An Interstate Compact to End Company-Specific Subsidies
Testimony before the Illinois General Assembly, House Revenue and Finance Committee
Chairperson Zalewski, Vice Chairperson Tarver, Spokesperson Reick, and members of the House Revenue and 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 potential solution offered by HB 95.
An estimated $95 billion is spent annually by state and local governments on economic development subsidies. These subsidies remain a tenacious problem, even as support grows for phasing them out. My research suggests that an interstate compact offers an opportunity for a cooperative solution.
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:
- 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.
- 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.
- Subsidies disrupt the normal workings of a healthy market and cause economic waste by
- protecting privileged companies from competition, enabling less efficient production,
- encouraging companies to make excessively risky bets,
- motivating investment and production decisions that are suboptimal, and
- inducing companies to pursue politically derived profits rather than focus on satisfying customers.
Making matters worse, the subsidies used in this 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 Illinois—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:
- 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.
- 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.
- 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.
- 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. The interstate compact proposed in HB 95 offers a path out of this self-destructive cycle. 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. The confidence such a commitment provides is critical because it removes the perceived vulnerability that comes from unilaterally exiting an arms race—even when the arms race causes more harm than benefit.
With the security offered by a compact, forward-thinking policymakers will be able to shift the paradigm to one where states create economic development by fully focusing on becoming great places to live, rather than wasting time courting corporations’ affection.
Thank you for the opportunity to speak to you today. I look forward to your questions.
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).