Helping Kansas Get the Best out of a Bad Deal: Megasubsidies for a Mystery Company

Kansas Legislature, House Commerce, Labor, and Economic Development Committee

Chair Tarwater, Vice Chair Long, Ranking Member Clayton, and members of the House Commerce, Labor, and Economic Development Committee:

My name is Michael Farren, and my research at the Mercatus Center at George Mason University focuses on evaluating government efforts to foster economic development. I am grateful for the invitation to discuss the unintended, but foreseeable, adverse effects of economic development subsidies, such as those proposed in Senate Bill (SB) 347.

An estimated $95 billion is spent annually by state and local governments on economic development subsidies. These subsidies remain a tenacious problem, despite increasing efforts to phase them out.

Academic research consistently shows that economic development subsidies fail to achieve their stated goals. They do not result in broad improvements in local and state welfare, nor are they likely to sway corporations’ decisions of where to locate or expand. This failure occurs for several reasons:

1. The higher-than-necessary taxes that pay for economic development subsidies create a negative economic effect that can reduce—or even exceed—the stimulating effect of the subsidy.
2. The average granted subsidy is likely to change only one out of every eight corporate location or expansion decisions. This means that almost 90 percent of subsidy spending is completely wasted, failing in its primary goal.
3. Subsidies disrupt the normal workings of a healthy market, causing economic waste by
   1. protecting privileged companies from competition, reducing their motivation to adopt the most efficient production techniques;
   2. encouraging companies to make excessively risky bets, in effect using taxpayer dollars to underwrite gambles that investors wouldn’t fund; and
   3. motivating investment and production decisions that are suboptimal, often because they are politically motivated rather than customer focused.

Making matters worse, subsidies cause slower national economic growth. This occurs even in the small number of situations when a subsidy does sway a corporation’s location or expansion decision. When a subsidy “works,” it has motivated a suboptimal economic decision that leads to an inefficient use of resources—getting less bang for the same buck.

An extreme example would be subsidizing the construction of indoor ski slopes on the flatlands of Kansas to compete with Colorado. Doing so is technically feasible—after all, New Jersey just opened the first indoor ski facility in the United States. But, as your mother probably warned you, “Just because New Jersey is doing it doesn’t mean it’s a good idea.”

Despite these harmful economic outcomes—and they are harmful indeed, because slowing economic growth impoverishes future generations—political-economic analysis suggests that the inertia of this policy is difficult to overcome. Superficially, these subsidy deals seem to benefit the policymakers who support them, and the subsidies are supported by powerful special interest groups. Here are some of the barriers blocking a change toward policies that would promote faster economic growth:

1. Academic research has shown that politicians appear to benefit when they are seen as “doing something” to improve the local economy. That is, expressed good intentions and the media attention from ribbon-cutting ceremonies appears to matter more (especially with regard to reelection campaigns) than the real adverse long-term economic effects of these policies.

(Reassuringly, when taxpayers and voters are reminded of the tradeoffs required by subsidies—higher taxes and reduced public services—their approval of these policies disappears).

2. Most nonacademic studies of economic development subsidies use a “benefits-only” analysis that ignores costs (especially the economic impact of the taxes needed to fund the subsidies) creating a culture of misinformation regarding the expected effect of the subsidies.
3. The uneven distribution of benefits (which are concentrated on the subsidy recipients) and costs (which are spread out across all other taxpayers) means that the recipients have a strong incentive to lobby for their subsidies, whereas the many dispersed taxpayers have difficulty mounting an effective protest.
4. The pressure to offer subsidies is particularly difficult to resist when politicians in other cities and states engage in the practice, creating something like an arms race, where policymakers feel compelled to support offering subsidies, even if doing so doesn’t seem right.

Despite megasubsidy deals being announced seemingly every day in recent weeks, there remains reason for optimism. Over the past few years, 15 states have introduced legislation to create an interstate compact that offers a path out of what has become an economic arms race. The ability of states to enact legislation to enter into a compact is enshrined in the US Constitution, and compacts provide a credible way for policymakers to commit to cooperation across state lines. The confidence such a commitment provides is critical because it removes the misapprehension that comes from a unilateral exit—even when the arms race leads to self-destruction, as each state keeps shooting itself in the foot over and over again.

With the security offered by a compact, forward-thinking policymakers would be able to shift the economic development paradigm to one where states encourage growth by fully focusing on becoming great places to live, rather than wasting time courting corporations’ (transient) affection.

Senate Bill 347

Regarding SB 347, economic research and my extensive experience studying deals like this offer a few key insights.

1. The suggestion that the collection of amendments offered by the Senate to the enabling legislation is a “deal killer”—as stated by Lieutenant Governor Toland—is unlikely to be correct. Academic research illustrates how nearly 90 percent of subsidies are wasted because companies would have made the same decision without the subsidy.

The subsidy package as currently constructed seems likely to eliminate any state tax liability for the company targeted by SB 347. The findings of peer-reviewed research suggest that adding even more icing to the cake Kansas is offering by making the tax credits refundable is highly unlikely to meaningfully sway the targeted company’s final decision.

2. Previous similarly sized subsidy deals from other states have enabled companies to receive tax credits equivalent to the value of the state income taxes their employees pay (which some argue, incorrectly, doesn’t cost the state anything). However, I have never seen a state take on the direct responsibility of reimbursing a company’s payroll expenses.

Payroll expenses are typically the largest cost companies face, and refundable tax credits connected to payroll reimbursement could lead to much higher subsidy payouts than currently anticipated. Kansas could be setting a dangerous precedent that will exacerbate future subsidy deals across the country, as well as ensuring that this particular deal never pays off for the state.

3. The one economically justifiable subsidy in this legislation is the reimbursement of training costs for new employees.

Current federal tax code forbids companies from counting employee training costs as a tax-deductible expense if that training prepares workers for a new kind of job. My previous research explains how this inability to properly deduct a critical cost of doing business reduces individual opportunity and economic growth. 

It’s difficult to say what the correct reimbursement of training costs should be, at least for the purpose of maximizing economic efficiency. But it is safe to say that economic development subsidies that are directed toward building workers’ skills (which increases economic productivity) are much, much more effective at creating long-run economic growth than corporate handouts.

Thank you for the opportunity to speak to you today. I look forward to your questions.

Attachments (3)

Michael D. Farren and Matthew D. Mitchell, “Targeted Economic Development Subsidies Don’t Work. An Interstate Compact Could End Them” (Policy Spotlight).

Michael D. Farren and Matthew D. Mitchell, “Interstate Compacts against Economic Development Subsidies: How to Stop the Economic Race to the Bottom” (Research Summary).

Matthew D. Mitchell et al., “Targeted Economic Development Subsidies Don’t Work: Negligible Community Benefits and Economic Development” (Research Summary).