Targeted Business Incentives are Not Good Public Policy

June 6th, 2005 by


Targeted state incentives do not provide a net economic gain. They merely redistribute jobs and investment from one business to another and from one region to another. Price adjustments in free markets lead to maximum efficiency in the use of resources. Targeted incentives destroy the efficiency of the free market by favoring inefficient businesses over efficient ones. A number of perverse market consequences result:

One, the subsidy distorts the rate of return that businesses use to judge the profitability of investment alternatives.

Two, the subsidy is designed to create “more jobs”; however, the subsidy will act to squeeze more socially beneficial investments out of the market if incentives are continued into periods of relatively full employment.

Three, political favoritism is an inherent byproduct of targeted incentives.

Fourth, these incentives are very expensive. The same funds, if used for worker training or to match federal Medicaid dollars would give a much greater payoff.

Argument for Economics

The new policy of providing cash or other direct targeted incentives to individual companies represents a distinct break from North Carolina’s economic development policy before the mid-1990’s.

This practice relies upon the unreasonable assumption that governments can best judge which businesses will contribute the most value to an economy, because the government is taking money away from some firms, workers and consumers – through taxation – and giving it to others. This “opportunity cost,” is rarely factored into the equation. It’s focus is merely on the jobs or economic opportunities that appear to be created, not whether there is a net expansion of jobs or economic opportunities once the clear opportunity cost of the policy is subtracted.

Cash and other targeted state incentives have not provided a net economic gain in any jurisdiction. Instead, academic studies examining the subject have found that such incentives bear no statistically significant relationship to measures of state economic performance or well-being.

These incentives merely redistribute jobs and growth from one area to another, or from one firm to another, or even from one individual to another.

Adam Smith, The Wealth of Nations, made the link between profits and the public good. Smith described a society that relied upon competitive market transactions between sovereign individuals to achieve greater prosperity for the entire nation rather than a society that relied upon government-directed economic policy.

Smith contended that every individual would endeavor to employ capital in support of domestic industry for practical reasons.

A “statesman who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.” Id at 423.

Marginal equivalences, achieved through price adjustments in freely competitive markets, eventually lead to both maximum efficiency in the use of resources, and maximum welfare of the participants, given an existing distribution of income.

The key economic piece of information that all consumers and firms regard in making their decisions is price. It is the price of goods and services, freely determined in the market exchanges between consumers and profit maximizing firms that allows the adjustments of marginal rates of transformation of resources into finished products, and then the consumption of products into consumer satisfaction.

In the absence of government intervention in market exchanges, or monopoly power in production, participants in the free market price system seek and find maximum welfare for all.

Targeted business incentives act as a price subsidy to a specific firm selected by the government over any other firm that may also make an investment. When government intervenes in the market the ratio of net return to capital is not the same for all savers and investors.

Some firms benefit from the government intervention, while other firms do not. Some consumers benefit from the government intervention, while others do not. The government determines who will win and who will lose as a result of the use of the incentives.

Once the process of government incentive price subsidies begins, a number of perverse market adjustments and consequences result, none of which has a market-based resolution that would restore price as the key information variable. The process of private investment decision-making becomes more and more politicized and arbitrary. This is true even if the government officials who decide are paragons of virtue.

First, the price subsidy distorts the rate of return throughout the capital markets that all firms use to judge the profitability of investment alternatives. The government incentive acts to drop the real rate of return of the recipient firm, compared to the prevailing market rate of return for non-recipients, thus making socially inefficient investments possible and more likely to recur.

Second, in the absence of a market-derived, commonly observed rate of return, the socially optimal rate of investment does not equal the time preferences of consumers for present versus future rates of consumption. It becomes more rational for non-recipient firms, who are not initially blessed by government largesse, to begin searching for incentive handouts and focusing their attention on obtaining easy government revenues, not on obtaining more difficult market derived profits. The rate of invesment does not equal the time preferences of consumers for present versus future rates of consumption. It becomes more rational for non-recipient firms, who are not initially blessed by government largesse, to begin searching for incentive handouts and focusing their attention on obtaining easy government revenues, not on obtaining market derived profits. The rate of investment declines for profitable enterprises that would be undertaken, thus adversely affecting consumption in the future.

Government handouts serve not only to produce socially inefficient investments that would not otherwise be undertaken in the competitive market, but also serve to distort the rate of investment required to produce optimal levels of welfare in the future. This process eventually leaves the government as the dominant force in determining both the socially optimal rate of investment for the future and the type and location of investments that will occur.

Third, the government subsidy is designed, according to its proponents to create “more jobs.”

The “more jobs” provided by incentives produces a stream of income that may or may not have been present in the economy prior to the incentive. If “more jobs” is created when “more jobs” is not required because of relatively full employment, then the government incentive serves to squeeze other more socially beneficial investments and capital out of the market. Since “incentive” programs have a long gestational period, they invariably carry over into periods of relatively full employment.

The government not only determines who wins and loses, but its action with the incentive has a secondary effect of squeezing other investment alternatives out of the market. It is not, then, rational for non-recipient firms to either commit capital to investments in jobs that would compete with the government subsidized investments, or to invest for future time periods.

Fourth, while dropping the real rate of return for the recipient firms, the government lowers the risk of failure for the firm compared to the higher risk levels faced by non-recipient firms. The subsidized firm has a lower level of commitment to the success or failure of the investment. The incentive acts as an insurance policy for the recipient firm. If and when things go bad, or if and when some other state offers a better incentive, the firm has less at risk in abandoning the project.

This type of government intervention becomes self-perpetuating. If it took a government subsidy to recruit the firm to the location, and that subsidy helps promote a lack of commitment to the investment, then it seems likely that it will take more incentives to keep the firm from leaving. Unless the government continually meets the competitive bids of other states, the firm, basing its decisions on the political process, and not the market rate of return or market rate of risk, will continually extract greater incentives from the government agent in order to stay. By this time it has a covey of lobbyists in state who will become adept at finding subsidies.

Fifth, over time, the price subsidy to the recipient firm distorts the adjustment relationship between returns to capital and returns to labor that are expected to occur in a competitive market. In perfect competitive equilibrium the marginal equivalency of profits to consumer satisfaction is reached after a series of price-based exchanges. By providing the incentive, the government allows higher nominal returns to be achieved by the firm, vis-a-vis non-recipient firms than is consistent with the payment of prevailing wages in the labor market, although the return appears lower when the government’s subsidy is counted as part of the recipient firm’s investment. POLITICAL FAVORITISM IS AN INHERENT BYPRODUCT OF THE SYSTEM OF GOVERNMENT RECRUITMENT INCENTIVES

When government selects the recipients of incentives it overrides consumer sovereignty of free choice in the market place. The government substitutes its own judgement in place of the collective, autonomous, free decisions of the market on what type of goods and services should be produced. Any such judgment by the government is inherently arbitrary and capricious.

The government has no way of determining the social advantages of its decision. But its decision creates winners and losers, many of whom cannot be identified in advance. The power to decide who gets the incentive is perfectly symmetrical to a power to deny an incentive, or to provide a disincentive to a private firm considering location in North Carolina.

The incentive process w/ill ultimately result in graft and bribery in the selection process as all arbitrary decision making does.

The writer represents Southern Wake County in the North Carolina House of Representatives.
Source: Representative Paul Stam submitted a version of this article as a brief in Maready v. City of Winston-Salem for the John Locke Foundation.