Who Really Gains from Billions in Economic Development Incentives?

Another state where Boeing has considerable operations, Washington, has given Boeing incentives valued at over $10 billion. But it’s not just big-name companies such as Boeing that have received such incentives. In 2022, for example, New York enticed Micron Technology with an incentive package valued at $6.4 billion and Wisconsin provided a $4.8 billion incentive for Foxconn in 2017. These are just a few of the so-called ‘megadeal’ incentives that are now widely used in about a third of U.S. states to get private firms to locate or expand their operations within the state’s political boundaries. It has now come to the point that even existing firms will threaten to leave states to get an incentive (in the case of Pennsylvania, one that had been there 70 years!).

Economic development incentives at these megadeal amounts were nonexistent two decades ago. But across the nation, by now over 30 incentive awards to single companies valued at $1 billion or more, and over 330 awards valued at over $100 million, have been granted. For readers interested their state’s largest development incentives, the Subsidy Tracker database from Good Jobs First is a great place to start.1 In total, states now spend over $40 billion per year on these economic development incentives, compared to less than $500 million per year across all states in the mid-1990s. These incentive programs take many forms including job development and retraining tax credits, tax abatements, infrastructure financing, outright monetary grants, or loans of public funds.

Crony Capitalism: Why Being Pro-Business Isn’t Necessarily Being Pro-Free-Market

Government programs that give targeted and concentrated benefits to some firms, but not others shine interesting light on one area of significant disagreement over policy between economists who consider themselves ‘pro-free-market’, and politicians and other people who claim to be ‘pro-business’. In many cases free-market economists support the same policies as individuals who consider themselves pro-business, such as reducing regulations or the corporate income tax. But economic development incentives are not one of these areas of agreement. Policies consistent with free markets should strive to be neutral, treating all businesses the same—a level playing field in which firms compete equally for the dollar votes of consumers and the employment of labor under the rule of law. Giving special advantages to those businesses who are the most politically connected, such as is done with incentive programs, is inconsistent with these ideals, and is typical of what is often called ‘crony capitalism’—a situation in which government favoritism replaces consumer preferences in driving the profitability of firms in the marketplace. Several published studies have indeed found that companies devoting more resources toward political lobbying are more likely to receive development incentives (Gabe and Kraybill, 1998; Aobdia, Koester, and Petacchi, 2021).

The politicians who grant these incentives argue that these taxpayer-funded subsidies to these large corporations are worth it because they create additional jobs, expand tax revenues, or provide other economic benefits to the areas in which these firms locate. Unfortunately, these claims are largely unfounded. There is now a large literature that examines the data and clearly brings into question the effectiveness and accountability of these programs, finding they do not lead to statistically significant improvements in tax revenue, employment, economic growth, or personal income.2 Readers familiar with the work of Frederic Bastiat in his famous parable of the broken window and his essay on ‘that which is seen and that which is unseen’ will easily understand why. New plants and new jobs are highly visible outcomes, and politicians love the media exposure of a good ribbon-cutting ceremony. But the opportunity cost of the resources, the small (unincentivized) local competing firms who go out of business or must pay more for labor, and a variety of other secondary effects and unintended consequences, are all parts of the unseen costs of these mega development incentives.

A few studies attempt to estimate the approximate cost per job created at incentivized companies. The cost per job created by the incentive package to Mercedes in Alabama, for example, was $192,730 (Calcagno and Hefner, 2009), and is as much as $170,000 for the incentive for Cabela’s in West Virginia (Hicks and Shugart, 2007). In Michigan, Hicks and LaFaive (2011) find a cost of $123,000 per job created in construction, with 75% of these jobs lasting for 1 year or less. Keep in mind these are the cost per gross, not net, direct job created. For example, a large portion of the employees at an incentivized facility may come from other jobs where they were already employed, so the number of net new jobs is always significantly less than the employment level of the incentivized firm.

Unproductive Entrepreneurship: Why Development Incentives Are Losers for the Overall Economy

While one might think that these incentive programs are simply zero-sum (causing a firm to locate in state A rather than state B, so one state’s gain is another state’s loss), there are reasons to believe that there are secondary effects, deadweight losses, and unintended consequences of these policies that lead them to actually be negative-sum—that is society is worse off with these incentive programs that it would be without them. As Bastiat would point out, the resources devoted to incentives are socially wasteful because they have an opportunity cost.

To be clear on this negative sum position, let’s consider crime as an analogy. When a burglar breaks into houses to steal jewelry the burglar’s gain is the homeowner’s exact loss. But this isn’t just a zero-sum activity. Think of the fact that in a world without crimes like this, homeowners wouldn’t have to spend money preventing theft (e.g., installing locks on doors, security systems, having a locking safe, etc.), and those individuals engaged in stealing wouldn’t spend their time investing in becoming better thieves—casing houses, planning escapes, and purchasing ski masks and crowbars. All these resources devoted to preventing theft by the homeowner and achieving the theft by the burglar are socially wasted resources, and these expenditures result in crime being negative sum (rather than zero sum) for society. Economists Gordon Tullock and William Baumol use the same logic to explain why transfers of resources from one group to another done through the political process are also, on net, unproductive.

Returning to development incentives, a large secondary effect created is that when governments begin to give away large subsidies such as this, firms will spend resources competing for the giveaways. The time and effort firms spend competing for these incentives is a form of unproductive entrepreneurship—these ‘rent seeking’ expenditures are a net loss to society. Making things even worse is that this type of political competition invites corruption, and there are several high-profile cases of outright corruption involved in the awarding of these large incentives.3

Granting these incentives also leads to the necessity of having higher taxes on other economic activities to make up for the lost tax revenue granted to these firms, and to fund the additional infrastructure demands caused by the incentivized firms and their workers. Perhaps of most consequence, states generally give these incentives precisely because they have one or more uncompetitive tax policies. In the case of South Carolina, property taxes on machinery & equipment (i.e., capital investment) are the worst (highest) in the nation. Research by Calcagno and Hefner (2018) has found that when states offer these incentives they delay or fail to adopt important reforms to their inefficient tax structures—reforms that would benefit all firms and improve the economy overall. So, in my state we are left with a few lucky, politically connected firms like Boeing or BMW who enjoy a break on these excessive property taxes on their capital equipment, while the thousands of other firms in the state, who compete with them for consumers, labor, and other resources, are left paying the highest tax rates in the nation.

Perhaps most troubling is the lack of accountability and transparency in most of the state incentive programs. Promises about job numbers are rarely subjected to follow-up analysis, and even when they are there generally are no consequences when companies do not live up to the promised number of jobs (or amount of capital investment). Unsurprisingly, there has been no accountability for the politicians who grant such socially wasteful programs. State officials have instead fought in court to keep the details of incentive programs and the recipient firms from being disclosed to the general public, arguing they do not want to disclose a single firm’s private operational data. Thus, the political actors who award these incentives know that key details and results will never be made public, and that it will be almost impossible to get the data (or hold anyone accountable) if the promises of the incentivized firms do not come into fruition.

So, What Is the Real Reason Why Economic Losers Sometimes Make for Political Winners?

When students in a principles of economics course are taught about the benefits of free trade, many ask their professor why we have tariffs and other restrictions on imports if these are not economically beneficial. The answer, of course, comes down to political incentives faced by voters, special interest groups, politicians, and bureaucrats as is explained by Leighton and Lopez (2013).4 Being an elected legislator from a district that has a steel mill who is losing revenue due to customers finding less expensive imported steel means supporting a tariff that raises the cost of imported steel to benefit the local firm. Doing so results in more votes for the incumbent’s reelection as well as likely campaign contributions. Similarly, we now know from volumes of published research that these economic development incentives are economically inefficient. So then, what explains their widespread (and growing) use by states? The answer, of course, is the same—political incentives.

Many of the papers that examine the (lack of) economic gains from these incentive programs do mention the possibility that political benefits likely accrue to the elected officials who grant them. For context, 2003 was the first year in which a U.S. state awarded an incentive to a single private firm valued at more than a billion dollars. A recent paper I coauthored with Gary Wagner and Peter Calcagno is the first to attempt to quantify them.5 Somewhat fortunately, these incentives are a recent phenomenon, so it is possible to measure the pre- and post-effects of states offering them. Our results suggest that once a state begins offering these megadeal economic development incentives, campaign contributions in the average state rise by almost a million dollars annually, driven by increases from construction and labor unions, lobbyists and lawyers, and pro-business advocacy and trade organizations. It is important to note that these increases in campaign contributions and other forms of lobbying and rent seeking are not just from the incentivized firms. Prior studies have found that for every incentive granted, there are at least three firms likely competing for incentives, meaning two thirds of the firms who spend effort currying favor with politicians to get an incentive never receive one. In addition, we find that the average incumbent legislator is rewarded with a 7-percentage point increase in their margin of victory in subsequent elections after a state begins offering these development incentives.

The somewhat obvious conclusion of our analysis is that the battle over the future existence of economic development incentives may lie more in overcoming the political benefits that perpetuate their existence than in demonstrating a lack of worthwhile economic effects. But there is a larger lesson to be learned.

Achieving Real Growth: The Case for Economic Freedom

The myth of economic development incentives is that somehow government favoritism, crony capitalism, or ‘wise-central-planning’ to put it bluntly, can create more prosperity than the alternative—which is a level playing field in which all firms are treated equally—they are all given the advantage of a development incentive in the form of lower broad-based taxes on capital, land, or profits. We now know just the opposite—that those states and countries that institute policies consistent with the concept of ‘economic freedom’ are the ones that are most prosperous. That is, broad based policies consistent with low taxes and government spending, clearly defined and enforced property rights, reasonable regulations, the rule of law, and free trade.

As was first outlined by Baumol (1990) and Sobel (2008), entrepreneurial individuals seeking to generate personal gain have a choice as to whether to devote their time and effort to productive, positive-sum activities, or alternatively toward unproductive, zero- or negative-sum activities, and will allocate their efforts toward whichever generates the highest personal return. This in turn is driven by the institutional structure in that whenever economic and political institutions make it easier for individuals to secure personal returns through government transfers, they will try hard to do so. But in areas with institutions providing for secure property rights, the rule of law, contract enforcement, and effective limits on government’s ability to transfer wealth through taxation and regulation, creative individuals are more likely to engage in productive market entrepreneurship—activities that create wealth for both themselves and for others. In contrast, in areas with lower economic freedom and greater government spending, regulation and transfer activities, these same individuals are instead more likely to engage in attempts to manipulate the political or legal process to capture transfers of existing wealth through unproductive political and legal entrepreneurship—activities that destroy wealth (e.g., lobbying and lawsuits). This reallocation of effort occurs because the institutional structure largely determines the relative personal and financial rewards to investing entrepreneurial energies into productive market activities versus investing those same energies instead into unproductive political and legal activities.

Economic development incentives create incentives for unproductive entrepreneurship, expand the rewards to political favor seeking, and work against the very ideals of the policies necessary to promote productive entrepreneurship and economic growth. Unfortunately, the gains to the politicians that award these incentives, and to the shareholders of the large firms who receive them, are too tempting to resist in the absence of strong constitutional constraints preventing them.

References

Aobdia, Daniel, Allison Koester, and Reining Petacchi. (2021) “The Politics of Government Resource Allocation: Evidence from U.S. State Government Awarded Economic Incentives.” Available at SSRN 3127038.

Baumol, William J. (1990) “Entrepreneurship: Productive, Unproductive and Destructive,” Journal of Political Economy, 98(5), 893–921.

Bartik, Timothy J. (2019) Making sense of incentives: Taming business incentives to promote prosperity. WE Upjohn Institute.

Calcagno, Peter T., and Frank Hefner. (2009) “South Carolina’s Tax Incentives: Costly, Inefficient and Distortionary,” in Peter T. Calcagno (ed.), Unleashing Capitalism: A Prescription for Economic Prosperity in South Carolina. South Carolina Policy Council: Columbia, South Carolina.

Calcagno, Peter T., and Frank Hefner. (2018) “Targeted Economic Incentives: An Analysis of State Fiscal Policy and Regulatory Conditions” Review of Regional Studies, 48(1), 71-91.

Gabe, Todd M., and David S. Kraybill. (1998) “Tax Incentive Requests and Offers in a State Economic Development Program,” Review of Regional Studies, 28, 1–14.

Hicks, Michael J., and William F. Shughart II. (2007) “Quit Playing Favorites: Why Business Subsidies Hurt our Economy,” Chapter 8 in Russell S. Sobel (ed.), Unleashing Capitalism: Why Prosperity Stops at the West Virginia Border and How to Fix It. Center for Economic Growth, The Public Policy Foundation of West Virginia: Morgantown, West Virginia, 117-130.

Hicks Michael J., and Michael LaFaive. (2011) “The Influence of Targeted Economic Development Tax Incentives on County Economic Growth: Evidence from Michigan’s MEGA Credits,” Economic Development Quarterly 25(2), 193-205.

Lopez, Edward J., and Wayne A. Leighton. Madmen, intellectuals, and academic scribblers: The economic engine of political change. Stanford University Press, 2013.

Mitchell, Matthew, Daniel Sutter, and Scott T. Eastman. (2018) “The Political Economy of Targeted Economic Development Incentives,” Review of Regional Studies, 48(1), 1-9.

Sobel, Russell S. (2008) “Testing Baumol: Institutional Quality and the Productivity of Entrepreneurship,” Journal of Business Venturing, 23(6), 641–655.

Sobel, Russell S., Gary A. Wagner, and Peter T. Calcagno. (2022) “The Political Economy of State Economic Development Incentives: A Case of Rent Extraction,” Economics and Politics, DOI: 10.1111/ecpo.12233.

Tullock, Gordon. (1967) “The Welfare Cost of Tariffs, Monopolies, and Theft,” Western Economic Journal, 5(3), 224–232.

Footnotes

[1] Available online at Subsidy Tracker.

[2] See, for examples, Hicks and Shughart (2007); Mitchell, Sutter, and Eastman (2018); Bartik (2019).

[3] See Tullock (1967) and Baumol (1990).

[4] See Chapter 4 for a more detailed explanation of how political incentives influence the outcomes of government policy.

[5] Sobel, Wagner, and Calcagno (2022).