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Volume 17, Number 4
Can States Buy Business?
Peter T. Calcagno
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
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"
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
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
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
Peter T. Calcagno teaches economics at
Jacksonville State University and is an adjunct scholar (and former fellow) of the Mises Institute.
Further Reading: James Bennett and Thomas J. DiLorenzo, Underground Government: The
Off-Budget Public Sector (Washington D.C.: Cato Institute, 1983); Dwight Lee and
McKenzie, Quicksilver Capital: How the Rapid Movement of Wealth Has Changed the
World (New York: The Free Press, 1991); Mark Taylor, "A Proposal to Prohibit Industrial
Relocation Subsidies," Texas Law Review, Vol. 72: 669 713. Alice Rivlin, "An
Economic War," The Region, June, 1996 (publication of the Federal Reserve Bank of