Why Targeted Tax Breaks From States Don't Work

Nobody knows what the total value is of all the tax breaks given by state and location governments as incentives to attract or keep businesses within their borders. A 2012 estimate by the New York Times placed the sum somewhere above $80 billion per year. All these incentives create three problems: states over-compete against each other, local communities become hostages to large employers, and small, perhaps innovative companies are placed at a clear disadvantage.

Economists have used game theory to show that pro sports teams pay athletes more than their standard worth because signing an athlete not only means that you gain their skills for your team but also that you deprive your competitors of those same skills. This unusual feature, which I am here calling over-competition, is obviously a plus for the athletes because the total salaries paid to all athletes in a league is higher due to the relative nature of the contests (for you to win, somebody must lose).

Such behavior makes much less sense among states. Yes, if one state gets a new car plant some other state (or states) is missing out. In some cases, where an existing operation is considering relocating, the jobs really are a zero sum game, meaning if they move that one state will gain the exact number of jobs that another state loses. Governors often act like they are, in fact, competing against each other (Texas' Rick Perry is the prime example) but there is no reason for them to do so other than politics.

Economically a state may feel it will gain more from the jobs than it gives away in tax breaks (although that is often not true), but they are still requiring their existing citizens and businesses to subsidize the newcomers. There is no clear reason why Texans should want to pay extra taxes in order to take jobs away from California.

Politically, governors find announcements of new jobs irresistible, particularly in the current weak job market. Even if they give away so much that their state will actually lose by gaining the jobs, governors will usually approve the deal because of the political image they can thereby accrue.

The fact that governors are keeping score and comparing the jobs gained in each state mean that these tax breaks to attract companies are too large, just like the athletes' salaries. The difference is that instead of a rich team owner footing the bill for excessive salaries, it is ordinary taxpayers.

Making things worse, decisions to offer tax breaks in order to attract a new business are the gift that keeps on giving. Typical deals offer five or ten years of tax breaks and many politicians figure to make back any losses in the later years when the business will start paying all the taxes due. Instead, what really happens is that, when tax breaks are set to expire, the business asks for additional tax breaks with an explicit or implicit threat that otherwise they will leave for greener pastures. Because local communities have often built infrastructure (sometimes including entire schools) in order to support the new company, if the company were to leave, the community would be left in far worse shape than before attracting those new jobs in the first place. They would lose the jobs but be stuck paying the costs of their suddenly unneeded infrastructure.

Because of this economic leverage which large employers can hold over local politicians, once a tax break is given it is very hard to ever put an end to the largess. This means that local communities are essentially held hostage to their largest local businesses with current and future politicians unable to undo deals foolishly made by their predecessors.

Finally, while some tax incentives are available to all businesses on a fairly equal basis (such as common programs to offer state tax credits for each job created), many of the biggest breaks are only available to companies sophisticated and connected enough to negotiate for them. These large, established corporations can more easily play one state off against another because the more operations you already have in different states the more credible the threat is.

The ability to collect larger tax breaks gives established companies a cost advantage over smaller upstarts, making it harder for young, innovative companies to compete with their larger adversaries. Given that most jobs are created by small companies, anything that tilts the scales in favor of big companies is likely to be bad for economic growth.

Overall, government tax breaks to attract businesses are almost always a bad idea. Unfortunately, the politicians in control of the tax breaks care more about re-election than economic welfare on a large scale. All politics is local is a famous saying; in this case, it means we provide far more tax giveaways than we should.