Should Government Hand Out Economic Favors?

One Perspective on the MEDC

The state of Michigan’s budget deficit requires substantial reductions in spending to meet revenue shortfalls and to avoid damaging Michigan’s business climate through higher taxes. One of the state agencies coming under long overdue scrutiny is the Michigan Economic Development Corporation (MEDC). A significant number of legislators want to reduce or eliminate the MEDC, an idea that is stimulating a debate in Lansing on the larger issue of the proper role of state government in fostering economic development.

Many legislators, reporters, businesspeople and other interested parties have contacted the Mackinac Center on this issue recently, and have accessed the wealth of related material we have posted on our Web site at http://www.mackinac.org/depts/ecodevo/. One businessman in particular raised some good questions, which our Director of Fiscal Policy, Michael D. LaFaive, answered in the letter below. We have deleted references to the person to whom the letter was addressed to protect his anonymity.

May 15, 2003

Dear Sir:

Thank you for asking about the Mackinac Center’s perspective on economic development in general and on the MEDC in particular. Quite often in the media, our views get condensed and short-changed, giving rise to misconceptions on such complicated issues.

First, the Center’s concerns about the MEDC do not mean we think that Michigan is finished improving its business climate. Quite the contrary, we recognize that while progress has been made, we are still a high-tax state with significant additional barriers that must come down if we are to make the state permanently strong. When the MEDC works to accomplish such things, we applaud, though we may suggest they could be better accomplished through leadership from other state officials or departments.

Second, government picking of winners and losers or otherwise attempting to redirect or thwart market forces is a discredited concept in economic development. The best business climate is one in which government “sticks to its knitting” and does its particular assignments well, at the lowest possible cost while creating a "fair field with no favors” environment for private enterprise. This means fixing the schools, maintaining infrastructure, keeping the environment clean, cutting tax and regulatory burdens, protecting rights to contract and property, nurturing a free and peaceful labor market, and making sure the judicial system is not abused by special interests.

Starting with his first term in 1990, Gov. John Engler began moving Michigan decisively in the right direction. By 1999, when the MEDC was created, Michigan was already well on its way toward becoming one of the nation’s top economic performers. Today, the only purpose such an institution serves is to draw businesspeople into the political process to secure short-term, politically dependent favors. This takes them away from what they do best — creating wealth and prosperity through unfettered entrepreneurship — with the effect that the state’s economy is needlessly politicized.

Third, selective (or discriminatory) tax abatements are not “corporate welfare” and are always better than direct subsidies to businesses. Allowing someone or some firm to keep what is essentially theirs in the first place is not welfare, whereas direct subsidies are. Moreover, no business should ever be faulted for accepting an abatement when it’s offered, for the same reasons that you and I should take every deduction or credit on our personal income taxes that we are entitled to. But this begs the question of what makes for the best overall policy for economic development.

We earnestly wish that all those interested in sound public policy would focus more on getting government to do the right thing for everyone, and less on getting government to do the right thing for a select few. We simply must get the politicians to understand the urgency and importance of fixing the fundamentals that impact us all.

Research shows no significant correlation between what state governments spend on “economic development” and their respective states’ economic performance. Recent data from the Commonwealth Foundation in Pennsylvania show that the states that spend the most on economic development programs often rank lower in overall economic growth than states that do not.

The activities of the MEDC are rarely covered objectively in the press, with the result being that the public hears little more than what MEDC news releases espouse. They hear, for instance, that the MEDC has enticed Boar’s Head of New York with $5.1 million in incentives to open a plant in Holland, Mich. What they don’t hear about is the adverse impact this has had on existing Michigan firms like Koegel of Flint or Kowalski of Detroit — firms that receive no favors from state government and whose tax dollars now go to train a competitor’s employees. Again, we hear plenty about MEDC inducements to Cabela’s, the well-known sporting and outdoor equipment retailer, to locate a store in Michigan. What we don’t hear is how that impacts existing sporting goods stores like Jay’s in Clare or taxpaying mom-and-pop stores everywhere in our state.

The very fact that MEDC funding has become an issue of contention in the Legislature underscores an essential point: that Michigan’s business climate should not be subject to ephemeral policies that come and go with this or that administration. Rather, it should rest upon a firm foundation of sound policy that ensures a level playing field for all and resists tinkering or undermining by discriminator interventions.

Michigan is far behind where it ought to be when it comes to economic competitiveness with other states. Here are a few of the reasons why, all of which cry out for attention by state policy-makers. Action on even one or two of these fronts would do far more for the state’s economic development than all of the gimmicks and programs of the MEDC:

  • A prescription drug policy that, if not changed, could ultimately drive Pfizer and other pharmaceutical companies out of our state. Pfizer CEO Hank McKinnell recently turned down Gov. Granholm’s offer of hundreds of millions of dollars in incentives because of the strings attached. “Quite frankly,” he said, “we don’t need tax incentives.” What Pfizer needs, he said, is a change in other policies that disadvantage the company in the prescription drug market. In this, as in so many other cases, bad policies of state government that don’t get fixed wind up producing an alleged “need” for MEDC action. The answer isn’t MEDC handouts, which can be counter-productive. The answer is to fix the bad policies that cause the problems in the first place.

  • A single business tax that represents one of the most onerous burdens on business of any state. Michigan would have to impose the highest corporate income tax in the nation in order to raise the level of revenue that our SBT does.

  • A rampant abuse of eminent domain that ranks Michigan among the three or four worst states in the nation for government abuse of property rights.

  • The absence of a right-to-work law or even of basic protections for workers in how their unions spend their dues dollars. In addition to shortchanging workers, this contributes to a powerfully anti-business perception among businesspeople in other states.

  • Poor schools, high utility costs, high workers’ compensation costs, an excessively intrusive regulatory environment, etc. The Mackinac Center focuses its attention on these kinds of issues because they are what leave Michigan disadvantaged vis-à-vis other states.

The MEDC concept, from a purely economic perspective, is flawed for two major reasons. Indeed, it would be safe to say that the MEDC is fine in theory, but in the real world it is impractical.

  • First, government has nothing to give anyone except what it first takes from someone else. When you take tax dollars from a thousand businesses, and give them to one, the one firm may have more resources to hire workers and create products, but the other thousand now have that much less. Even worse, the money taken from others must be laundered through at least two expensive state bureaucracies (MEDC and the Michigan Treasury Department) by way of state salaries that remove productive investment dollars from the economy. The 231 employees at the MEDC receive millions in pay and benefits annually that would best be left in the hands of productive entrepreneurs. When the MEDC gives out tax credits, it sometimes makes it harder to cut taxes for all Michigan businesses.

  • Second, there seems to be an unexamined assumption out there that state bureaucrats know more about how to foster wealth and job creation than business owners, consumers, workers, bankers, investors and managers, whose collective decisions form our market economy.

If you can permit me a 30-second digression I’d like to dispel the myth that state employees might be able to invest taxpayer money more effectively than taxpayers themselves:

How many ways can you arrange three items? This is a simple factorial problem. The answer is six. Now, how many ways can you arrange 20 items? The answer is roughly all the seconds comprising 10 billion years. Let us extend this phenomenon one step further. A deck of playing cards has 52 cards. It is very conceivable, even likely, that no shuffling of the deck anywhere in the world has ever or will ever produce an identically shuffled deck.

Yet central planners continue to operate under the illusion that they can somehow create exotic policy schemes and marshal the information necessary to organize our economy and commercial concerns in such a way that it would improve our lives more than if we were simply left alone to shop for, or invest in, the products and firms that we as individuals prefer most.

In other words, MEDC proponents who argue about ensuring that Michigan will have jobs in city “X” or “Y” in the future through government investments, subsidies or targeted tax relief are presuming (quite falsely, we believe) that they know more about where scarce resources should be placed in Michigan than do the hundreds of thousands of Michigan bankers, investors, marketing experts, entrepreneurs, and consumers whose resources they co-opt.

For example: a bio-science laboratory in Grand Rapids is a great idea, one with which I would have no argument. But my preference would be to clear the decks of government barriers to such a project and then let the marketplace — not Lansing bureaucrats offering other people’s money — decide whether it makes good sense. Perhaps, if left in the hands of the marketplace and its entrepreneurs, several smaller-scale research laboratories would be built in Grand Rapids, or maybe in Ann Arbor, East Lansing, or Houghton. The point is that public employees at the MEDC cannot be expected to know better than the marketplace where these things ought to be located.

I would like to share with you now a few of my favorite examples from history where government directly intervened in the economic affairs of its citizens.

  • Railroads and a canal in Michigan. In 1831 19-year old Stevens T. Mason was appointed Michigan territorial governor. In 1837 Mason demanded state action for the building of railroads and canals because he saw them as the wave of the future. Mason, however, deemed private ownership of these transportation mechanisms “extortion from the public” and persuaded the Legislature to invest $5 million in start-up revenue for one canal and two railroads. It was a disaster. After seven years, the state-run canal, which was supposed to stretch from Mt. Clemens to Kalamazoo — a distance of 160 miles — had gone only 16. It cost $350,000 and was shut down and written off after earning no more than $90.32 in total revenue. The two railroads Mason tried to build suffered similar fates: After nine years, neither made it across the state, and one only halfway. They were sold off to the private sector on the condition that they be rebuilt and extended across the state within three years.

  • Flight. Did you know the Wright brothers were competing with a government-subsidized rival when they built their first-ever flying machine? The U.S. government gave $100,000 to astrophysicist Samuel Langley to help him facilitate the development of a new technology — “a heavier-than-air flying machine.” The Langley plane flopped twice (into the Potomac River). Only nine days after the second failure, the unsubsidized Wright brothers flew at Kitty Hawk. Incidentally, the Wright brothers only spent $1,000. As one congressman remarked at the time, “The only thing Langley made fly was government money.”

  • STP. You’ve heard of the Supersonic Transport Plane. The European version, known as the Concorde, was designed and built under the guise of a public-private consortium of governments and businesses. The British and French thought it was necessary that their governments and businesses join forces to compete more effectively with American industry. Estimates made by the British indicated that there was a world market for up to 500 STPs in 1970, and that by selling only 30, the plane would pay for itself. What happened? It cost 15 times what government “experts” estimated, and a full 20 years to get flying from the time it was conceived. In addition, British and French taxpayers invested 650 million pounds (in 1970 pounds, not adjusted for inflation), of which only one-third were recovered through sales. Today only 13 Concordes fly worldwide and British Airways receives less than 2 percent of its annual revenue from Concorde flights. The United States almost went down this same road, but our own STS consortium was mercifully de-funded in 1971. The Brits just announced that they’re grounding their Concord program permanently.

  • Sematech. A U.S. “consortium” of just 14 private semiconductor businesses was able to lobby the federal government for annual subsidies because it said it was a “critical industry.” They were successful and excluded roughly 100 semiconductor businesses operating in the United States from receiving the same favors. Sematech not only received subsidies, but also used its power to deny access to path-breaking technologies to competitors outside the consortium. This they did by cutting secret deals with firms on the condition that they exclude non-consortium members. After $800 million and no measurable benefits from subsidizing the program, Congress pulled the plug.

These are just four examples of government’s failure to invest scarce resources wisely. There are hundreds, perhaps thousands, of similar stories from around the globe. In addition, most academic studies have concluded that targeted business incentive programs have little impact on economic growth, or successful research and development.

Consider a fifth and very questionable investment. Here in Michigan, one of the newest programs is the Life Science Corridor Initiative (LSCI), funded primarily with tobacco settlement funds, the idea being that tobacco companies should pay because they are responsible for large health costs borne by the state for smoking-related illnesses.

There are at least 45 LSCI-type programs sponsored by units of government around the country, and many of these are funded through the $8.5 billion state tobacco settlement money. Consider just one of the grants issued through the LSCI.

GeneGo, Inc. GeneGo is a private firm that works in what is known as the “post-genome bioinformatics and systems biology” field. That is, the company maintains a database of models for human tissues and diseases to help researchers discover previously unrecognizable ways that people acquire and suffer from certain diseases and to discover even new ways to treat those diseases. GeneGo, Inc., moved to New Buffalo, Mich. (about one mile inside the state border) from its original home in Portage, Ind. According to The Detroit News, GeneGo moved to Michigan after being promised a “$200,000 state grant and the possibility of future funding” from state officials.

The initial state favor provided to GeneGo appears to have come in the form of a very low-interest loan of $210,000 made by the MEDC through a private venture capital fund, known as Sloan Enterprises, L.L.C. Sloan was the recipient of $843,000 awarded through the 2001 fiscal year LSCI grant process. The loan rate is 6 percent. According to one Michigan venture capitalist who asked to remain anonymous for fear of retribution, this loan rate is about 24 percent less than what most venture capitalists demand for taking outrageously high risks.

In other words, since MEDC officials are not risking their own money, they don’t feel compelled to charge a risk premium in exchange for loaning money to ventures with a high likelihood of failure. If venture capitalists won’t voluntarily risk their own money for a 30 percent return on investment, Michigan citizens should not have to watch their tobacco settlement dollars placed at risk for a 6 percent return.

The venture capitalists I know tell me they can go down the list of Life Science grant winners and explain to me exactly why the private sector rejected those very same candidates for investment dollars — lack of business acumen on the part of the grantee, for instance. Can we really be so sure that the state is “creating” jobs by investing in firms that private investors thought too risky to touch?

State officials might respond by saying, “Well, we are not investing taxpayer’s money, it is tobacco settlement money.” That’s correct, but it is important to remember that everything has a cost, even if it is just what economists call an “opportunity cost.” If we direct tobacco settlement money to high-risk industrial policy, we have to find other ways to fund the less glamorous needs of the state, such as road improvements and police.

Empirical Evidence

The Commonwealth Foundation study analyzed what each state in the union spent on its “economic development” programs and compared that figure to each state’s respective economic growth as measured by several factors. The study generally found no correlation between development programs and jobs or economic growth — or it found that the correlation was actually negative.

In 1996, Commonwealth ranked Michigan ninth among the 50 states in what it spent on economic development programs per capita. If such programs are clearly helpful, Michigan should rank at least ninth, or somewhere in the neighborhood, in terms of per-capita Gross State Product (GSP). Yet, it ranked a far poorer 25th. By contrast, Texas was dead last in its program spending on economic development per capita. Did it rank among the lower-achieving states in GSP terms? No — it did better than Michigan, with a ranking of 19th. More recently, in 2000, California was dead last in per-capita spending on economic development programs and eighth among the states in per capita GSP.

Hundreds of academic studies on economic development have been published in peer-reviewed journals over the last decade, on everything from tax-incentive and job-training programs to property tax abatements and enterprise zones. The conclusions of each narrowly defined study are as wide ranging as the studies themselves. On balance, they generally show negative results. But what is truly striking about these many studies is that they never ask, “instead of creating this program which shows negative or inconclusive results, what would happen if government simply removed barriers to job growth for everyone?” “What if,” I would ask, “instead of cutting taxes for three companies per month — as Michigan does with its “MEGA” program — we cut taxes for thousands of businesses across the state?”

Terry Buss of Suffolk University produced the most recent academic literature survey on economic development programs that I am aware of, in 2001. He read 300 academic papers and reported on their findings, saying:

“This article looks at the literature on state tax incentives to business as an economic development tool — tax exemptions, tax rates, specific taxes, and tax exports to other states. Initially, I ask, how have states used tax incentives in the past? How do states justify their use? Are tax incentives good politics and economics?

“In reviewing the literature, by necessity, I report general trends and conclusions supported by a few “favorites.” Indeed, there probably is no other approach that would suffice to capture findings for more than 300 articles.”

The following are two points made in his “few favorites” conclusion:

  • Myriad studies exist on individual tax incentives. Many taxes and incentives, it should be emphasized, have never been studied or widely reported. Studies of specific taxes are split over whether incentives are effective, though most report negative results.

  • Firms may need tax incentives to increase their viability in some locations, but researchers cannot definitely say which businesses or which locations.

I think one of the best summaries of these arguments was made by then-Michigan Senate Majority Leader John Engler when James Blanchard was the sitting governor. Senator Engler said:

“The proponents of this legislation [involving the Strategic Fund] argue that rather than treat everyone in the marketplace [or everyone who might wish to come into the marketplace] equitably by dealing with Michigan’s oppressive tax burdens, we should instead simply set up business to become their partner in order to help overcome the tax burdens. Well, that works fine if you are a friend of government, if you’re a friend of the current administration, if you know somebody, or if you can get to know somebody, or if you can hire the right lobbyists, or if your legislator is in the right place, or any number of keys that sort of unlock the magic door that controls these funds.”

Finally, on the issue of whether ending MEDC subsidies and selective tax treatment and related “industrial policy” would constitute “unilateral disarmament” in the incentives wars between the states, I would argue that for reasons stated above, the benefits of what the MEDC does are vastly exaggerated, while the drawbacks of what it does are vastly understated. Moreover, it would not constitute unilateral disarmament if many MEDC policies were replaced with proactive policy changes I’ve touched on here and which the Mackinac Center has long advocated. Make Michigan’s business climate the very best through low taxes, a reformed labor market, world-class schools, and a host of other commonsense policies, and you’ll do far more to make our state a premier place to start or relocate a business than all the favors that the MEDC can possibly hand out to a select few. For more on this topic, I refer you to a 1996 article by our president, Lawrence W. Reed, in Regulation magazine, entitled, “Time to End the Economic War Between the States.” It is accessible at http://www.mackinac.org/718.

While I cannot assume that I’ve won you over with my arguments, but I do hope that I at least have explained in a reasonable way the Mackinac Center’s positions. I trust that even if we still disagree, you will see the value of our perspective in honing the public debate.

Sincerely,

Michael D. LaFaive

Director of Fiscal Policy