Attracting Businesses During the Great Recession

Published July 26, 2010

The latest unemployment numbers show the nation remains in the deepest economic recession since the Great Depression. Economists are predicting a “double dip” recession, meaning things may get worse before they get better.
What can elected officials do to attract businesses during the Great Recession? The key lies in building a better business climate, the panoply of public policies that affect investment, business startups, and profitability. A good business climate encourages people to start new businesses, existing businesses to grow, and national and international businesses to invest in an area. A poor business climate does the opposite.
I recently reviewed an extensive body of research on business climates for a new installment in The Heartland Institute’s Legislative Principles series, titled “Ten Principles for Improved Business Climates.” Here are the 10 most important public policy decisions policymakers can make to keep existing businesses and attract new ones.

1.    Keep total tax burden low.

Keeping the total burden low is the first principle of a good business climate. Economists estimate that for every 1 percent decrease in taxes, we would see a 0.3 percent increase in economic activity—and a similar opposite effect for higher taxes.
In 2001, Richard Vedder, a distinguished professor of economics at Ohio University, examined several-dozen measures of taxes and spending in the years 1957, 1977, and 1997. He reported, “In every single case, without exception, the results are consistent: High or rising taxes are associated with lower amounts of economic growth. The use of more sophisticated statistical models produces the same sort of result: higher taxes, lower growth.”
In 2006, economist J. Scott Moody reported the impact of taxes on population growth, personal income growth, and employment growth for all 50 states from 1994 to 2004. Low-tax states had population growth rates 172 percent greater than high-tax states (17.5 percent versus 6.4 percent), personal income growth 32 percent greater (75.6 percent versus 57.3 percent), and employment growth 78.6 percent greater (23.3 percent versus 13.0 percent).

“Taxes are an important cost to business, as important as the cost of labor and raw materials,” Tax Foundation President Scott Hodge told Budget & Tax News in 2006. “Nearly all of the best states raise sufficient revenue without imposing at least one of the three major state taxes: sales taxes, personal income taxes, and corporate income taxes.”

2.    Keep taxes on businesses low.

Second in importance only to keeping overall tax burdens low is keeping the business tax burden low. With a top federal rate of 35 percent, U.S. companies pay nearly the highest corporate tax rates of any industrialized country. State taxes add to this burden, making it even more difficult to compete with businesses in India, China, and other economic powerhouses.

Small businesses typically pay capital gains taxes, personal income taxes (more than 90 percent of businesses file taxes as individuals, and therefore pay personal income taxes rather than corporate income taxes), unemployment taxes, death taxes, sales taxes, and property taxes. It is this total tax burden that must be kept in mind, not one or two specific tax rates.

3.    Avoid corporate welfare.

The opposite of taxing corporations is giving them public welfare by selectively lowering taxes on some businesses or offering them subsidies to come to or stay in a city or state.
A 2001 review of more than 300 scholarly papers on economic development programs found “studies of specific taxes are split over whether incentives are effective, although most report negative results.”

Even if robust evidence of a positive effect of targeted incentives were to be found, it would not tell us whether the tax dollars given away would have produced better returns if left in the pockets of taxpayers. Because private firms are locating on the basis of subsidy rather than markets, inefficient enterprises are subsidized at the expense of efficient ones.
4.    Remove privileges enjoyed by labor unions.

Unions in 2009 represented just 12.3 percent of the nation’s wage and salaried workers. Nevertheless, through their power to strike and disrupt a business’s activities, unions continue to raise wages in some industries above levels that would otherwise prevail. In an age where labor and capital are highly mobile, raising wages above levels justified by workers’ productivity can damage both the business and its workers.

Union leaders more concerned with gaining immediate benefits for workers irrespective of their productivity force businesses to do one of three things: substitute machines and technology for some workers; relocate operations to places where worker compensation is in line with worker productivity; or close operations.

Many states intentionally or unintentionally extend privileges that make it easier for unions to organize, threaten to strike, or steer government contracts to union shops. Removing those privileges can improve a state’s business climate.

5.  Lower minimum wages.

Lowering the legal minimum wage is also a way to improve a business climate.
Compensation is largely determined by a worker’s productivity. A worker who produces more value to a company than he or she is being paid has an incentive to seek work at companies willing to pay more, and other companies will see the opportunity to profit by hiring that worker. This is why wages go higher than the minimum wage: Businesses compete for workers.
When governments set a minimum wage, they do nothing to increase a worker’s productivity, and they prohibit a decrease in compensation. This leaves only one option for the employer who has a worker whose productivity is below the level of compensation: termination.

High minimum wages create a climate where young people and others entering the workforce have fewer job opportunities.

6. Reduce workers compensation costs.

Workers compensation statutes ensure workers injured or disabled on the job receive fixed monetary awards. Workers compensation insurance was a compromise between workers and employers, both of whom wanted to avoid lawsuits over workplace injuries.
Over time, this deal has produced unpleasant unintended consequences. Workers compensation premiums have risen rapidly to subsidize a few industries with poor safety records. Also, workers often report injuries that may not be work-related because workers compensation benefits are better than regular health insurance benefits

Reforms that would reduce workers compensation costs include adjusting premiums according to the experience of individual firms rather than occupational or industry risk ratings; combining employee health plans and workers’ compensation medical coverage so employees could use the same provider networks and employers could pay the same negotiated fees; and creating Workers’ Compensation Accounts (WCAs) that would give workers more flexibility in how to spend the money allocated for their benefit.

7.    Keep housing affordable.

Affordable housing is an important part of a good business climate because workers consider housing costs when negotiating wages or salaries.

Proposals to increase real estate industry regulation are in the news as a result of record foreclosures, a collapsing credit market, spiraling losses for some of the nation’s largest financial institutions, and the spectacle of government agencies racing to find short-term solutions to stop the bleeding. But many of these problems stem from regulatory policies that unnecessarily raise costs, limit competition, and expose taxpayers to risk.

Restoring order to housing markets requires adopting a “no bailouts” policy. Holding lenders and borrowers accountable according to the terms of their contracts is the only way to “solve” the home mortgage crisis. Insulating people from the consequences of their decisions is what gave rise to the housing bubble.

8.    Reduce the burden of regulations.

Government regulations have a major effect on the business climate. The Americans for Tax Reform Foundation estimates the cost of regulations at all levels in the United States at more than $1.5 trillion per year. Studies of regulations at the national level in the United States have found many regulations impose costs much greater than the benefits they create.
Economist James L. Johnston, a founding member of The Heartland Institute’s board of directors, offered a theory of regulation in 1996. Johnston observes that regulation often emerges when three conditions are present: the product or service is subject to substantial shifts in supply and demand, supply reliability cannot be achieved through precautionary stocks or other market techniques, and substantial social costs are incurred when supplies are interrupted. The intended effect of regulation in such cases is to improve the stability of supply by encouraging extra investment in reliability.

Johnston’s theory explains why electric utilities and the supply of doctors, for example, are so widely regulated, and why the emergence of new financial instruments (such as mutual funds and futures and options markets) and institutions (such as Underwriters Laboratories and J.D. Powers and Associates) make regulation less necessary.

Deregulation, perhaps guided by Johnston’s theory of regulation, could improve business climates while benefiting consumers.

9. Discourage lawsuit abuse.

The legal system plays a major role in enforcing contracts and upholding the rule of law, which in turn affects the business climate. A good state tort system—the subset of laws governing questions of liability in the event of injury—compensates victims fully, in a timely fashion, and without excessive costs. A bad tort system produces unpredictable awards, requires months or years of litigation before awards are made, and consumes a significant portion of monies in lawyer fees and court costs.

Unfortunately, the U.S. tort system has become increasingly dysfunctional. Reforms that have proven to be the most beneficial in states where they have been adopted include limiting noneconomic tort damages, capping or banning punitive damages, limiting contingent fees, adopting a “loser pays” policy, and enacting stiffer sanctions on frivolous claims.

10. Attract members of the creative class.

A final component of a good business climate is adopting policies that make cities and communities attractive to scientists, engineers, entrepreneurs, and other members of what’s known as the creative class.

Members of this class are younger than the average worker and change jobs more frequently, and consequently prefer to live in cities with lots of job opportunities—”thick” job markets—to avoid having to relocate. Creative people spend more time outside the home and the office and view their cities the way tourists do, as a collection of places to visit to have fun.

Cities and states that keep these preferences in mind can avoid wasting millions of dollars on “economic development” schemes that target the wrong people or attempt to draw them to the wrong places.

Effective Policies

These 10 policies are backed by extensive research, often in the form of 50-state report cards that objectively rank states according to their policies and success or failure. Policymakers who are sincere about creating jobs and ending economic suffering can do more than just talk about how they share their constituents’ pain. These are 10 things they can do that would really make a difference.

Joseph L. Bast ([email protected]) is president of The Heartland Institute and publisher of Budget & Tax News.