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.