How Governments Use Financial Incentives to Try to Steer the Economy

By Mr. Jacob Bundrick

Earlier this month, software engineering firm Elyxor pledged to create 45 new tech jobs in North Little Rock over the next five years. Arkansas Online quoted Governor Asa Hutchinson as saying, “While we have a diversified economy in Arkansas … we will not be complete as a state and complete as an economy until we have a dynamic, sustained technology sector in this state.” As I explained in my first post in this series, Elyxor will receive an income tax credit for 1 percent of its total payroll in exchange for hiring these employees. This situation is a prime example of the government trying to steer the economy to help with economic development.

One reason why many politicians and taxpayers support such financial incentives for businesses is that they think governments can influence specific economic activities by designing and issuing incentives that address perceived needs such as job creation, project investment, or research and development. Governments are also supposedly able to influence industry composition, or the types of businesses in the state, by offering targeted business incentives.

Steering the economy doesn’t work, though, and can actually be harmful for two reasons: regional unrealism and resource allocation. Let me explain what I mean by those terms.

Specializing in Comparative Advantages Helps Regions Prosper

Regions prosper when they specialize in the industries where they have a comparative advantage, meaning they produce a good or service more efficiently than other regions do. For example, Arkansas has a comparative advantage in rice farming. The state’s water resources and topography allow Arkansas farmers to grow rice more efficiently than farmers in other states. This comparative advantage has led Arkansas to produce roughly half the nation’s rice.

Specialization in comparative advantages often leads to industry clusters. When these clusters occur naturally, they can further boost economic productivity. The economic benefits of natural clusters, such as those for computer and software development firms in Silicon Valley, have led economic developers to attempt to create artificial clusters. Arkansas’s targeted business incentives, which are designed to attract companies that specialize in transportation logistics, information technology, life sciences, bio-based products, agriculture, and advanced materials and manufacturing systems, are one example.

Incentives, however, are not necessary to attract firms that align with a region’s natural comparative advantages. The comparative advantage alone, whether it is the workforce, technology, or location, is reason enough for firms in that industry to locate in the region. If Arkansas had a comparative advantage in “knowledge-based” industries, such as software development, knowledge-based firms would locate in Arkansas regardless of the incentives the state provided. We see this natural clustering without government incentives in California, where Brook Taylor, spokesman for the Governor’s Office of Business and Economic Development, said that data centers in Silicon Valley “are being built in spite of the fact that we don’t have specific tax credits or incentives for them. Companies are just building them here because it makes sense.”

Regional Unrealism Hurts Arkansas’s Economy

Steering the Arkansas economy into industries where it does not have a comparative advantage, however, makes Arkansas worse off. Mercatus Center economist Matthew Mitchell points out that Arkansas would actually “make itself poorer if it tried to specialize in ways that were inconsistent with its comparative advantage.” Market distortions lead to regional unrealism, which is the accumulation and use of resources in areas and activities in which they are not best used. When a state does not do what it is good at, but rather what it dreams it could be good at, its economy does not reach its production potential and the state is poorer as a result. To see how regional unrealism harms states, consider Arkansas’s comparative advantage in rice production.  Imagine that Arkansas’s leaders thought that ski resorts were the key to a successful economy. By issuing enough subsidies and tax breaks, Arkansas could turn its rice fields into ski lodges. Rather than Arkansas farmers raising roughly half the nation’s rice, vacationers would be skiing down fake slopes. Would this arrangement make Arkansas wealthier?

Clearly, it would not. The state would waste massive resources and opportunities trying to support a ski industry. The land, labor, and climate of eastern Arkansas is much better suited for growing rice than it is for downhill skiing. Another region that is less efficient at producing rice might make up for the lost production in Arkansas, but since it is less efficient, rice prices for consumers would rise. Arkansas and its residents are much better off when the state uses its resources to farm rice instead of pretending to be Colorado.

While this is a very clear example of how regional unrealism makes states worse off, it’s not always this obvious. Most times it occurs at levels that are very hard to see. Issuing tax breaks and subsidies to support wind energy or information technology may not seem as absurd as trying to cultivate skiing in Arkansas, but if firms such as Nordex and Hewlett Packard Enterprises are not here because of natural economic conditions, we are making ourselves poorer.

Markets Allocate Resources Better Than Government Intervention Does

Why do people think the government should steer the economy? They may assume that the government is better than the market at allocating resources. However, Nobel Prize-winning economist F. A. Hayek pointed out that no single person or entity knows all the relevant information about the entire economy that is required to make optimal decisions. There is no omniscient wizard who knows exactly which widgets need to be made, how many need to be made, where they need to be sold, and at what price. Rather, people have specific, tacit knowledge about a business or industry, and the potential to earn a profit motivates them to react to market signals, such as prices. Governments, on the other hand, do not have the same profit incentive and are too far removed from market signals to behave in the same way. Individuals reacting to market signals lead the economy to focus on its comparative advantages better than government manipulation does.


The idea that governments can steer economies into sustained economic growth is a myth. History has repeatedly shown this. Government manipulation, although often well intentioned, ends up hurting more than it helps. By limiting government intervention, politicians not only allow entrepreneurs and businesses to make the best economic decisions for their firms, but they also clear the path for states to specialize in their comparative advantages. The outcome is more prosperity for individuals and states alike.