Understanding the Harm Caused by Economic Development Subsidies

Click here to view Dr. Farren's testimony (7:28–14:00).

Chair Arp, Co-chair Hines, and members of the Finance 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 problems associated with economic development subsidies and the proposal to provide $16 million in property tax abatements for an unnamed company’s distribution center.

An estimated $95 billion is spent annually by state and local governments on economic development subsidies. These subsidies are a long-standing problem for local and state governments. Public support to phase them out is growing as their failures are becoming increasingly obvious.

Academic research consistently shows that economic development subsidies fail to achieve their stated goals. That is, 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 taxes or diverted funding that pays for economic development subsidies create a negative economic effect that can reduce—or even exceed—the stimulating effect of the subsidy.
2. The average accepted 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 and cause economic waste by
   1. protecting privileged companies from competition, enabling less efficient production,
   2. encouraging companies to make excessively risky bets,
   3. motivating investment and production decisions that are suboptimal, and
   4. inducing companies to pursue politically derived profits rather than focus on satisfying customers.

Making matters worse, the subsidies used in what has become an interstate arms race 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 the subsidy “works,” it has motivated a suboptimal economic decision that will result in an inefficient use of resources. An extreme example would be subsidizing Florida orange growers to move to northern Indiana—doing so is technically feasible, but obviously not a wise decision.

Despite these adverse economic outcomes, political-economic analysis suggests that governments continue to pursue economic development subsidies because the subsidies appear to be beneficial for the policymakers who support them:

1. Academic research has shown that politicians seem to benefit by being seen as “doing something” to improve the local economy. That is, good intentions and the short-term goal of good optics appear to matter more (especially with regard to reelection campaigns) than the real long-term economic effects (which are hard to accurately measure). However, when taxpayers and voters are informed 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 a prisoner’s dilemma where a policymaker feels compelled to support offering subsidies, even if doing so doesn’t seem right.

There is reason for optimism today. State and local governments are increasingly turning away from wasteful competition using subsidies and toward cooperative solutions that lead to widespread economic development and social growth. These solutions include a renewed focus on regionalism, rather than a dog-eat-dog competition over the local tax base, and an interstate compact intended to gradually phase out subsidies altogether.

I hope the resources I have provided will prove useful as you consider whether to provide a $16 million property tax abatement for a company whose operations dictate that it must locate somewhere near Fort Wayne.

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).