West Virginia Legislature, Commission on Interstate Cooperation
January 11, 2022
Chair Woodrum, Chair Stouch, and members of the Commission on Interstate Cooperation:
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 West Virginia, including developing a compact that would improve interstate cooperation.
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. West Virginia was one of the original six states that proposed legislation to create such a compact in 2019, and the state has an opportunity to become the nation’s leader in moving this initiative forward.
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 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.
- 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.
- Subsidies disrupt the normal workings of a healthy market, causing economic waste by
- protecting privileged companies from competition, reducing their motivation to adopt the most efficient production techniques;
- encouraging companies to make excessively risky bets, in effect using taxpayer dollars to underwrite gambles that investors wouldn’t fund; and
- 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 Florida orange growers to move to West Virginia—doing so is technically feasible, but obviously not a wise decision.
Despite these harmful outcomes—slowing economic growth immiserates future generations—political-economic analysis suggests that the inertia of this kind of policy will be difficult to overcome. This is because, on the surface, subsidies seem to benefit the policymakers who support them and because the subsidies are supported by powerful special interest groups. The following points illustrate some of the barriers blocking a change toward policies that would promote stronger economic growth:
- 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 appear 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.)
- 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 are less motivated and have difficulty in 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 something like an arms race, where policymakers feel compelled to support offering subsidies, even if doing so doesn’t seem right.
Thankfully, there is reason for optimism today. West Virginia’s continued leadership in developing an interstate compact offers a path out of what has become an interstate 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.
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)