January 29, 2020

Understanding Why Economic Development Subsidies Are a Problem and What Can Be Done about Them

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Chair Ancel, Chair Cummings, members of the House Committee on Ways and Means, and members of the Senate Committee on Finance:

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 possible solutions available for Vermont.

Today, I will illustrate why economic development subsidies are a problem, why they remain a problem despite growing agreement that they should be phased out, and opportunities for unilateral and multilateral solutions.

First, academic research shows that economic development subsidies generally don’t succeed in achieving their stated goals. That is, they don’t result in broad improvements in local and state welfare (although they obviously benefit the companies receiving them). This occurs for several reasons:

  1. The taxes needed to fund economic development subsidies create a negative economic effect that can reduce—or even exceed—the stimulating effect of the subsidy.
  2. Subsidies disrupt the normal workings of a healthy market and cause economic waste by
    1. protecting the privileged company from competition, enabling less efficient production,
    2. encouraging companies to take improperly risky bets or motivating forms of production that are suboptimal, and
    3. encouraging companies to spend resources lobbying rather than focus on pleasing customers.
  3. On a national level, subsidies for economic development are, at their very best, a zero-sum game that fails to encourage improved economic outcomes for all Americans.

Despite these economic problems, political-economic analysis implies 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-run goal of good optics appear to matter more (especially with regard to reelection campaigns) than the real long-run economic effects (which are hard to accurately measure).
  2. Most nonacademic studies of economic development subsidies use a “benefits-only” analysis that ignores 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, while the difficulty of organizing many dispersed taxpayers inhibits their ability to mount 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 it doesn’t seem right.

Thankfully there are some opportunities for reform that can address the problems caused by economic development subsidies.

  1. Constitutional provisions, called anti-aid clauses, exist in most states and technically disallow many state and local subsidies. However, the legal understanding of which government subsidies are disallowed has eroded over time, leading to the current era where subsidies proliferate.
  2. An interstate compact to end corporate subsidies is drawing increasing interest in many state legislatures. A compact would offer a credible way for states to commit to ending the subsidy arms race they find themselves in.

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

This publication was produced for testimony before the State of Vermont House of Representatives, House Committee on Ways and Means; the State of Vermont Senate Chamber, Senate Committee on Finance; and the Vermont House Committee on Commerce and Economic Development