A No-Win Arms Race on State and Local Business Incentives

A firm announces a plan to build a new facility, but where? Local and state development officials compete to attract the firm with ever-more-generous tax breaks and subsidies. This scene plays out again and again – even though research shows that incentives do not substantially influence firm behavior, even in the face of media exposes about wasteful giveaways. Why? Governments hope to encourage jobs and business profits, and hubris leads officials to believe “this time will be different,” even if incentives have not worked before. 

 

But something more pervasive is also at work. My research with Stephen Ellis demonstrates the role of “business climate” in driving economic development professionals and government officials to engage in an incentives arms race. Officials feel they must offer incentives, because  failing to compete to attract businesses will be interpreted as evidence that their locality is not business-friendly. States and localities will therefore continue to compete, to the point of giving away more than the value of the new firm or facility. Can American citizens find ways to prevent  the negative effects of this no-win arms race? 

 

“Business climate” is a broad concept invoked to indicate how pro-business a community is. A good business climate is believed to influence firm decisions over the longer term. Many economic development officials emphasize that offering incentives is a way to grab the attention of firms that may want to grow in their locality in the future. In this way of thinking, offering big tax breaks or subsidies is simply the unavoidable cost of promoting local development – just like the cost of advertising analogous to firms promoting certain brands or products. 

 

Consider Alabama’s perception of the marketing value it gets in return for giving huge subsidies to attract a new Mercedes-Benz plant, incentives totaling more than $168,000 per new job. "It's an attention grabber,” explained one development advisor, who argues that the fiscal cost is not the point. According to Governor Jim Folsum, the Mercedes deal was a symbolic way to “break through old stereotypes and announce to the corporate world that Alabama is open for business.” 

 

The corporate world is not the only audience. Politicians who want to appear to be “doing something” to create jobs use incentives to send a pro-business signal to voters as well as firms. Each locality's desire to demonstrate a superior business climate fuels the incentives arms race. 

 

A simple formal model can be used to show why it is that, when many localities compete to offer incentives for a new business facility, the economic consequences are likely to be perverse for all.