A Conversation with John Hood

President, John Locke Foundation

March 9, 1996

John Hood directs the activities of the John Locke Foundation, a Raleigh, N.C., nonprofit policy institute. The Foundation conducts research and produces publications on public policy issues relevant to state and local government within North Carolina. The Foundation's efforts are directed towards advancing "public understanding of society based on the principles of individual liberty, the voluntary exchanges of a free market economy, and limited government."


Debunking Incentives
Opportunity Costs
Free Enterprise?
Role of Government
Political Incentives

Debunking Incentives

The two most prevalent justifications for using incentives can be summed up as follows. On the one hand, one might argue that incentives really do generate economic development and are a wonderful tool. On the other, those who consider themselves pragmatists might say, "We're not really sure about economic benefits, but everybody else seems to be doing it. We'll be left out if we didn't participate."

The second argument is really a corollary of the first. If incentives don't actually have a significant impact on economic development, then one state's lack of incentives versus other states should not be a concern. So if you don't like incentives, or you don't think they're good public policy, then the fact that other states are pursuing them is not an argument for you to pursue them.

Incentives simply can't be shown to have a significant influence on general economic development. There may be political beneficiaries of incentives, which I'll discuss in a moment, but the economic beneficiaries are very unclear. Its clear that the firm receiving the money is an economic beneficiary. But beyond that, benefits are ambiguous.

Obviously, another clear beneficiary is a previously unemployed worker who lands a job at a new firm attracted to his community by incentives. On the other hand, suppose that worker was not unemployed, but he was instead employed at the local textile mill. Let's say BMW arrives and that worker says, "Hey, that automotive plant's going to be paying high wages, and I'd really like to work there." So he gets a new job using skills basically comparable to those he used at the textile mill. Now the textile mill is a loser in the labor market.

In addition, incentives, being a subsidy, allow the receiving firm to spend their revenues on other things; maybe one of those is bidding up labor costs. In this way, the very existence of the incentives supported through the taxes paid by the textile mill end up hurting the mill.

Similar forces might be at work in the land market. The BMW plant comes into the community, buys up prime land, perhaps even getting some sort of land subsidy to do so-- a not uncommon practice. Now, the textile firm was thinking about building a new facility, but there's no more land. Or, the asking price of real estate has risen through the demand generated by the new arrivals. So the textile mill loses again. Not only that, but the losers, the existing industries, are paying for their punishment: they're the ones whose taxes have gone to sustain incentives.


Opportunity Costs and Incentives

For every incentive grant there is an opportunity cost. You're basically redirecting economic decision-making away from the most efficient processes towards the most politically expedient ones. The money used, for example, to provide an under-cost sewer line or to buy up land for an industrial tenant or lower borrowing costs cannot be used for something else. The question then becomes: Is the opportunity cost greater than the economic beneficiaries' gain or indeed is the opportunity cost plus the direct costs of providing that incentive smaller than that economic beneficiaries' gain?

Based upon experience with economic decisions and markets in general, you've got to think that the opportunity costs plus the direct costs of incentives are going to be greater than the benefits. The studies that I have looked at show very clearly that economic development policies based on subsidies, particularly incentives, cannot be shown to have any significant impact on economic performance. I have dared the state or anybody else to produce a study refuting this point, but nobody ever has. The burden of proof is clearly on proponents of incentives. If you call yourself a pragmatist and nothing points to a clearly favorable outcome, you should be able to justify why you feel compelled to use incentives.
Free vs. Tethered Enterprise

The whole nature of our free enterprise system is that you do not know today what investments will lead to greater economic value 10 years from now. You might think you know. You might think that attracting the Mercedes Benz plant to North Carolina would be a great thing. What you don't know is whether the Mercedes Benz vehicles are going to sell. Now Alabama has Mercedes. If the Mercedes sport utility vehicles do not crack the market, do not sell well, that plant will not exist for long. So what would be -- what is the actual economic benefit of having a plant that might try out a new product, but then fail after 5, 6, 10 years? Yes, the wages looked higher when you first lured it in, but the plant doesn't exist any more.

Government planners are not clairvoyant. No one except a time traveler can tell me that the opportunity cost of spending incentives on a new plant are better in this moment than making other sorts of investments that might generate employment in firms that you don't perceive to be as high-waged or as high-valued but that have a prospect for surviving over 10 or 20 years. Isn't it far better to let the market guesstimate -- which is what markets do -- the best investment on the basis of past performance, on the basis of the merit of the idea. Firms should risk their own money to test ideas in the market. Mercedes should be spending its own money to test the idea that its sport utility vehicle will beat out Chevy and Toyota, not tax revenues.

Although we're talking about "trophy" firms, the same conditions apply across the board. North Carolina newspapers are replete with articles about companies that took incentives and then moved from one North Carolina town to another or from North Carolina to another state.

Even if you were able, which I doubt, to set up guarantees that the firm would not receive any benefit until certain conditions were met, incentives would still distort the market. Private decisions are made on the basis of the government's allocation of incentives.

Look at Merisel -- a California company that has received incentives to move its manufacturing site to Cary, North Carolina. Right now, Merisel is close to bankruptcy; it's very unlikely that they will relocate the plant. However, they do have some land which they are selling at a great profit in Cary. More important, I know very well that there are private actors in the market in the Raleigh/Durham area who have started making investment decisions based on Merisel's arrival. There are firms who expected to sell services to Merisell, maybe realtors who started poking around. Let's say that Merisel doesn't show up, and we never spend any of the government incentive money on Merisel. You have still used government power to bait people into making speculative expenditures that will eventually accrue to nothing.

Now in the private marketplace, people make speculative expenditures all the time that don't pan out. They hear a rumor that a firm is coming, and they try to position themselves to sell the land. This is what economic development is all about -- a lot of speculative expenditure. I am not going to weep any tears for those who lose out by speculating, but isn't it a problem if your government is baiting you into making the wrong kinds of speculation?

The Proper Role of Government

Furthermore, there are opportunity costs on the government side. Governor Hunt and the Department of Commerce spend an incredible amount of time chasing industrial relocations and defending incentives and otherwise promoting this idea. This is time and money that could be spent otherwise -- pursuing educational reform, cutting taxes, reforming regulations to reduce their cost, things like that. There is even a political opportunity cost that is not satisfied by simply creating rules that keep money from going to a firm unless they create a certain number of jobs by certain date.

You really have to start from fundamentals. What is the purpose of government? What is its role? And when you do that, you will determine that business recruitment, not just incentives, I mean more generally business recruitment activities themselves, are probably not a government function. They are not public goods in the classical sense.

What the state does in this area is interfere. They step forward and place political considerations in favor of economic ones. I have heard stories of this in North Carolina just recently where a company may be looking for a site in an urban area and then state recruiters step in to direct them towards a rural site, even though that may not be in the best interests of either the firm or the rural community in question. And of course they are doing that for political purposes. The state through its intervention is trying to spread opportunities, to redistribute income, which may or may not be the economically efficient investment. The state is disrupting the natural relationship between firms and economic developers in the private sector.

To assume that every business in the community or in the state benefits every time there is a relocation is not to understand economics very well. Let firms who believe they have an advantage or benefit to be gained from a development activity pursue their interests. Don't force those who believe they will not benefit from that activity to fund it. For example, if the Raleigh Chamber of Commerce states as its goal to generate higher wage jobs, and you as a manufacturer believe that will deplete your pool of available labor, you have the choice to stop belonging to or supporting the chamber. At least you can't be forced to fund your own competition, which is not true when the government gets involved.

There are private actors who have a huge motivation to participate in and promote economic development whether the state does it or not -- economic developers who work for banks, utility companies, insurance companies, chambers of commerce... Realtors and developers are obviously another group. Banks spend a lot of time trying to counsel potential borrowers on how to run a successful business, which is perfectly logical. These are the people whose livelihoods are made or broken out of fostering new business, whether recruiting companies from out of state or creating new companies right here.

The most productive way to think about government's role here is to think about what legitimate services can governments or should governments provide at all. If you decide that public education is a legitimate public purpose, which I think it is, then you provide it. The general road system is something else that necessitates some sort of taxed fund for obvious practical reasons. I'm still not arguing that these are economic development functions; I'm saying that these are functions the government can serve and serve well, and they may or may not involve economic development. Roads may just as well involve me being able to go see my mother which is probably not perceived of as an economic development function; nevertheless, it's a legitimate function of government to provide a road that will take me to my mother.

Political Development Incentives

Now I mentioned the political advantages and benefits of incentives earlier. Incentives are not designed to create jobs. They are designed to create job announcements. The real reason why incentives are important is that they orient economic development towards big bundles of jobs for which politicians can take credit. It's impossible for a politician to take credit for creating a handful of jobs in a hundred different firms in their area directly. It's physically impossible. You can't create a media event at each workplace. The media will stop going after about 3 or 4.

However, if you can get a thousand jobs in one chunk, you can go cut the ribbon, and you get the credit. I'm bi-partisan about this, whether its [former North Carolina Republican] Governor Martin or [current Democratic] Governor Hunt who shows up at a plant to cut a ribbon and gets a big story in the Raleigh News and Observer. Subsequent follow-ups will be on page 6B, business section, if at all. Then the governor runs a political ad that claims, "Under my term as governor, North Carolina has created so many new jobs." There's the picture of the governor in front of the plant. What isn't shown is the analysis of jobs created versus jobs lost. Incentives have the extraordinary capacity to link a politician very specifically with an economic development gain. There we have the real purpose for incentives.

When the commerce department says they are trying to create jobs, one would think that they would have numbers since they've been trying to do this for over a decade. But they don't have that information; only in the last month have they begun to make an effort to amass it. Which tells me very clearly they don't care. The horizon is the news cycle, the political cycle, both of which are short-term and emphasize the initial announcement not subsequent actual economic performance.

Economic development occurs over a much longer period than either the media or political cycle, so the temporal and ideological distance between political purpose and importance of incentives and their economic purpose and importance is crucial to understanding the debate. It's absolutely crucial.

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