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Why Financial Incentives Do Not Increase Economic Activity

By Mr. Jacob Bundrick

In my last post, I went over the basics of why tax incentives and subsidies are considered staples of economic development. In this post, I’ll explain why they don’t work as politicians might hope.

A common argument in favor of financial incentives is that tax breaks and subsidies motivate firms to create new jobs and invest in new projects, which sparks demand for more products and services within the local economy.

For example, if Hewlett-Packard builds a plant, then construction workers get hired, computers get bought, employees eat at local restaurants, and so on. As demand rises, more firms are attracted to the area and either establish new operations or expand existing operations, leading to further job creation, project investment, and an overall uptick in economic activity.

This uptick increases public revenue as new businesses and employees pay taxes on their earnings and purchases. With increased public revenue, governments may be able to afford to decrease marginal tax rates on businesses or individuals or increase the number or quality of public goods and services. And who doesn’t want lower taxes or better schools, roads, and parks?

While these arguments seem sound, the reality is that financial incentives often fail to spur economic activity for several reasons.

Positive and Negative Spillover Effects from Tax Breaks and Subsidies

Traditionally, incentive programs are evaluated only by the jobs, local investment, and tax revenue directly created by the firm that receives the incentive package. For example, the annual report of the Governor’s Quick Action Closing Fund only reports the direct number of jobs created or retained and the direct investments made by the companies receiving subsidies.

But new and expanding firms create spillover effects that both help and hurt surrounding businesses. Some of these effects support economic growth.

-Labor pooling encourages economic growth by increasing the concentration of workers in the area with specialized skills and knowledge.

-Technology spillovers, or the exchange of technology among people and firms, increase efficiency and innovation. -Knowledge sharing, or the exchange of thoughts, concepts, and ideas among people and firms, also leads to increased innovation.

But there are also several negative spillovers. Increasing the number of firms in a location

-increases the demand for a variety of inputs, such as labor and real estate, which increases the cost of labor and rents and raises the cost of doing business.

-means that, unless infrastructure is expanded, more firms are competing to use the same level of roads, railways, utilities, and communication systems.. The resulting congestion can slow the movement of people and products, which hurts a company’s profits.

-makes tax hikes more likely. An influx of businesses and people means that demand for public goods such as roads, schools, and police will increase. Public money (taxpayer dollars) pays for these goods, which means that the government must collect more revenue. While more businesses and people mean that the tax base will expand and the government will collect more revenue even if it doesn’t raise tax rates, increasing the demand for public goods also increases the likelihood that taxes will rise to keep up with demand for public goods. (Related: Taxes Take Their Toll on Arkansas Manufacturing)

-leads to the cannibalization of existing firms. Tax breaks and subsidies provide a cost advantage to firms that receive them over firms that don’t. When a particular market is saturated (isn’t big enough for more firms), providing a cost advantage to select new firms through incentives allows them to “steal” employees and customers away from existing firms, often to the point that some existing firms must close.

Because of these spillover effects, both positive and negative, tax incentive projects should be evaluated based on their total impact on an economy—not just based on the direct effects from the incentivized firm.

When Looking at the Whole Economy, Tax Incentives for Businesses Don’t Help As Much As Politicians Think They Do

Much research on the net effects of tax incentives for businesses has found that large, new firm locations have a much smaller benefit on the local economy than advertised. In other words, the negative spillover effects outweigh the positive ones. Research by economist Kelly Edmiston examining the effect of new firm locations and existing firm expansions in Georgia found that “after five years, each 100 new employees hired by a new or expanding firm results in a net gain of only 29 workers to the resident county.”

In addition, research in the Southern Economic Journal found that using tax incentives to attract large firms to an area doesn’t have any positive overall effect on the private sector, and likely doesn’t increase tax revenue, either. These findings contradict the common argument that financial incentives increase economic activity. If new firms take employees and customers from existing firms, there are no positive spillovers.

Rent-Seeking

Because incentives reduce the cost of doing business, firms that receive incentives have an artificial competitive advantage over similar firms that do not receive them. The government-granted competitive advantage gives incentivized firms a better chance of survival than those that do not receive aid. By providing advantages to select firms, the government is picking winners and losers rather than letting the market decide. Who do you think should decide whether, say, Target or Walmart is more successful in your hometown: the government or the customers who shop there?

Another problem is that when governments pick and choose who receives financial incentives, they create an environment of rent-seeking: the use of resources to gain financial advantages without creating value in the overall economy. Firms use their resources to lobby for political favors that provide competitive advantages rather than creating a better product or service. Are you, as a consumer, better off when Dillard’s spends money lobbying for a subsidy (that your tax dollars pay for) or spends money on better quality clothes and a more unique shopping experience? Is the economy better off when Dillard’s spends money courting governments for handouts instead of courting customers, whose purchases lead to jobs and economic growth? By issuing financial incentives, governments are encouraging firms to waste resources courting politicians instead of focusing on value-adding activities.

When politicians increase the rewards, or financial incentives, for unproductive behavior, more entrepreneurs engage in unproductive entrepreneurship, which leads to a misallocation of talent and hurts the economy in the long run.

Seen and Unseen Effects

Policy makers need to consider both the seen and unseen effects of economic policies because policies do not have a single outcome, but a series of outcomes. Only the initial outcome is immediately apparent; subsequent effects take time to develop. However, failing to consider the unanticipated outcomes of policy is dangerous. Policies that have short-run benefits often have negative long-run outcomes, and vice versa. Sound economic policy requires foresight to anticipate the future consequences of today’s decisions.

In the case of policies that provide financial incentives to select firms, the immediate, seen effect is that the firm receiving corporate welfare creates new jobs. This effect is often well documented in photo opportunities with politicians. What we don’t see are the other Arkansas jobs destroyed or the jobs that would have come to Arkansas but don’t because of the unintended consequences of financial incentives. While a handful of firms and the workers they hire may initially benefit from subsidies and tax breaks, the economy at large suffers in the long run.