by Peter T. Calcagno. Originally published in The Free Market, April 1999.
Taxes distort the price system and always alter behavior away from the free-market ideal. That is why, as J.B. Say said, the best tax is always the lowest tax. But in recent years, state and local governments have been using the tax system, along with direct subsidies of all sorts, to influence where particular firms locate, all in an effort to generate more growth and thus more tax revenue. Can states and localities really “buy growth” for themselves through this means?
The National Association of State Development Agency claims that every state has made the attraction, retention, and expansion of business a part of their basic operations. States are pursuing “investment strategies” with an unrivaled intensity and sophistication.
In 1992, South Carolina’s state government offered BMW $100 million in incentives to build a plant. In 1993, Alabama’s state government gave Mercedes Benz a $250 million subsidy to build a new plant. That same year, Indiana presented United Airlines with a $300 million deal to build a facility. Also, in 1993, Kentucky lured a Toyota plant away from Missouri by providing a $125 million tax incentive.
Kentucky acquired a new steel plant with $140 million in tax credits. New Mexico has lured business away from California using tax incentives.
These numbers only include direct costs. When a new business is subsidized to enter a rural area, for example, there are new roads to build, new schools to fund, and new utilities of all sorts to provide. State and local government stand ready to provide all of these services at taxpayer expense. What has led to this so-called “economic war between the states”? Dwight Lee and Richard McKenzie in their book Quicksilver Capital claim that technological advances, starting in the 1980s, have allowed firms greater choice over locations. Firms compare corporate and property tax rates of various states to decide where to locate.
If true, this would generate tax competition between states. Firms will locate in one state over another to take advantage of the tax differential. The process of competition in the market place would place constraints on the taxing power of state governments. We might even see declining tax rates at both the corporate and personal level.
Alas, marginal tax rates among the states are not declining. Instead, we see competition among state development agencies not to lower taxes to all firms and encourage economic growth, but to offer direct support or direct financial incentives to selected firms. This is called “industry targeting,” and anecdotal evidence suggests it can be effective in attracting investment. State officials claim that the government’s objective is economic growth. However, state government officials act for their own benefit, and the bureaucratic motivation for using direct financial incentives is something other than enhancing state economic growth. State governments want to maximize their tax revenue.
In the early 1980s, it appeared that states would begin lowering taxes due to market pressure. Very quickly, however, another method emerged. By using direct financial incentives, a state can target a particular manufacturing firm and offer it incentives and tax exemptions without reducing existing revenue. That way the state government can claim that it has “created jobs” and promoted economic growth for the state.
The use of direct financial incentives can serve another purpose to politicians. It allows state spending on development to be conducted off-budget. In most cases, state development agencies issue the direct financial incentives. The operating expenditures of the agency are part of the budget, but the expenditures associated with the direct financial incentives are not. This allows the state to circumvent public approval and still “balance the budget.”
The practice of offering state financial incentives is nothing new in American history. It was popular during the railroad era, between 1830 and 1880, too. Cities subsidized the railroad industry to guarantee a connection along the railway. But public outrage at the inevitable political corruption led to constitutional provisions that prohibited state lending or investment in the capital stock of private firms.
The use of financial incentives by state and local industrial development agencies became common again during the New Deal. Federal agencies encouraged states to issue industrial development bonds. The first to do so was Mississippi in 1936. Today, every state now has some type of development agency, each a living testament to FDR’s baneful political legacy. In the 1980s, state and local governments developed new types of direct financial incentives to avoid federal regulations and state constitutional constraints.
These schemes do not generate economic growth; they only cause firms to change their locations, not their production plans. State governments are causing firms to shift resources not based on market conditions but on distorted prices due to state incentive policies. One should recall the famous “Lesson” of Henry Hazlitt: what economic development would have occurred if state development agencies had not intervened in the first place?
Some economists claim that so long as incentives are directing firms to areas with high unemployment, these policies are wonderful. In fact, the free market already does this, directing resources to where they are in greatest demand and cheapest to employ. State financial packages can only distort prices and resource allocation.
One commonly proposed solution is for the federal government to declare financial incentives and firm bidding illegal. Alice Rivlin, the vice chairman of the Fed, suggests that states “make their tax policies more uniform, to compete on excellence of their services, not on the lowness of their taxes.”
But a tax harmonization similar to the European community would actually make the problem worse. Tax competition between states places constraints on government spending and lowers tax rates to allow for real economic growth. Legislating high taxes across the board will cause states to compete through state development agencies. They will not reduce taxes; they will merely subsidize and benefit one firm at everyone else’s expense.
So what is the answer? States should stop circumventing their constitutions that generally prohibit tax funds being used to benefit particular businesses. The whole institution of the state development agency needs to be scrapped as a futile and frequently corrupt effort in economic planning that only ends up redistributing other people’s money. What we need is a free market within the states and economic competition among states, not a war among state government agencies.
Republished under Creative Commons Attribution License at http://mises.org/freemarket_detail.aspx?control=30