The Economic War Among the States
Imagine: You are a top economic adviser to the governor of a Ninth
District state. Your state's economic development agency actively recruits
businesses to the state by offering special incentives, such as a tax
break or a loan at a below-market interest rate, to companies planning
to relocate or expand. Recently, however, some economists and politicians
have spoken out against this use of public funds, saying that it wastes
money which could be better spent on public goods, such as highways
and education. On the other hand, many argue that special incentives
are a form of community investment that helps states develop their economies.
In response to this debate, Congress is considering a bill that would
prohibit states from using incentives that benefit a specific company.
Your governor has been called to testify before a congressional committee
on this issue and must decide whether to support the prohibition of
incentives or oppose it. Your job is to research the controversy and
present the governor with a position paper that recommends whether to
support the bill.
Should states be permitted to use targeted incentives to recruit
States and local governments are spending enormous amounts of money to lure businesses
into their region. Consider the following examples in the Ninth District.
A county board committed itself to a deal of over $1 million to bring
an airline maintenance facility to Sawyer, Mich. Deadwood, S.D., offered
actor Kevin Costner's company $7 million to build a casino in their
town—almost $6,000 per capita. Northwest Airlines received a
financial package roughly worth $700 million to build two airplane
repair facilities in an economically depressed region of Minnesota.
Montana made a $5.5 million loan to Pasta Montana for building a plant
in Great Falls. Of course, some regions spend less than the examples
listed here. While some of these efforts may prove successful, some
fall short when the recruited business doesn't live up to expectations—or
worse yet, fails completely and closes. Are economic incentives worth
Even if a state answers "no" to that question and wants
to drop out of the bidding war, it would be politically difficult
and perhaps costly for the state to stop offering incentives while
other states continue to do so. Such a state might lose the bidding
war by default and businesses might look elsewhere. If the state's
business climate is healthy and inviting, it might be able to overcome
the lack of government handouts. However, few states so far seem
willing to try.
Incentives have been challenged in court, most notably by William Maready,
a trial lawyer in Winston-Salem, N.C., who argued that the use of public
funds to subsidize private companies was against the Constitution of
North Carolina. A Superior Court judge ruled in favor of Maready; however,
the state's Supreme Court overturned the ruling and declared that incentives
contribute to the "general economic welfare" of the state and are an
appropriate use of public funds.
Another way to end the "economic war" would be to have
Congress pass a law that prohibits targeted incentives—the
root of this year's Essay Contest question. Below are the basic
arguments behind the cases for and against targeted incentives.
The case for targeted incentives
Supporters of incentives argue that they enhance the local economy and
nurture traditional government functions. While opponents claim that
incentives take money away from producing public goods, supporters counter
that this concern is exaggerated. Instead, supporters emphasize that
incentives help boost the local economy, including the indirect effects
that incoming businesses have on the economy. For example, a new plant
will boost employment in a community by the number of people it hires
plus the number of jobs needed to supply materials and services for
the plant and its employees. Furthermore, incentives can help accelerate
infrastructure projects and expand community colleges and technical
Some incentive supporters argue that incentives should be used to provide
equity; states can use incentives as a tool to help revitalize a depressed
economy or support a particular industry. Businesses generally don't
consider the effects on the local economy when they make their location
decisions, but states and local governments do. States can direct investment
to the areas that need it most. The effect of investment in an economically
depressed area can have a greater effect than the same investment in
healthy area. Even if there is a small loss in efficiency, it is offset
by gains in equity.
Another argument is that some government cooperation is usually necessary
for major private projects, whether or not there is competition among
states. Take, for example, the Mall of America in the Twin Cities. Roads
and utilities, among other things, needed expansion so that the Mall
of America could be built. Government cooperation was necessary to make
Aside from economic considerations, incentives can be administered
with "clawbacks"—clauses that protect governments
if a company does not meet the requirements of a bargain. For example,
if the incoming business doesn't employ a certain number of people
within an agreed time frame, its tax reduction could be eliminated
or it may be required to repay its incentives to the state. Incentive
supporters argue that even though some bad agreements are made,
this isn't a reason to prohibit a practice that, if done right,
could benefit society.
In general, incentive supporters say that the costs and benefits of
each incentive expenditure must be evaluated carefully, but if administered
appropriately, they can be a profitable investment in a state's economy.
The case against targeted incentives
Those who oppose targeted incentives argue that incentives cause inefficiency
and waste. They argue that subsidies and preferential taxes distort
prices and disrupt the free market. Incentives encourage companies to
locate where they are subsidized the most, not where they would perform
most efficiently. For example, a corn milling plant might decide to
locate in a non-agricultural state because it could receive special
treatment from the state, such as a decrease in taxes. Since the company
would be located far from its source of raw materials, the result would
be an inefficient use of resources. In addition, when one company pays
less taxes, competitors are placed at a disadvantage. In this case the
market will not support the most efficient company, but the one that
received special treatment.
In addition, incentive opponents contend that economic incentives do
not create new jobs or businesses, they only move them from state
to state. They say incentives are at best a "zero-sum"
game: The total number of jobs or businesses stays the same nationwide.
Meanwhile, however, millions of dollars pass from the government
into private hands in this process, resulting in a net loss for
The loss of efficiency combined with the lack of net growth explain
why incentive opponents say the situation on a national level is
actually a "negative-sum" game. Incentives decrease efficiency
with no national gain of jobs or growth.
Most incentive opponents support general competition between states,
where states appeal to businesses with such attractions as low
taxes for all companies, high quality infrastructure and an effective
education system. It is preferential taxes and targeted incentives
that they oppose.
Toolbox of concepts
The following economic concepts will help you evaluate the debate over
Almost everything has a cost. When economists talk about the cost
of a good or service, however, they mean something different than
noneconomists. For example, when economists calculate the cost of
a car, they include both the money used to buy the car and the loss
of income that the money would have earned if it hadn't been spent.
This sort of price includes the loss of what could have happened,
and is called the "opportunity cost" of a decision, often
defined as the "best alternative forgone." Even decisions
that don't involve money have opportunity costs. For example, if
you walk to a store that is giving away free mugs, you don't pay
money for the mug, but you lose the time that it takes to walk to
the store and back. Depending on what you could have done during
this time, the opportunity cost of the mug could be more sleep,
extra wages or many other things.
When a government spends money on targeted incentives for businesses,
it forgoes the benefits it could have received from the next best use
of that money. For example, the money could have been put in a savings
account to earn interest, or spent on a public good, such as education.
Cost-benefit analysis is the examination of a public project and the
evaluation of its total costs and benefits to all concerned. The most
important part of cost-benefit analysis is the identification and quantification,
if possible, of all the effects of the project. These effects can include
changes in production, changes in prices, environmental effects, shifts
in income distribution and other social or economic effects. Changes
are considered not only for their present effects, but their long-term
implications as well. The negative and positive aspects of these changes
are then evaluated to determine if the project is worthwhile.
A cost-benefit analysis of a deal with a business that involves incentives
can determine if the benefits are worth the costs. The state may ask
the following questions: How many jobs will the incoming business create?
What effect will the deal have on other sectors of the economy? What
are the opportunity costs of giving the business a tax break?
Market competition usually determines the most efficient use of
scarce resources. However, there may be times when the market produces
an inefficient result, called a market failure. They occur when
noncompetitive behavior exists, public goods are underproduced or
externalities—external costs or benefits—are present.
When market failures occur, government intervention is sometimes
used to correct them. Government has the capacity to discourage
noncompetitive behavior, such as monopolies, produce public goods
and adjust for externalities.
In the case of an externality, part of the cost or benefit of a good
falls on a third party. Since the company producing or buying a good
doesn't account for all costs and benefits of the good, the market will
not allocate resources efficiently.
For example, the process of manufacturing widgets creates air pollution.
Unless the government taxes companies for emitting pollutants into the
air, the local widget company won't consider the environmental and health
costs borne by its neighbors in determining how many widgets to produce.
It will probably produce too many widgets. Once all costs of pollution
are included, the company will produce the number of widgets that most
efficiently uses resources.
Incentive opponents argue that by using incentives, state governments
keep markets from operating at their optimal levels. They say that since
there isn't a market failure to be corrected, the government shouldn't
interfere in the decisions of the free market and distort the allocation
of resources by offering incentives.
On the other hand, some incentive supporters argue that government
is fixing a market failure when it uses incentives. For example, when
a business locates in a state, benefits are realized by the entire state,
not just the business. Since the business wouldn't take those external
benefits into account, the state should step in. Some also contend that
there sometimes isn't enough information available for businesses to
determine where to locate. States can bridge this gap in part by recruiting
businesses that are well-suited for the state.
Still, incentive opponents claim that it is difficult to prove that
there is a market failure, and they contend that the market generally
makes better decisions than the government about which companies are
best for its state.
As an economic adviser to the governor, your are responsible for presenting
him or her with a recommendation on whether or not to support a congressional
bill that will ban the use of targeted economic incentives. Evaluate
the pros and cons of targeted economic incentives with economic concepts,
such as efficiency, opportunity cost, market failure and externalities.
Now it's time for you to read what economists and journalists have
written about the issues and talk to economic development agencies and
business leaders who would be affected by this bill if it were developed
in real life. Then place your pen on the paper or your fingers on the
keyboard and argue whether states should be allowed to use targeted
economic incentives to recruit businesses.