is likely because of the local labor force, quality of life, geography and other criteria. A level playing field—one without the artificial competition of incentives—would likely enhance those positive rural attributes.

OK, for argument's sake, let's assume there is a problem. Why get the federal government involved? Congress has no right to tell local governments how to operate in these matters. However, Congress does have the right to regulate interstate commerce, especially in these matters, because state and local governments are interfering with interstate commerce.

On their own, local governments won't—indeed, can't—stop using subsidies and preferential taxes to attract and retain businesses. As long as a single state engages in this practice, others will feel compelled to compete. Only Congress, under the Commerce Clause of the Constitution, has the power to enact legislation to prohibit states from using subsidies and preferential taxes to compete with one another for businesses.

To address this issue, a bill by Rep. David Minge (D-Minn.) has been presented to Congress that would apply a confiscatory tax to all preferential subsidies, thus rendering them useless as an incentive tool. Such a bill would not only put an end to the economic subsidy war, but would also allow local governments to make better use of their public funds and to create an attractive business environment based on general tax rates, education and infrastructure.

The answer to local economic development is not to give awards to preferred businesses and suffer the rest to carry the burden, but to create a general business climate conducive to economic growth.