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The Dilemma of State Economic Development

August 28, 2007

Tags Free MarketsTaxes and SpendingPolitical Theory

I live in Alabama, and my state's economic development agency is perhaps among the most active in the country. It is now certainly among the best funded, as voters here recently approved a referendum increasing a cap on the oil and gas royalties that fund its activities to $750 million. It will use this money (ostensibly) to generate jobs, retain existing jobs, attract capital investment, nurture nascent industries, and rescue stagnant ones.

Since state governments waste millions of dollars a year with conscripted capital, it is hard to oppose this spending. After all, this is spending not for special interests, but for everyone. Right?

Well, not necessarily. Although we should always be wary whenever public officials ask for more of our money, increasing funding for state economic development programs increases the likelihood that states will waste resources competing with each other for the favor of firms. The economic concept of the prisoner's dilemma explains why.

The prisoner's dilemma can occur when one economic actor must take into consideration the reactions of another economic actor when making economic decisions. For instance, say that Smith decides to invest in one market out of concern that if he doesn't, Johnson will. What if Smith invests too much, so that the benefit from investing in the market is minimal, or even negative?

Such dilemmas are more likely to be avoided when economic actors spend their own money, but this factor does not apply to state economic development agencies operating in the public sector. One can see a prisoner's dilemma at work in the Alabama Development Office, which orchestrates the benefit packages offered to expanding firms. The appeal of this practice is straightforward. If the state offers (say) $1 million in tax dollars to entice a manufacturer to Huntsville, and the result is an increase in tax revenues for any sum greater than $1 million, then the state and (presumably) taxpayers are better off in the end.

But are they? That's where the prisoner's dilemma comes in. When other states are competing for the same firms to operate in their states as well, wise firms will hold out for the best offer. This forces states to take into consideration economic development packages being made by their competitor states. An aggressive state can win the firm's favor, but the incentive package will cost much more. Is it still worth it?

Robert Lynch argues that it isn't. The Washington College economist has been studying state subsidy issues for 20 years and found that such packages rarely cause firms to expand in geographic areas that they would not have otherwise expanded to without state incentives. The implication is that many of the businesses choosing to locate in Alabama or any other state would have moved there anyway.

This is because states have comparative advantages beyond the control of their state development offices that are important to relocating or expanding firms. Alabama, for instance, has many attributes that make it incredibly attractive for capital investment. It is a right-to-work (read: low labor cost) state that has a world-famous work ethic. It combines the nation's lowest capital gains and property taxes with affordable housing. It has extremely temperate weather conditions that make it preferable for manufacturing goods traditionally associated with northern climates. It has also become one of the leading retirement destinations of all states that don't start with the letter F.

Taken altogether, this means that the marginal benefit of economic incentive packages to firms is not that great. Lynch concluded in a recent interview, "I wish politicians wouldn't get involved in that game."

Unfortunately, the temptation to do so is great. From a political perspective, funding that doesn't require tax increases and results in agreements that cast a favorable light on the minor-league redistributionists (i.e., state legislators) is quite welcome. Creating incentive packages to entice prospective firms can be a godsend to pols trying to counter the adverse effects of existing state policies that weaken property rights or otherwise encourage the exit of capital and labor to other states or even overseas.

But the political class they comprise is not going to highlight other implicit costs inherent in expanding the scope of state-level industrial policy. These include higher relative costs of living in areas that do not receive direct benefits from the business expansion, weakened property rights institutions that are essential in a competitive and global economy, lost incomes to taxpayers who are forced to finance state development schemes, and perverse malinvestments that result when firms base spending priorities on the desires of legislators motivated by corruption and rent-seeking by powerful groups and lobbies.

Indeed, these malinvestments are multiplied when carried out among a cartel of fifty states, each competing with the other for limited capital. When they do, each state development agency becomes a net negative to its state, at which time taxpayers would be better off if they all shut down. They should. As hard as it may be for the arrogant state development community to believe, the vast majority of economic growth that occurred in the United States was actually coordinated without any such such central planning boards.

Besides, a better way for states to attract industry can be found in a study conducted by former Michigan governor John Engler when he served in the Michigan legislature. Engler found that the best long-term strategy for attracting business was to maintain a simple, low-tax and low-regulatory business environment. Such strategy is not politically attractive — it hardly shaped Engler's policies when he was governor — but it explains much of the capital flow, not only within the United States, but throughout the world.

State economic development agencies stand athwart this minarchist ideal. Their increased prominence today is just the latest form of mercantilism that classical economists rightly opposed in the past. We should do so again, not only because less interventionist policies reduce coercive redistributions committed in the name of state gross domestic product; they also save money and attract firms, simply by avoiding a prisoner's dilemma.


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