Only Congress has ability to end
this economic war

Copyright 1995 News & Record (Greensboro, NC)

August 20, 1995
Melvin Burstein and
Arthur Rolnick
Federal Reserve Bank of Minneapolis

Editor's Note: While state and local economic developers often decry the use of economic incentives, they say they are needed as long as other cities and states offer them. But unilateral disarmament of these economic weapons seems unlikely. In this article, special to the News & Record, two economists from the Federal Reserve Bank argue that for the good of the U.S. economy, Congress must act.

Earlier this year, St. Louis, Mo., pursued an aggressive economic development initiative to lure the Los Angeles Rams professional football team to relocate to their city at a cost to state and local taxpayers estimated as high as $720 million.

Last year, Amarillo, Texas, decided to undertake an aggressive economic development initiative using a different strategy. Some 1,300 companies around the country were each sent a check for $8 million that the company could cash if it committed to creating 700 new jobs in Amarillo.

What is so remarkable about these two initiatives is that they are not remarkable.

Competition among states for new and existing businesses has become the rule rather than the exception. A 1993 survey conducted by the Arizona Department of Revenue found that more than one-half the states use subsidies' and preferential tax treatment to retain and attract specific businesses.

Yet while states spend billions of dollars to retain and attract businesses, they struggle to provide such public goods as schools and libraries, police and fire protection, and the roads, bridges and parks that are critical to the success of any community.

Surely, something is wrong with this picture.

The framers of the Constitution surely had something different in mind in granting Congress the power to regulate interstate commerce under the Commerce Clause. The objective was to create an economic union, something the Articles of Confederation—predecessor of the U.S. Constitution—failed to do.

Under the Articles, the states had freely engaged in destructive economic warfare by imposing all types of trade barriers against one another.

To address this, James Madison added the Commerce Clause to the Constitution. The clause grants Congress the power to regulate "Commerce...among the several States..."

The time to use that power, for the good of the nation, has come. Economists find that state competition for businesses through general tax and spending policies (that is, policies that apply to all businesses) is beneficial.

Such competition helps lead all states to provide the amount of public goods their citizens are willing to pay for, something that would be difficult to achieve without such competition. However, when the competition is through subsidies and preferential tax treatment to retain or attract specific businesses, economists find it is generally harmful to the overall national economy.

To understand this conclusion, it is critical to understand the distinction between public and private goods.

A public good, unlike a private good, is one in which a single person's consumption of that good does not subtract from another person's consumption.

A lighthouse is an often cited example of a pure public good: The light from a lighthouse used by one ship on a foggy night does not prevent its use by another ship.

Providing for the national defense, clean air and a legal system are other examples of goods that any citizen can consume without subtracting from what can be consumed by any other citizen in the community.

Besides pure public goods, there are some goods that lack the explicit quality of a public good but give off external effects that qualify them as such. Health care provided to an individual is a private good, but it may have external effects that are public. For example, having one person inoculated for some communicable disease makes for a healthier environment, and a healthier environment is a good that any person can consume without subtracting from the consumption of any other person.

Economists have found that while the production of private goods is best left to market forces, the production of public goods should be the principal role of government because the market fails to produce enough public goods.

Stated simply, the reason the private market falls Is that since people cannot be excluded from consuming public goods, charging people for, what they consume is difficult. It is often impossible to say if and how much of a public good a person consumes. How much does one consume of a healthy environment, or national defense or a lighthouse beam?

We turn to the government, then, to finance and provide for the use of public goods. Government, by its very nature, can solve the financing problem for it has the power to appropriate funds from its citizens (the power to tax).

Competition among states through general tax and spend policies leads to the right amount of public goods.

But, from a national perspective, this is not the case when states compete for specific businesses through preferential tax treatment and subsidies for specific businesses. Indeed, the overall national economy suffers.

This may not be easy to see from the view of a single state or city. Officials may boast about the new businesses they have attracted, the old ones they have retained and the number of jobs they have created.

And in many instances they are correct to boast. They have either managed to maintain their tax base by enticing a local business to stay or they have added to their tax base by enticing an out-of-state business to relocate.

As long as the subsidies and tax breaks given to a business are worth less than the revenue the business will contribute to the state over its operating years, the citizens of the state are better off than if their state officials had not played this competitive game. The state has more jobs and hence more tax revenue to pay for public goods than if it had not competed.

But even though it is rational for individual states to compete for specific businesses, the overall national economy is worse off for their efforts.

Economists have found that if states are prohibited from competing with incentives for specific businesses, there will be more public and private goods for all citizens to consume.

To illustrate this point, let's consider the two likely outcomes of incentive competition. In the first outcome, suppose a state successfully offers a local business enough subsidies and preferential tax treatment to keep it from leaving. The state could claim a victory of sorts (for no business was lost), but it is worse off.

Competition has simply led the state to give away a portion of its tax revenue to a local business. Consequently, they have fewer resources to spend on public goods, and the country as a whole has too few public goods.

Suppose the business was enticed to relocate by a competing offer from another state. In this second outcome, the damage to the overall economy can be even greater.

At first glance, when businesses relocate, there appears to be no net loss to the overall economy; jobs that one state loses, another gains.

Yet on closer examination we can see that this is not just a zero-sum game. As in the case with no relocation, there will be fewer public goods produced in the overall economy because, in the aggregate, states will have less revenue. This follows because the revenue decline in the losing state must be greater than the revenue increase in the winning states (if this was not true, a business would not have relocated).

There are other ways in which incentive competition may harm the national economy:

  • Total output may decline if businesses are enticed to move from their optimal locations.

Suppose a company chooses to relocate Its manufacturing plant from a warm climate state, like Louisiana, to Alaska, even though its operating costs are substantially higher in a cold weather climate.

Assume that the company is well compensated by Alaska for the move and for the additional operating costs. It now takes more resources for this company to produce the same quantity of output in Alaska than it did in Louisiana.

Consequently, each business that is enticed to relocate represents a loss of efficiency for the overall economy and hence less output, less tax revenue and fewer public and private goods.

  • States may increase taxes or those firms that are less likely to move to offset the lost revenue from firms that have moved (or have threatened to move) and received special tax treatment.

It is a well-known proposition in economics that taxes generally distort economic decisions and at an Increasing rate.

Consider the hypothetical example of a tax on machines those used in car washes. Without a tax or with a very small tax, the most efficient and profitable way to operate a car wash is to invest In high quality machines that require only few workers. As the tax increases, the most profitable way to operate the car wash will be to invest In less sophisticated machines that require more labor.

Although fewer cars will be washed per day, having less expensive machines reduces the tax payment, more than compensating for the lower productivity.

And since tax distortions generally grow at an increasing rate, at higher tax rates relatively fewer cars are washed.

In general, it can be shown that the optimal tax (the tax that distorts the least) is one that is uniformly applied to all businesses. Allowing states to have a discriminatory tax policy, one that is based on location preferences or degree of mobility, will result In the overall economy yielding fewer private and public goods.

  • State competition for specific businesses involves one additional loss that could make those already mentioned pale by comparison.

We have assumed that states have the information to understand the businesses they are courting; that is, their willingness to move, how long they will stay in existence and how much tax revenue they will generate.

In practice, states have much less than perfect Information. Assuming all states are so handicapped, they will on average end up with fewer jobs and tax revenues than they had anticipated, and at times the competition may not even be worth winning.

For example, Pennsylvania, bidding for a Volkswagen factory in 1978, gave a $71 million incentive package for a factory that was projected to eventually employ 20,000 workers.

The factory never employed more than 6,000 and was closed within a decade.

Despite this downside, only federal legislation can prevent states from using subsidies and preferential taxes to attract and retain businesses. The states won't end this practice on their own.

The courts can only examine the constitutionality of state laws, ad hoc, in the context of an actual case or controversy.

The courts do not have the power to regulate the states in their use of subsidies and preferential taxes to attract and retain businesses other than in the context of a particular case.

Only Congress, with its sweeping constitutional powers, particularly under the Commerce Clause, has the ability to end this economic war among the states. And the time for Congress to act is long overdue.

Reprinted by permission of the News & Record.

Latest Articles
Federal Reserve Consumer Help