Friday, April 8, 2011

Problems with Decentralization: Tax Breaks to Attract Businesses

The New York Times has an excellent article discussing the zero sum games that companies frequently make states and municipalities pay to attract jobs.  Rather than being job creating, most of the time these tax incentives are little but bids for where jobs a company already plans to create will be located, with or without the tax incentives someone gets the jobs.  With the tax incentives however, businesses will end up investing in a less than optimal location due to its regulatory arbitrage, since the tax breaks are made more valuable than the inefficiency of ignoring comparative advantages.

This is an unsolvable problem with decentralization in a modern economy.  It used to be that most economies were primarily local, or were highly dependent on local resources or the particular skills of a relatively immobile labor force, that prevented businesses from playing these games.  However, in the modern economy these factors are no longer present.  Businesses can pretty much locate where they want (at the extremes of course this isn't true, but generally speaking they can) so if institutions are set up to allow for this, as they are in the US with our relative degree of decentralization allowing states and localities high levels of discretion, they get to play this game of playing states and municipalities against each other for the best deal.

This happens even on a fairly small scale.  A regional rib chain managed to get a basically tax free location for several years by deciding to announce it wanted to come to the region but was looking at several alternate locations.  Local cities fell over each other trying to see who could offer the most shameless deal to attract a restaurant.  The power of business relative to government has shifted fairly decisively in favor of business at all but the federal level. 

The more we seek to decentralize away from federal control the worse this will get.  Which isn't to say this doesn't happen at the federal level, look at defense contractors, Boeing, or claims about being able to relocate internationally, but it is far more difficult to make this threat credible at the national level than it is the local.  Same with the idea of the rich leaving.  With the lowest tax rates in the developed world they ain't going anywhere.  Few are willing to trade the amenities of the developed world for an armed compound in Nigeria, no matter how much lower the taxes are.  On the state level however, many will trade the high taxes of California or New York for the low taxes of Texas.  Never mind that Texas has to import so many of its skilled workers from the school systems that the high taxes of California and New York pay for, as long as they're big enough suckers to pay for this, Texas makes out like a bandit because plenty of workers are available from these high tax states which, once trained, would love to maximize their income in Texas.  Of course, once those states get driven to the lowest common denominator by an eroding tax base everyone loses out since they'll have to lower taxes to retain their workers, cutting the services that produced the high skilled workers in the first place.

This is what I mean by externalizing the costs and internalizing the benefits.  A business playing two municipalities against each other leads to each trying to internalize the benefits of the new jobs.  The costs are externalized since it is born by the tax payers that have to pay additional taxes to make up for the taxes that the business would have contributed.  This scales up at the state level so that Texas externalizes the costs of training its workers to states such as New York or California while internalizing the benefits of those skilled workers.  Rather than having to pay the cost of training these workers while they are unproductive children, it just gives a sufficiently large tax incentive to attract them.  This strategy however simply hurts everyone in the long run.  It works when only a few places are doing it, but once it goes on for awhile people learn and lower taxes to match.  At this point, everyone ends up worse off to prevent anyone from defecting to profit from others investment.

Kinda went off on a tangent on that.


  1. I have to say, Tz, that I never really understood the problem with decentralization before reading this blog. I grew up in a conservative household so if anything I had been a little biased in favor of it, but since reading this I have come to appreciate that many of the supposedly local decisions really aren't local in in impact at all.

  2. It seems a little like a self-solvng problem, though. As municipalities give away taxes to attract businesses, the public sector should aggregate around the federal axis.

    On the other hand, what the businesses seem actually to be doing is shifting their corporate tax burden to their employees. Texas seems to actually have the same size government in per capita spending as California (and a similar deficit.) The big difference as far as I can tell is that property taxes in Texas substitute for corporate taxes here in Cali.

    Way off topic- I wrote a novel last year which I've been too busy/lazy to send to a publisher. If you find an agent or something, let a fella know, ok?

  3. Almost as off-topic. It makes me sad that I can't recommend gcross' comment. Implicit recommendation, ok, dude?

  4. Reminds me of the system in the Byzantium, but you would have to equate landlords with business. In the end, the imperial court was not receiving any money from the landed nobility, just pittances from plebes and merchants and trades. The empire crumbled...But I keep hammering at you with this story over and over again.

  5. That is why I sort of felt that the Irish deserved the problems they got. I have no respect for an economic model that cannot at least theoretically be reproduced all over the world with a great result, instead stealing the fruits of investments made in high tax countries.

  6. G,

    There's a certain mythology in this country about decentralization, I'm not really sure what it's roots are really. Dates back to at least the anti-Federalist papers. Which is why I harp on the subject, it's said to be great with little understanding of the costs/benefits.

    While I'm often going on about the problems, I do recognize that many benefits are real. Such as the ability of less desirable states to attract people with lower taxes. This helps to even out population and business. The problem results when an otherwise fairly desirable place does this to attract even more people.

    Like most things, I believe that things should tend toward the mean. In the US however, we're already at an extreme end on this so I believe in putting pressure to shift things back towards international means. Competitive states tend to weed out bad policies over time, so divergence only last for a short period until others start imitating you. If no one is imitating you, then it's a really good hint that deviation was the wrong choice.

  7. Doug,

    Those are good points. I'm aware from reading Free Exchange that the situation with Texas is complicated, but they definitely have the low tax reputation. I think the dynamics I was point out exist, but in the complex situation of the real world it's hard to think of clear examples that don't requiring more explaining the reasons for choosing than actually drawing conclusions from.

    If I actually finish my book and find an agent I'll let you know, but I have a lot of unfinished projects so I wouldn't put money down betting I'll get there (though maybe I should as a way of motivating myself). At least you got your novel done, which is a step further than I am.

    If I get really ambitious I may have to get around to mastering wordpress or something that will give me more tools. Since I still haven't gotten around to choosing a background, finishing my definitions list, finishing my book list (since I haven't been buying a lot of new books recently, I've got a big stack to read first), or creating a blog roll that may be a while in the future yet.

  8. Cornel,

    I love Byzantium, so I never tire of references to it. Feel free to hammer away with that story. I think something similar happened in most societies though. It seems every society develops some form of elite justifying ideology that says the powerful are already contributing so much to society, and have some special qualities shown by their high position that allow them to do this, that we shouldn't tax them so they can do more of those things the powerful do to make society happy and well off. It kinda amazes me how creative societies get in finding ways to justify why their specific set of powerful people have some special quality that makes their society so special and that anyone buys these stories since every society has one and it's always different. And always transparently self-serving.