New research suggests creating ‘Interstate Compact’ to end an economic development subsidy war between states

A new study by researchers at the Mercatus Center at George Mason University is proposing an Interstate Compact to end the competition that is prevalent with the practice of development subsidies. According to the paper “An Interstate Compact to End the Economic Development Subsidy Arms Race” by Michael D. Farren and Matthew D. Mitchell, if states and cities enter into compacts they can refrain from offering subsidies to companies in an attempt to poach companies from one another.

What are economic development subsidies?

When Amazon was trying to decide where to move their new headquarters, different states came forward and provided incentives for Amazon to move to their cities. Among the incentives offered were things like tax breaks and cash grants from respective cities. These incentives were in exchange for the anticipated jobs that Amazon was going to bring to those cities. These are called economic development subsidies.

States and local policymakers offer subsidies in order to attract new businesses or incentivize already existing businesses to expand. In exchange, these businesses will bring more jobs and overall economic development. Subsidies are usually tied to performance and distributed after set goals are reached.  Unfortunately, subsidies have been found to more likely than not undermine economic development. Generally, subsidies do not have a significant impact on economic development.

Why subsidies don’t work

The story of Amazon is one of the most recent cases of a state offering billions to a company in order for the company to move to the state. But it is not the first one of its kind. Historically, there have been other bigger subsidies provided to some other companies. Here are some of the highest subsidies provided.

1. Boeing BA, -2.43 percent (Washington, 2013): $8.7 billion

2. Alcoa AA, -1.36 percent (New York, 2007): $5.6 billion

3. Foxconn (Wisconsin, 2017): $4.8 billion

4. Boeing (Washington, 2003): $3.2 billion

5. Amazon (New York, 2018): $2.6 billion

It is easy to see from the figures above that subsidies are costly to taxpayers. They cost state governments by requiring funds that must pulled from other public services. Sometimes states raise taxes in order to provide these subsidies. But apart from their sheer cost, there are other reasons why subsidies do not work. Some of the reasons include the following;

1) It is estimated that only one out of every eight subsidies influences a company’s decision about where to locate, whether to expand, or whether to stay put. That means that most of the estimated $95 billion states and cities spend on subsidies every year is wasted.

The state of Maryland for instance offered amazon incentives totaling $8.7bn. New Jersey’s incentives amounted to $7 billion. But Amazon ended up choosing New York and Virginia based on the fact that, that’s where most skilled employees tend to live or want to live. Based on this, there is a chance, Amazon was still going to move to the places it selected regardless of the availability of incentives.

2) Subsidies can also protect the subsidized company from competition. The company may not have to work quite as hard to create value for its customers or control costs as it would have without the subsidy.

Why policymakers offer subsidies

Even though research shows subsidies are less likely to significantly impact development, states and cities still offer them to companies. This may be due to numerous reasons. These are some of the reasons provided by Michael D Farren and Matthew D Mitchell;

1) Many of the costs of subsidies (such as those listed above) are generally not considered, or are under-counted, before investment decisions are made.

2) Taxpayers face greater difficulty in organizing to oppose subsidies than companies face in campaigning to maintain them.

3) Politicians believe it is politically advantageous to offer subsidies, especially when politicians in other localities are doing so. A recent survey found that 84 percent of mayors believe it is beneficial to offer subsidies.

Subsidies in Minnesota

Subsidies are common to most states and are not particular to big companies like Amazon. Offering subsidies is one way that the Minnesota state government spends its money.  For instance, in February of this year, the state of Minnesota provided $1million in grants and loans to Minnetronix, a technology company based in St. Paul. The subsidy was intended to help Minnetronix add jobs and keep its headquarters in St. Paul.

In 2014, the Minnesota Department of Economic Development created a special fund called Job Creation Fund. This is a “pay-for-performance” program that supports businesses after they meet benchmarks for new jobs and private investment. Since 2014, the fund has provided grants to 71 Minnesota cities. Part of the funds for the grant to Minnetronix came from this program.

Interstate Compacts

Interstate compacts would essentially be states making agreements to refrain from offering subsidies that are intended to poach companies from one another. This will reduce the negotiating leverage that most companies have over choosing location. For instance, when Amazon announced that it was moving forward, states scrambled to present the best incentive to Amazon, probably in some cases disregarding the overall cost of those incentives.

If states had prior agreements, there would have not been competition, and Amazon would have had to consider other factors when deciding where to move. It is quite possible tax incentives were not one of the top factors Amazon was going to consider in order to choose a location. But the fact that Amazon was able to incite such competition between states helped it get extra handouts at the cost of taxpayers.