Jacob Bundrick and Dr. Tom Snyder will speak before the State Agencies & Governmental Affairs – Senate Constitutional Issues Subcommittee at 1 p.m. Monday in the Old Supreme Courtroom at the State Capitol regarding their research examining the effects of targeted business subsidies on economic growth.

Bundrick and Snyder’s working paper titled �� takes an empirical dive into the relationship between Quick Action Closing Fund (QACF) subsidies and private employment and private establishments in Arkansas’s counties.

The study was released by the Mercatus Center at George Mason University and accepted for publication in the academic journal The Review of Regional Studies.

You can read the agenda for the meeting . A summary infographic of Bundrick and Snyder’s work can be found here.��

ACRE Policy Analyst Jacob Bundrick discussed state government’s track record in creating jobs with cash subsidies through the Quick Action Closing Fund in an op-ed published on January 20th in the Arkansas Democrat-Gazette.

The Quick Action Closing Fund (QACF) allows the state to provide cash grants to select entities in the hopes of attracting and retaining businesses within Arkansas. The state legislature has appropriated approximately $176 million to the QACF since it was created in 2007. The Arkansas Economic Development Commission has said the program is responsible for creating or retaining nearly 20,000 jobs in Arkansas.

In his op-ed, Bundrick references a working paper he co-authored with BT����Associate Professor of Economics and ACRE Scholar Dr. Thomas Snyder entitled “” The working paper was published December 6, 2017 by the Mercatus Center at George Mason University and the academic paper this study is based on will be published in 2018 in the academic journal The Review of Regional Studies.

Bundrick and Snyder found that Quick Action Closing Fund subsidies have “no meaningful relationship” with county-level employment.

Bundrick writes in his op-ed:

“Overall, we conclude that there is reason to be skeptical of the Quick Action Closing Fund as a job creator at the county level.

Great fanfare surrounds the job announcements tied to these subsidized projects. However, focusing our attention solely on the benefits to the subsidized company ignores the costs to the local economy.

Quick Action Closing Fund subsidies are not free money. Tax dollars spent on subsidies could have been spent by taxpayers elsewhere and still have increased economic activity. Similarly, public officials could have used these tax dollars for other potentially more productive public expenditures such as highway funding.”

You can read the full op-ed.

Bundrick is also the author of the ACRE policy review, “Tax Breaks and Subsidies: Challenging the Arkansas Status Quo”and recently participated in a organized by UCA’s Center for Community and Economic Development.

Will Issue 3 bring jobs or bankruptcy taxes? Issue 3 proposes to allow local governments to appropriate tax dollars directly to private companies for economic development projects and to pay private organizations for economic development consulting work. Issue 3 would also expand the type of projects for which local debt can be issued as well as increase the number of taxes that can be authorized to retire economic development bonds.

The proposal to loosen the restraints on municipalities stems from a that payments made by the cities of Little Rock and North Little Rock to local chambers of commerce were unconstitutional. Proponents argue that passing Issue 3 will resolve the legal question and enable local governments to offer enough incentives to attract businesses.

, executive director of the Arkansas Economic Development Commission, claims that “when a local community has no defined ability to spend funds for economic development purposes, it is at an immediate disadvantage versus communities that have this ability.” Issue 3 would allow all communities to develop defined spending plans that might help cities and counties develop both direct and indirect employment.

Randy Zook, president and CEO of the Arkansas State Chamber of Commerce/Associated Industries of Arkansas, that “ambiguities in our state Constitution have left our communities with their hands tied when it comes to using local resources to recruit employers.” However, voters should remember that constitutions are put in place to limit government power. Expanding government officials’ ability to use local tax dollars and public debt to finance private economic development projects comes with costs.

For example, Fayetteville city attorney that allowing cities and counties to finance private economic development projects means that “Arkansas cities will likely be invited into bidding wars with each other for new ‘economic development’.” Businesses could threaten to leave for the neighboring town if their current host city did not provide more incentives. This would put Arkansas cities into contests with each other to see who can write the biggest check, which ultimately drives up local tax burdens. Little Rock would compete not just with Oklahoma City and Nashville, but also with Conway and Rogers. Rather than spurring job creation, existing jobs would simply be moved from one Arkansas city to the next.

Furthermore, local governments take on significant financial risk when tax dollars and local debt are used to finance private businesses. , provides a cautionary tale. In March 2015, more than one-third of Port St. Lucie’s debt ($335.5 million) was from “failed or faltering economic-development deals for which the city fronted money with a promise of repayment.” This means that taxpayers in Port St. Lucie are being forced to pay $335.5 million (plus interest) for projects they will see little to no economic benefit from. The city’s struggle with economic development debt led to a If Issue 3 passes, how many Arkansas cities would follow the path of Port St. Lucie?

While many government officials are cautious about such projects, others might not be as diligent – or they might be mistaken. There is always the chance that city and county officials would take risks hoping that they will pay off and, perhaps, also gambling that if their bet fails, the state might step in and pick up the bill. After all, Arkansas taxpayers have seen this before.

In the 1920s, Arkansas’s municipalities to finance road construction projects. Yet, the debt burden quickly became insurmountable for municipalities. In an effort to rescue the failing road districts, the State of Arkansas assumed local road debts. However, Arkansas was hit hard by the 1927 flooding of the Mississippi River system and the Great Depression that followed a few years later. By 1933, Arkansas was drowning in its debts and became the first and only state to declare bankruptcy during the Depression.

Using local tax dollars and public debt to finance economic development projects brings both risks and rewards. Relaxing the constitutional restraints on local governments may enable Arkansas’s communities to attract new economic development, but at what expense? Arkansas voters must ultimately weigh the cost of higher tax burdens and the risk of bankruptcy against the possibility of new employers.

Issue 3 is a complicated ballot measure. The bill runs 9 pages of legal text and it amends at least six sections of the Arkansas Constitution. No wonder voters are confused! In this blog post, we will discuss the benefits and costs of Issue 3’s major change: removing the cap on bonds the state may issue for economic development.

How Issue 3 Impacts Amendment 82 Bonds

Amendment 82 of the Arkansas Constitution allows the state to issue general obligation bonds for the purpose of funding economic development projects. These bonds are generally reserved for large projects such as the��. For a company to receive Amendment 82 bonds, the general assembly must approve the bonds’ issuance by a vote.

Currently, the state is only authorized to issue bonds of up to five percent of the state’s general revenues collected during the most recent fiscal year. However, Issue 3 proposes to completely remove this cap, expanding the state’s ability to fund economic development projects.

What are the Pros?

By expanding Amendment 82 bonds, Arkansas could attract huge economic development projects that are not possible under the current Constitutional restrictions. For example, Arkansas may be able to draw an automobile assembly plant that the state hasn’t been able to land because of the five percent cap. Mississippi was able to beat out Arkansas for Toyota in 2007 because worth of incentives for the project. Removing the cap on Amendment 82 bonds would give Arkansas the ability to write a check big enough to attract an auto factory or any other super project that would likely never come to Arkansas without incentives.

An additional benefit is that Arkansas may be able to secure mega projects without incurring fiscal costs. If Arkansas disperses Amendment 82 bond proceeds as a loan rather than a grant, there is no cost to the state’s budget, provided that the company continues to make its payments. The firm pays the state and the state uses those payments to repay the Amendment 82 bonds. Arkansas may even come out on top if the interest rate the firm pays the state is higher than the interest rate the state pays bond holders. Attracting firms that Arkansas would not otherwise draw without using tax dollars means no fiscal cost to the state.

However, history has proven it an unrealistic expectation for Amendment 82 bond proceeds to be delivered solely as loans. The entire (a project which ultimately did not come to fruition) was approved as a grant and just $50 million of the $125 million given to Big River Steel was in the form of a loan.

What are the Cons?

Famed economist that “the good economist takes into account both the effect that can be seen and those effects that must be foreseen.” Arkansas may be able to land large economic development projects with Amendment 82 bonds, but doing so comes with hidden costs.

Arkansas takes on significant risk when it issues economic development bonds. Consider the following hypothetical example:

Arkansas legislators approve a $300 million Amendment 82 bond issue to lure an auto assembly plant. The bonds are sold to the public and the proceeds are provided to the auto company: $180 million as a grant and $120 million as a loan. Arkansas taxpayers are on the hook to repay bond holders for the $180 million grant and the auto company is responsible for the $120 million provided as a loan. Now, imagine that the auto manufacturer files for bankruptcy, which is not hard to do since GM and Chrysler both essentially did so in 2009. Arkansas no longer receives payments from the business and must find another way to repay the Amendment 82 bond holders. Who do officials turn to? That’s right, taxpayers. Taxpayers must now pay for the entire $300 million issue.

Supporters of Issue 3 have argued that the five percent cap on Amendment 82 bonds puts some economic development projects just out of reach. But it’s important to recognize that the proposed amendment does not simply raise the cap to 10 percent or 15 percent of state revenue, it eliminates the cap completely. There will effectively be no limit on how much the Legislature can issue in bonds.

How much debt would Arkansas issue to attract a few companies? 100% of state revenues? $10 billion? While giving $1 billion in incentives seems crazy and hyperbolic, (after Missouri offered them a measly $1.7 billion). Removing the cap on Amendment 82 bonds opens the door for Arkansas to do the same. It provides Arkansas officials an avenue to gamble limitlessly on economic development projects with the backing of the citizens of Arkansas.

Conclusion

Issue 3 is a complex, but important ballot measure. Its major change, removing the cap on economic development bonds, has both pros and cons for the Arkansas economy. On one hand, it may provide the state what it needs to attract major economic development projects. But, in doing so, Arkansas would be taking on significant amounts of debt, risking the solvency of the state.

In a future blog post we will discuss another aspect of Issue 3: its impact on economic development at the local level. A lays out some interesting costs and benefits which we will expand on.

Supporters of financial incentives for businesses argue that incentives are designed to protect the taxpayers who pay for them. Tax incentives generally pay out only after a company makes a business investment. An example is the tax credit for 1 percent of payroll that Elyxor will receive for creating 45 jobs over the next 5 years in North Little Rock. Governments will not award firms a job-creation tax credit if they do not create jobs, just as governments will not give firms a research and development tax credit if they do not engage in research and development.

Subsidies are different: they generally provide payments up front. Because of this, subsidies often come with clawback agreements, which allow governments to take back a portion of the granted money if a firm fails to create the agreed upon number of jobs or make the promised investment.

How Clawbacks Fail to Claw Back Tax Dollars

On the surface, clawbacks seem like a valuable safeguard that limits taxpayers’ risk. However, clawbacks work only as well as they are enforced. If governments don’t enforce them, taxpayers have minimal protection from failed projects.

Consider the case of Hewlett-Packard (HP) in Conway. HP received a $10 million grant from Arkansas’s Quick Action Closing Fund, which provides subsidies to select businesses that locate in Arkansas, in return for its promise to create 1,000 permanent, full-time jobs by the end of 2013. At the deadline, however, the Arkansas Democrat-Gazette reported that . Did Arkansas’s government ask HP to pay back 40 percent of its grant? No. It it received and negotiated an agreement that would “encourage the company to continue hiring people,” according to Arkansas Business. But HP continued to underperform, as evidenced by a in early 2015. But even with both clawbacks, as of the end of fiscal year 2015, HP had been allowed to keep 91.85 percent��of the money it received for providing only 60 percent of the jobs it promised, according to the Accounting of the Economic Development Incentive Quick Action Closing Fund as required by Act 510 of 2007.

Another problem with clawbacks is that they do not protect taxpayers when a company receiving a subsidy with a clawback agreement goes bankrupt. If this happens, there is little chance that taxpayers will see any money recouped. German manufacturer is a prime example. After receiving $1.5 million from the Quick Action Closing Fund, the company entered bankruptcy and has been unable to return any grant money to the fund.

Financial Incentives for Businesses and the Moral Hazard Problem

Financial incentives for businesses also create the problem of . Moral hazard arises when people engage in risky activities that they otherwise would not because they share the risk with others. Put more simply, people tend to take more risk when using someone else’s money instead of their own. Politicians are willing to provide incentives to riskier ventures, such as wind turbine manufacturer Nordex in Jonesboro or Beckmann Volmer in Osceola, because they are using taxpayer money. Likewise, firms engage in riskier endeavors when they can use incentives to fund projects instead of making the investment with the company’s own money. The risk of the politician’s handout is spread among the taxpayers; it doesn’t fall on the politician or the benefiting firm. A failed project does not lead to a loss for the government or for the business, but for the taxpayer.

What Else Could Arkansans Get for Their Tax Dollars?

Politicians also largely overlook the of financial incentives. Opportunity costs are the alternatives one forgoes when using resources in a particular manner. In other words, what could a state have done with the money if it did not provide financial incentives?

One alternative use of incentive money would be to leave tax dollars in taxpayers’ hands. Individuals would keep more of the money they earn and use it in a manner that best suits their interests. For example, in 2013 alone, every taxpaying family in Arkansas would have had an extra $179 if the state had left incentive money from business tax incentives, the Quick Action Closing Fund, and Amendment 82 bonds in taxpayers’ hands.

Another alternative use of incentive money would be to work toward increasing the number of Arkansans with a college degree. University of California at Berkeley professor finds that cities with greater growth in their share of college graduates also experience greater growth in manufacturing plant productivity. This finding is important for Arkansas because according to the , only 21.4 percent of the state’s population age 25 and older has attained a bachelor’s degree or higher. Arkansas ranks eighth in this category among the nine neighboring states, which also include Alabama, Kansas, Louisiana, Mississippi, Missouri, Oklahoma, Tennessee, and Texas.

A third alternative use for incentive money would be to hire K–12 teachers. Arkansas had 8 for the 2015–16 school year, and it has 10 critical academic licensure and endorsement . The state also has 54 school districts with a critical shortage of teachers, according to the Arkansas Department of Education and the Arkansas Department of Higher Education. The state is providing corporate welfare to a handful of firms while many of Arkansas’s children are not receiving the education they deserve. Using the 2013 cost of financial incentives ($218,563,864), Arkansas could have hired 4,500 teachers for one year at the average Arkansas teacher salary () instead of providing favors to a handful of firms.

Conclusion

When governments give financial incentives such as tax breaks and subsidies to businesses, the taxpayer often becomes an unwitting victim. Companies don’t always fulfill the promises they make in exchange for the money they receive, and governments don’t always ask for that money back when companies fail to make good on their promises. When states like Arkansas use taxpayer money to fund hit-or-miss economic development projects, they are more than likely bypassing more productive uses of that money.

Earlier this month, software engineering firm Elyxor pledged to create 45 new tech jobs in North Little Rock over the next five years. Arkansas Online quoted Governor Asa Hutchinson as saying, “While we have a diversified economy in Arkansas … we will not be complete as a state and complete as an economy until we have a dynamic, sustained technology sector in this state.” As I explained in my first post in this series, Elyxor will receive an income tax credit for 1 percent of its total payroll in exchange for hiring these employees. This situation is a prime example of the government trying to steer the economy to help with economic development.

One reason why many politicians and taxpayers support such financial incentives for businesses is that they think governments can influence specific economic activities by designing and issuing incentives that address perceived needs such as job creation, project investment, or research and development. Governments are also supposedly able to influence industry composition, or the types of businesses in the state, by offering targeted business incentives.

Steering the economy doesn’t work, though, and can actually be harmful for two reasons: regional unrealism and resource allocation. Let me explain what I mean by those terms.

Specializing in Comparative Advantages Helps Regions Prosper

Regions prosper when they specialize in the industries where they have a , meaning they produce a good or service more efficiently than other regions do. For example, Arkansas has a comparative advantage in rice farming. The state’s water resources and topography allow Arkansas farmers to grow rice more efficiently than farmers in other states. This comparative advantage has led Arkansas to .

Specialization in comparative advantages often leads to industry clusters. When these clusters occur naturally, they can further boost economic productivity. The economic benefits of natural clusters, such as those for computer and software development firms in Silicon Valley, have led economic developers to attempt to create artificial clusters. Arkansas’s targeted business incentives, which are designed to attract companies that specialize in transportation logistics, information technology, life sciences, bio-based products, agriculture, and advanced materials and manufacturing systems, are one example.

Incentives, however, are not necessary to attract firms that align with a region’s natural comparative advantages. The��comparative advantage alone, whether it is the workforce, technology, or location, is reason enough for firms in��that industry to locate in the region. If Arkansas had a comparative advantage in “knowledge-based” industries, such as software development, knowledge-based firms would locate in Arkansas regardless of the incentives the state provided. We see this natural clustering without government incentives in California, where Brook Taylor, spokesman for the Governor’s Office of Business and Economic Development, said that “are being built in spite of the fact that we don’t have specific tax credits or incentives for them. Companies are just building them here because it makes sense.”

Regional Unrealism Hurts Arkansas’s Economy

Steering the Arkansas economy into industries where it does not have a comparative advantage, however, makes Arkansas worse off. points out that Arkansas would actually��“make itself poorer if it tried to specialize in ways that were inconsistent with its comparative advantage.”��Market distortions lead to regional unrealism, which is the accumulation and use of resources in areas and activities��in which they are not best used. When a state does not do what it is good at, but rather what it dreams it could��be good at, its economy does not reach its production potential and the state is poorer as a result.��To see how regional unrealism harms states, consider Arkansas’s comparative advantage in rice production. ��Imagine that Arkansas’s leaders thought that ski resorts were the key to a successful economy. By issuing enough subsidies and tax breaks, Arkansas could turn its rice fields into ski lodges. Rather than Arkansas farmers raising roughly half the nation’s rice, vacationers would be skiing down fake slopes. Would this arrangement make Arkansas wealthier?

Clearly, it would not. The state would waste massive resources and opportunities trying to support a ski industry. The land, labor, and climate of eastern Arkansas is much better suited for growing rice than it is for downhill skiing. Another region that is less efficient at producing rice might make up for the lost production in Arkansas, but since it��is less efficient, rice prices for consumers would rise. Arkansas and its residents are much better off when the state uses its resources to farm rice instead of pretending to be Colorado.

While this is a very clear example of how regional unrealism makes states worse off, it’s not always this obvious. Most times it occurs at levels that are very hard to see. Issuing tax breaks and subsidies to may not seem as absurd as trying to cultivate skiing in Arkansas, but if firms such as Nordex and Hewlett Packard Enterprises are not here because of natural economic conditions, we are making ourselves poorer.

Markets Allocate Resources Better Than Government Intervention Does

Why do people think the government should steer the economy? They may assume that the government is better than the market at allocating resources. However, Nobel Prize-winning economist pointed out that no single person or entity knows all the relevant information about the entire economy that is required to make optimal decisions. There is no omniscient wizard who knows exactly which widgets need to be made, how many need to be made, where they need to be sold, and at what price. Rather, people have specific, tacit knowledge about a business or industry, and the potential to earn a profit motivates them to react to market signals, such as prices. Governments, on the other hand, do not have the same profit incentive and are too far removed from market signals to behave in the same way. Individuals reacting to market signals lead the economy to focus on its comparative advantages better than government manipulation does.

Conclusion

The idea that governments can steer economies into sustained economic growth is a myth. History has repeatedly shown this. Government manipulation, although often well intentioned, ends up hurting more than it helps. By limiting government intervention, politicians not only allow entrepreneurs and businesses to make the best economic decisions for their firms, but they also clear the path for states to specialize in their comparative advantages. The outcome is more prosperity for individuals and states alike.

Proponents of financial incentives for business argue that tax breaks and subsidies don’t create costs to the state’s budget. Advocates reason that if Arkansas forgoes taxing a firm in some way, and that firm truly would not have located in the state without the tax break, there is no cost to the state. Arkansas does not forgo any tax revenue by issuing the tax break because taxing the firm would have led it to locate elsewhere, which means Arkansas would not receive tax revenue, anyway. If, however, the firm or its employees are not completely exempt and do pay at least some taxes, Arkansas would actually see a tax revenue increase despite the tax break—not to mention that the state would also see the other benefits associated with bringing in more business. In short, proponents say tax breaks may make the state better off.

This argument, though, hinges on the assumption that financial incentives are the deciding factor in where a firm chooses to locate. In Arkansas, officials assume that the jobs created in state-involved economic development projects would not have been created without state intervention. State leaders thus assume that these projects lead to net fiscal gains. But are these fair assumptions?

Are Tax Incentives Really the Deciding Factor in Where Firms Locate?

Anecdotal evidence suggests that incentives are frequently not the deciding factor in where firms locate. In a 2016 analysis, Brian Fanney of the revealed that some companies receiving state aid would have expanded regardless of whether they received incentives. Here are two examples:

Bad Boy Mowers of Batesville would have expanded in Arkansas even without the nearly $4 million it received from the state from 2012 through 2014, according to Scott Lancaster, general counsel for the company.

The state provided Peco Foods of Independence County with $485,000 worth of incentives, but chief operating officer Benny Bishop said, “We would have chosen Arkansas for expansion even without state incentives.”

Issuing tax breaks and subsidies to firms that are going to expand or locate in Arkansas regardless of aid means that the state forgoes tax revenue that it would have otherwise received or sacrifices other, potentially more productive uses of its tax dollars. When incentives are not the deciding factor in where a firm chooses to locate or expand, they are nothing more than a giveaway to politically favored firms—a poor use of tax dollars. What’s more, Arkansas officials take false credit for creating jobs that would have been created anyway. Peco Foods and Bad Boy Mowers are just two examples. But how many other firms have we given aid to that didn’t really need it?

Problems with Letting Businesses Buy and Sell Tax Incentives

States also create costs to their budgets when they allow firms that receive incentives to sell their incentives to other companies in the secondary market. The Arkansas Economic Development Commission allows Arkansas companies to sell certain income tax credits, such as the , the , and the . Let me explain why companies would want to sell or buy a tax incentive and how doing so costs states and taxpayers money.

Consider this hypothetical scenario:

Company A receives $100,000 from the In-House Research by Targeted Business Income Tax Credit to aid in oncology research. However, Company A fails to turn a profit because it has yet to have a breakthrough and develop a medicine to sell. Company A cannot use the $100,000 income tax credit because it does not owe any income taxes. But Company A knows it can sell the tax credit.

Company A sells the credit for $80,000 to Business B, which does owe Arkansas income taxes. When filing taxes, Business B uses the tax credit to reduce its income tax liability by $100,000. Company A is $80,000 better off because it was able to sell its useless incentive to Business B for $80,000. By buying Company A’s tax credit for $80,000, Business B lowered its tax burden by $100,000, so it is $20,000 better off.

The state of Arkansas is the big loser. By allowing Company A to sell its income tax credit to Business B, Arkansas lost $100,000 of tax revenue that it otherwise would have received. In other words, the sale of this tax credit cost the state money, making Arkansas residents worse off.

Furthermore, allowing the sale of incentives to third-party businesses means that the state is effectively subsidizing more than just the company it intended to aid. In our hypothetical scenario, Business B benefited from the state trying to aid Company A, even though the state had no intention of aiding Business B. Business B may or may not belong to the industry the incentives were designed to target. In Arkansas, the�� (AEDC) decides who can and cannot buy tax credits on the secondary market.

The best solution for Arkansas is to eliminate tax credits altogether. But if abolishing tax credits cannot be accomplished, Arkansas should, at the very least, eliminate the ability to sell tax credits. To achieve this, the state should allow these credits to expire unused if the firm remains unprofitable or, as the least desirable option, turn these transferable credits into refundable credits. Refundable credits mean that if the company cannot use the tax credits, the state will trade the credits for cash. In our hypothetical scenario, this means that Company A would still receive $100,000 even if it had no taxable profits to offset. Company B would no longer be involved in any transactions. Although it is not necessarily desirable for the state to award an unprofitable business cash, refundable credits would at least prevent the government from unintentionally subsidizing companies that it had no intention of subsidizing in the first place.

How Financial Incentives for Businesses Hurt Taxpayers

The costs of financial incentives to Arkansas’s budget also likely lead to other negative outcomes. By nature, subsidies shift public money away from public goods, which creates one of two results:

1. Without increasing tax revenue, the city, county, or state issuing the subsidy must decrease the amount of public goods in its jurisdiction. Likely outcomes include a drop in the quality or quantity of infrastructure, a less developed workforce due to reductions in education, and a decrease in the quality or quantity of public goods like roads, education, parks, and bike paths that improve quality of life.

2. The government, wishing to maintain the current level of public goods, raises taxes. Higher taxes are problematic not only for the taxpayers that must pay them but for the broader economy. shows that states with lower taxes enjoy faster economic and employment growth than high-tax states.

Targeted tax breaks have a similar effect. Tax incentives likely lead to increases in marginal tax rates for business that do not receive tax incentives. When the government provides tax incentives to certain companies, it narrows the tax base and lowers the state’s revenue. To make up for the lost revenue, all other taxpayers must pay more. Otherwise, the government must spend less on public goods.

Either scenario—reduced public goods or increased taxes—discourages firms from locating in the region. Firms become less attracted to a region as infrastructure congestion increases and the quality of both the infrastructure and the workforce diminishes. Higher taxes and costs of doing business discourage firms, too.

Conclusion

If you’ve been following this series of blog posts, you now know how tax breaks and subsidies are supposed to help local economies grow, why these financial incentives don’t help the economy like politicians say they do, and how tax breaks and subsidies for businesses affect government revenue and spending on public goods. In my next post, you’ll learn about how governments use financial incentives to try to steer the economy.

In my last post, I went over the basics of why tax incentives and subsidies are considered staples of economic development. In this post, I’ll explain why they don’t work as politicians might hope.

A common argument in favor of financial incentives is that tax breaks and subsidies motivate firms to create new jobs and invest in new projects, which sparks demand for more products and services within the local economy.

For example, if Hewlett-Packard builds a plant, then construction workers get hired, computers get bought, employees eat at local restaurants, and so on. As demand rises, more firms are attracted to the area and either establish new operations or expand existing operations, leading to further job creation, project investment, and an overall uptick in economic activity.

This uptick increases public revenue as new businesses and employees pay taxes on their earnings and purchases. With increased public revenue, governments may be able to afford to decrease marginal tax rates on businesses or individuals or increase the number or quality of public goods and services. And who doesn’t want lower taxes or better schools, roads, and parks?

While these arguments seem sound, the reality is that financial incentives often fail to spur economic activity for several reasons.

Positive and Negative Spillover Effects from Tax Breaks and Subsidies

Traditionally, incentive programs are evaluated only by the jobs, local investment, and tax revenue directly created by the firm that receives the incentive package. For example, the only reports the direct number of jobs created or retained and the direct investments made by the companies receiving subsidies.

But new and expanding firms create spillover effects that both help and hurt surrounding businesses. Some of these effects support economic growth.

-Labor pooling encourages economic growth by increasing the concentration of workers in the area with specialized skills and knowledge.

-Technology spillovers, or the exchange of technology among people and firms, increase efficiency and innovation. -Knowledge sharing, or the exchange of thoughts, concepts, and ideas among people and firms, also leads to increased innovation.

But there are also several negative spillovers. Increasing the number of firms in a location

-increases the demand for a variety of inputs, such as labor and real estate, which increases the cost of labor and rents and raises the cost of doing business.

-means that, unless infrastructure is expanded, more firms are competing to use the same level of roads, railways, utilities, and communication systems.. The resulting congestion can slow the movement of people and products, which hurts a company’s profits.

-makes tax hikes more likely. An influx of businesses and people means that demand for public goods such as roads, schools, and police will increase. Public money (taxpayer dollars) pays for these goods, which means that the government must collect more revenue. While more businesses and people mean that the tax base will expand and the government will collect more revenue even if it doesn’t raise tax rates, increasing the demand for public goods also increases the likelihood that taxes will rise to keep up with demand for public goods. (Related: Taxes Take Their Toll on Arkansas Manufacturing)

-leads to the cannibalization of existing firms. Tax breaks and subsidies provide a cost advantage to firms that receive them over firms that don’t. When a particular market is saturated (isn’t big enough for more firms), providing a cost advantage to select new firms through incentives allows them to “steal” employees and customers away from existing firms, often to the point that some existing firms must close.

Because of these spillover effects, both positive and negative, tax incentive projects should be evaluated based on their total impact on an economy—not just based on the direct effects from the incentivized firm.

When Looking at the Whole Economy, Tax Incentives for Businesses Don’t Help As Much As Politicians Think They Do

Much research on the net effects of tax incentives for businesses has found that large, new firm locations have a much smaller benefit on the local economy than advertised. In other words, the negative spillover effects outweigh the positive ones. Research by economist Kelly Edmiston examining the found that “after five years, each 100 new employees hired by a new or expanding firm results in a net gain of only 29 workers to the resident county.”

In addition, found that using tax incentives to attract large firms to an area doesn’t have any positive overall effect on the private sector, and likely doesn’t increase tax revenue, either. These findings contradict the common argument that financial incentives increase economic activity. If new firms take employees and customers from existing firms, there are no positive spillovers.

Rent-Seeking

Because incentives reduce the cost of doing business, firms that receive incentives have an artificial competitive advantage over similar firms that do not receive them. The government-granted competitive advantage gives incentivized firms a better chance of survival than those that do not receive aid. By providing advantages to select firms, the government is picking winners and losers rather than letting the market decide. Who do you think should decide whether, say, Target or Walmart is more successful in your hometown: the government or the customers who shop there?

Another problem is that when governments pick and choose who receives financial incentives, they create an environment of rent-seeking: the use of resources to gain financial advantages without creating value in the overall economy. Firms use their resources to lobby for political favors that provide competitive advantages rather than creating a better product or service. Are you, as a consumer, better off when for (that your tax dollars pay for) or spends money on better quality clothes and a more unique shopping experience? Is the economy better off when Dillard’s spends money courting governments for handouts instead of courting customers, whose purchases lead to jobs and economic growth? By issuing financial incentives, governments are encouraging firms to waste resources courting politicians instead of focusing on value-adding activities.

When politicians increase the rewards, or financial incentives, for unproductive behavior, more entrepreneurs engage in , which leads to a misallocation of talent and hurts the economy in the long run.

Seen and Unseen Effects

Policy makers need to consider both the because policies do not have a single outcome, but a series of outcomes. Only the initial outcome is immediately apparent; subsequent effects take time to develop. However, failing to consider the unanticipated outcomes of policy is dangerous. Policies that have short-run benefits often have negative long-run outcomes, and vice versa. Sound economic policy requires foresight to anticipate the future consequences of today’s decisions.

In the case of policies that provide financial incentives to select firms, the immediate, seen effect is that the firm receiving corporate welfare creates new jobs. This effect is often well documented in photo opportunities with politicians. What we don’t see are the other Arkansas jobs destroyed or the jobs that would have come to Arkansas but don’t because of the unintended consequences of financial incentives. While a handful of firms and the workers they hire may initially benefit from subsidies and tax breaks, the economy at large suffers in the long run.