'Peer Pressure' Sets Up States For Failure as VCs

The reason so many governments allow themselves to be held up for massive subsidies to attract businesses is familiar to anyone who has ever had a teenaged child: Peer pressure. States and municipalities feel they have no choice but to open the vault for potential employers because everyone else seems to be doing the same. Rather than throw up their hands and give into crony capitalism, maybe governments need to throw in their lot with each other and ban it, or at least limit it.

In an example of government-see government-do, Wisconsin Governor Scott Walker sought to justify the state’s $3 billion proposed incentive to land a multi-billion-dollar investment by Foxxconn – probably the biggest state incentive package in U.S. history other than for aerospace – by telling The Weekly Standard: “The reality is we would never be even in the ballpark for being considered for something like this unless we offer (tax incentives.)”

In other words, Wisconsin feels it has no choice but to resort to crony capitalism because everyone else does it. But it is not unfair to ask: Do governments really know what they are doing when they open their vaults to companies? Perhaps the most obvious problem with picking winners and losers is that it is often hard for governments to recognize winners, and even harder to avoid losers. Incentives to companies that receive them become disincentives to companies that don’t but are forced to help pay for them, and compete with them for customers, capital, and employees. Assessing which businesses are likely to grow and which are likely to fail, never mind how many jobs an investment will yield or even whether it will pay for itself, is complex and demanding. Venture capital firms struggle with similar questions, applying rigorous analysis to measure, evaluate and minimize risk. Successful venture capital firms spare no effort to evaluate corporate management, potential market size, and a product’s viability – measured in tight time frames. In contrast, Wisconsin’s Legislative Audit Bureau has found that increased state tax revenue from Foxxconn job growth would not offset the state’s spending on it until at least 2042 — and then only if a goal of 13,000 jobs is actually reached and all went to Wisconsin residents.

Moreover, venture capital firms are prepared to never see a penny back from a significant number of their investments. Only 1 out of every 10 companies that a venture firm invests in will meet expectations, according to a partner at the venture firm Founders Collective. Failure rates across the industry – shutdowns or returning capital – are 40-50 percent, according to a partner at Redpoint Ventures.

Venture capital firms are able to afford that burnout rate by spreading their bets and collecting big on those that pay off. Can governments match the VC level of risk-reward analysis? Even if they could, are they able to benefit enough from the investments that pay off to cover the costs associated with those that fail to? And bear in mind that governments have far less leverage than venture capital firms: Companies seeking investments flock to VC firms, but states seeking investment flock to companies. When Wisconsin entered the bidding for the Foxxconn plant, six other states were in the competition. State governments also face less direct accountability: VC firms that make too many bad investments go under. Their partners lose their livelihood. On the other hand, by the time it becomes clear how much a state or local investment actually cost per job, the officials that approved it are usually long gone.

Governments across the United States are certainly sparing no expense in the effort to snare investments. In 2015 alone, state and local business incentives came to $45 billion, including tax credits, property tax abatements, investment tax credits, R&D tax credits and customized job training, according to the W.E. Upjohn Institute for Employment Research. That’s significantly more than all U.S. venture capital firms invest in a year. The costs to taxpayers are getting pricier; business incentives have more than tripled since 1990. How well are these governmental incentives actually working? No one seems to know. As the Pew Research Center has documented: “No state regularly and rigorously tests whether [their incentives] are working and ensures lawmakers consider this information when deciding whether to use them, how much to spend, and who should get them.” 

We have seen this movie before, or at least something comparable. In the interwar years, national governments raised tariffs against each other. In their willingness to beggar their neighbors, they ended up beggaring themselves. At the end of World War II they recognized their folly, and attempted to combat it by creating a regime of multilateral trade agreements aimed at curbing protectionist tariffs and non-tariff barriers. It has been an imperfect solution at best – bureaucratic, time-consuming, based on the faulty premise of reciprocity, and sometimes counterproductive, with a dispute-settlement mechanism that often seems to give a permission slip for higher tariffs. But as flawed as it is, the WTO agreement does make trade freer than it otherwise would be.

A similar approach is needed to curb the dirigiste auction in which governments constantly seek to outbid each other, allowing themselves to be played off against each other and against their own people and economies. Even if a multilateral agreement on government enticements could not end them all immediately, at least they could control them, and reduce the costs they impose on taxpayers, entrepreneurs who compete without subsidies, and the market economy itself.

Even if no government is willing to unilaterally disarm, costs can be significantly reduced by a wide variety of reforms, including eliminating or limiting certain types of incentives, restricting the ability of businesses to receive incentives if they have no corporate income tax liability, restricting incentives to the first few years of an investment, requiring rigorous cost-benefit analyses, and restricting the subsidy-per-job. Under EU rules, for example, a country’s incentives are regarded as export subsidies; if they exceed a certain size they are deemed illegal.

A negotiated framework to curb crony capitalism would not end it. But it would circumscribe the costs, and provide a basis for diminishing the negative impact. Governments should grasp the opportunity to cut the Gordian knot of counter-productive growth. To paraphrase Benjamin Franklin: Either they hang together, or they hang separately.