The Economic War Between The States

Years ago, this satirical piece in The Onion poked fun at interstate rivalries with its account of “Middle West peace” in peril.

Thankfully, battles between U.S. states haven’t resulted in actual violence for nearly 150 years. However, there is another kind of battle going on between states, and even between communities within states, that has been destructive in a different way.

I am speaking of the economic battles states and localities wage against one another when they compete for new businesses via economic incentives such as tax breaks, regulatory exemptions, or taxpayer funded grants and loans that are offered only to specific companies.

In 1996, economist Lawrence Reed wrote a widely reprinted essay titled “Time to End the Economic War Between the States.” Reed called the constant battle of states and localities to outdo one another with economic incentives to prospective employers “an exercise in mutual assured destruction, or at least one in which the victories are Pyrrhic ones at best, with the victors losing almost as much as the vanquished.”

Nine years later, in 2007, Federal Reserve economist Arthur Rolnick used nearly the same language in testimony to Congress about the ill effects of this approach. He proposed that Congress use the Constitutional interstate commerce clause to prohibit states from engaging in these tactics — although that raises questions of its own for advocates of federalism and smaller government.

According to Reed, the earliest example of this type of economic incentive was the Commonwealth of Pennsylvania’s offer of $86 million in incentives to build a Volkswagon factory in 1976. The factory was supposed to produce about 20,000 new jobs, but actually employed only 6,000 people before it shut down 10 years later.

The practice really took off in the 1980s with highly publicized competitions between states and communities for new manufacturing plants and other facilities. More recently, states have competed for TV and movie productions with tax incentives for producers who shoot on location.

Most states now have economic development organizations devoted entirely to putting together incentive “packages” for new or existing businesses. Aggressive pursuit of businesses with tax breaks and other public subsidies has become so common that major employers have come to expect and even demand it, and most state and local governments have concluded they have no choice but to play the game.

Some businesses seem to use these incentives almost as a form of extortion — for example, professional sports franchises that threaten to move elsewhere if they do not get public financing for a new stadium or arena.

Both economic conservatives and liberals have criticized this approach and noted that it rarely delivers all the benefits promised.

So, is there any way to call a cease fire in this war? Reed says yes, and points to a period in the early 1990s when his home state of Michigan did just that. In 1991, Michigan Gov. John Engler instituted an economic development approach he called “fair field and no favors.” Instead of granting targeted tax or regulatory breaks only to certain businesses, he opted to reduce financial and regulatory burdens on all businesses — dramatically slashing property taxes, unemployment insurance costs, and worker’s compensation costs.

The results, according to Reed, were astounding: by 1995, he states, unemployment in Michigan had plunged to a 25-year low, per capita income increased nearly twice as fast as the national average for the same period, and new manufacturing jobs were being created at a rate 2.5 times the national average. Even so, the “peer pressure” to get back into the economic development incentive game eventually proved too strong to resist, and the economic renaissance in the Wolverine State did not last.

Reed concluded that “tit-for-tat, not sound economic policy, is what propels state economic development strategies these days.” He adds:

“Oddly enough, the broad-based, generalist approach to economic development is denigrated by the incentive advocates as “unilateral disarmament.” The Michigan experience from 1991-95 suggests it is just the opposite. There may be no better way to “arm” your state for economic development than to cut the burdens of government on everyone.… If unilateral disarmament means we take a Rust Belt state and turn it into an economic dynamo in the space of one gubernatorial term, then we need more unilateral disarmament, not less.”

(A postscript: Michigan’s new GOP governor, Rick Snyder, yesterday announced a return to that “disarmament” policy that will, among other things, abolish targeted economic development incentive tax credits and institute a flat rate corporate tax.)

Meanwhile, existing businesses that never sought tax breaks or whose tax breaks have expired may jump into the game and start demanding their own concessions. This is particularly likely to happen if the tax breaks, rather than the inherent advantages of that location (e.g. proximity to a major market, a skilled workforce, reliable transportation arteries) were the primary reason for the company’s decision to set up shop there.

It may also occur if the state or community offering the incentives has onerously high base tax rates that kick in after the artificial break extended to that particular company expires. For example, this development in the ongoing economic border war of sorts between Illinois and Wisconsin over taxes might seem to be a win for Illinois — but it required a giveaway of taxpayer’s money to land the new business in question. Meanwhile, New Jersey Gov. Chris Christie has promised that any business which relocates from Illinois to New Jersey won’t be charged his states high corporate taxes “as long as I am governor.” The obvious question, of course, is what happens after he is no longer governor.

Either way, when the publicly financed “honeymoon” is over, there’s nothing to keep the business from flirting with other potential suitors and starting the cycle all over again.

Also, many economic development programs turn out to be a net loss to taxpayers because they do not create nearly as many jobs as anticipated. Frequently the company simply eliminates as many or more jobs from another location, even within the same state or community, as it creates at the new location. As Rolnick noted:

Unfettered competition among private businesses has generally proven to be a very successful economic system … And experience has shown that Smith was right. Those countries that have relied on a market-oriented economy have outperformed (based on virtually all measures of success) those countries that have relied on a central planning strategy.

But what is true of individuals acting in their own interest is not necessarily true of state governments acting on behalf of their local citizens. Competition among governments based on their general tax-and-spend policies leads to a better outcome for the overall economy. However, when that competition takes the form of preferential financial treatment for specific companies, the overall economy is made worse off. Such competition results in a misallocation of resources and, in particular, too few public goods.

While I don’t mean to oversimplify the issue, I can’t help but wonder why some people who would consider it wasteful pork to spend, say, $100 million on a public works program would not bat an eye at the same amount being given to a private company in the name of job creation. Again, the question is not whether states should promote job creation or recruit new business — they should —  but whether they should do via general measures (not just taxation and regulation, but also non-governmental advantages such as location, availability of transportation, quality of workforce or quality of education) or targeted incentives.

Also, while there’s nothing wrong with shopping around for a favorable location to locate or start up a business, for large companies to constantly expect or demand special treatment from state and local governments as a condition of doing business is, in my opinion, just as much grasping for a “government handout” as are many of the programs some conservatives love to hate, like the Earned Income Tax Credit, Medicaid, ethanol subsidies, etc.

Excessive reliance upon tax breaks and public subsidies to attract large employers inevitably means that the tax burden is shifted to smaller businesses that lack the clout or expertise to lobby for such concessions. You could even call it, to borrow a phrase from recent discussions of Catholic social teaching, a “preferential option for the rich and powerful.” It also seems to prove the truth of Leona Helmsley’s infamous boast that “only the little people pay taxes.”

For that reason, I think it would be a good idea, and more in keeping with Catholic social teaching, to move away from that approach as much as possible. Your suggestions as to how we should do this are welcomed.

7 Responses to The Economic War Between The States

  • Michigan had the right idea: if a state government wants to encourage economic development, it should just cut taxes. Let the market decide where new businesses and jobs are needed. Business owners and workers will be more productive if they know they all get to keep more money than if they have to worry about competing against each other for grants and credits. And a dollar that’s never taxed will have more economic impact than one that’s hauled off to the capital, trimmed to pay for all the bureaucracies it passes through, and then spent back out for development.

    But even when that so obviously works, as it did in Michigan, the temptation for politicians to decide what’s best for everyone and play Sim City with their constituencies is just too strong.

    It’s always seemed particularly unfair (and stupid) when my town gives taxes breaks or subsidies to a big box store that moves into town, and doesn’t give the same deal to businesses that have provided jobs and products here for decades. I don’t think any real conservative would support such a thing; what would it be designed to conserve?

  • My late revered accountant Mort Lipsky [RIP] always insisted that a business should not make decisions based on taxes. Businesses should look to do business. Taxes are a cost of that business. To rely on tax breaks is to rely on the word of politicians. Need one say more?

  • Gabriel,
    Businesses hunt for low tax environments precisely because they are a cost of doing business. Businesses try to minimize all costs.

    All,
    While I agree with much of the criticism embedded in Elaine’s post and subsequent comments, one must also realize that there is nothing particularly wrong with governments competing for business and jobs. Without competition among governments taxes would only increase. Competition has merit.

  • That said, I still think “tax harmonization” is the most frightening phrase in politics.

  • One economic development tool that has been way overused in Illinois (don’t know if other states do it) is the Tax Increment Financing District or TIF. Here’s an example of how it might work:

    To encourage development in a blighted area, local officials will create a TIF District there. A TIF usually lasts about 20 to 30 years but can be extended. When a TIF is created, the amount of property tax revenue from that district that will go to local governments (including the city, schools, libraries, parks, etc.) is frozen at its pre-TIF level. Any additional revenue generated by increased property values during the life of the TIF, instead of going to local government, is set aside in a special fund which business owners in the TIF can use to make improvements.

    If TIF Districts are confined to a relatively small area that wasn’t generating a whole lot of tax revenue to begin with (like an abandoned factory site), they can do some good. However, if you end up with one-half or more of an entire city or town being in a TIF District (this happens rather frequently; I believe more than half of downtown Chicago is in a TIF District), that cuts very heavily into the public goods the presence of new industry, etc. is supposed to support. Plus, control of TIF funds can easily become a vehicle for local pols to reward their favorites or punish their non-favorites. I would say it’s time to abolish them.

  • professional sports franchises that threaten to move elsewhere if they do not get public financing for a new stadium or arena.

    Precisely what happened with the Houston Oilers. And then they went and built a new stadium anyway to attract the Texans. Go figure. (The disAstros and Rockets got new stadiums too).

  • Elaine,

    Great to see your article here. I have recently written my second book on this subject (see website link), Investment Incentives and the Global Competition for Capital. In it, I estimate that U.S. state and local governments spend close to $50 billion a year to attract business. This competition actually goes back more than 100 years, when cities tried to attract railroads to lay track through their cities.

    By the way, the Reed article you mention was preceded by Melvin Burstein and Arthur Rolnick’s “Congress Should End the Economic War Among the States” in the 1994 Annual Report of the Federal Reserve Bank of Minneapolis. They argued, and I agree, that a federal solution is necessary because the states do not take account of the effects of their bidding on other states. The European Union, in fact, has fairly successfully implemented control over its Member States’ subsidies to attract investment.

    FYI, tax increment financing is used (and generally heavily abused) in almost every state of the country.

    Thanks again for your article.

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