Analysis: Targeted Tax Incentives Unnecessary, Ineffective

Published July 1, 2006

For more than a decade, the Michigan Economic Growth Authority (MEGA) has been doling out significant tax incentives to businesses that promise to create new jobs or retain existing ones. Yet the Great Lakes State has routinely turned up at the bottom of state economic rankings. Many of the corporations state development officers have declared to be winners of tax incentives have turned out to be losers in the marketplace.

Kmart Corporation, for example, twice was offered millions of dollars in tax savings from MEGA, but that did not prevent the company from going bankrupt less than 16 months after Michigan’s job czars had declared it a winner for the second time. The company has since moved its corporate headquarters out of Michigan.

Kmart is just one example of failed economic development incentives noted by many scholars across the country. Nonetheless, as the 2006 campaign season begins, voters can be sure that a great many politicians will be crowing about the job-creating prowess of their administrations or pet economic development programs.

Programs Don’t Work

Every state runs some type of development program, and about 45 specifically employ “targeted tax relief” for corporations. The preponderance of evidence indicates such programs do not work as advertised.

The modern economic war between the states for jobs began in the 1930s, when Mississippi developed programs that were supposed to create net new jobs by luring employers south. Since then there has been a nationwide profusion of state-based programs designed to “create” or “retain” jobs within the various states’ geographical borders.

According to two separate measurements–one by Prof. Kenneth Thomas of the University of Missouri-St. Louis and another by Profs. Peter Fisher and Alan Peters of the University of Iowa–state and local units of government annually offer more than $48 billion in economic development incentives (such as tax credits, abatements, and subsidies) through scores of programs.

Most Report Negative Results

Scholarly interest in these programs has grown with the programs themselves. In 2001 Terry Buss, then a professor of public management at Suffolk University in Boston, published his analysis of more than 300 peer-reviewed papers on state development programs. He found, “studies of specific taxes are split over whether incentives are effective although most report negative results.”

In 2004, economists Fisher and Peters conducted a “metareview” of academic literature. A metareview is a review of findings from other scholars who have themselves done large-scale literature reviews, such as the one conducted by Buss.

Like Buss, the duo found mixed results but questioned the worth of many incentives, saying, “[T]he most fundamental problem is that many public officials appear to believe that they can influence the course of their state economies through incentives and subsidies to a degree far beyond anything supported by even the most optimistic evidence.”

Michigan Incentives Costly, Futile

Michigan’s MEGA, a targeted tax incentive program, has been in operation for 11 years. It is designed to grant business tax credits for up to 20 years to corporations that agree to create or retain a certain number of jobs, among other requirements. Along with tax credits, the state often arranges for the firms to receive other benefits, such as job training subsidies or property tax abatements. In the first 10 years of the program, MEGA offered more than $3 billion in incentives to just over 200 firms in fewer than 230 deals.

In April 2005, Prof. Michael Hicks and I published an exhaustive review of the program. The report included a time series econometric analysis designed to measure the MEGA program’s impact on state employment, the unemployment rate, and changes in per-capita personal income.

In short, there was no real impact in any of these categories. We found that for every $123,000 in tax incentives offered, one construction job was created, but all jobs disappeared within two years.

No county in the state without companies receiving MEGA awards fared worse in economic development measures– including per-capita personal income, employment growth, and unemployment rate–than those that hosted MEGA firms. In addition, of the 127 MEGA deals that should have produced all their promised jobs at the job site in question by the end of 2004, we could find only 56 that had claimed credit for creating jobs, and only 10 did so in the expected time frame.

Programs Typically Fall Short

Research suggests a number of fundamental reasons why these development programs often fall short.

One is opportunity cost. There truly are no free lunches. In order for government to give something to someone it must first take it from someone else. This is easily apparent with direct subsidies, but there are also opportunity costs to targeted tax relief. This is because handing out hundreds of small tax cuts can make it more difficult to cut overall business tax rates.

A second is administrative burdens. The bureaucrats who run state development programs don’t work for free, and the tax dollars taken from job providers and others represent a job-killing cost of running a job-“creating” program.

A third problem is government’s fatal conceit. Bureaucrats just aren’t smart enough to outthink the marketplace. The idea that government officials can somehow survey the economic landscape, comprehend it in all its detail, and then improve it in a way that would leave everyone better off is the “fatal conceit” of central planners.

No better example of this in action can be found than in Michigan’s treatment of Kmart, which had been based in Troy. MEGA officials declared Kmart a “winner” twice by offering $30 million in tax credits to expand in the state. Less than 16 months after the second deal, the company declared bankruptcy and later moved its headquarters out of state. Kmart collected $6 million in tax relief for jobs that no longer exist. And Kmart is not the only MEGA business to declare bankruptcy after bureaucrats had declared it a job-creating dynamo.

The fourth problem is rent-seeking. The pursuit of special favors from government imposes real job-killing costs on economies. Harold Blumm, writing in the Cato Journal, has shown empirically that rent-seeking has “a relatively large negative effect on the rate of state economic growth.” In other words, economic growth is better without programs that encourage rent-seeking.

Government Relations a Cash Cow

One example of rent-seeking in the economic development arena was noted by the John Locke Foundation in North Carolina. The organization obtained a 2004 PowerPoint presentation by Ernst & Young consultants titled, “Turn Your State Government Relations Department from a Money Pit into a Cash Cow.” The presentation detailed how private-sector businesses could effectively obtain and retain tax incentives from government.

If a government really wants to improve economic growth and development, there are two proven ways of doing so. First, sweep away the many unnecessary hurdles to entrepreneurship and employment that currently exist, such as high taxes and unnecessary regulation. Second, concentrate on improving the few things government should do, such as policing streets.

With these things in place, markets will create jobs without any vast and expensive state apparatus designed to “assist” them.

Michael D. LaFaive ([email protected]) is director of the Morey Fiscal Policy Initiative at the Mackinac Center for Public Policy and co-author of the economic development study “MEGA: A Retrospective Assessment.”

For more information …

Kenneth P. Thomas, “Competing for Capital: Europe and North America in a Global Era” (Washington,DC: Georgetown University Press, 2000).

Alan Peters and Peter Fisher, “The Failures of Economic Development Incentives,” Journal of American Planning Association 70:1 (2004), 28.

“The Effects of State Tax Incentives on Economic Growth and Firm Location Decisions: An Overview of the Literature,” Economic Development Quarterly 15:1 (2001), 99.

“Rent Seeking and Economic Growth: Evidence from the States,”

“MEGA: A Retrospective Assessment,”