Back to Basics: State Tax Policy and Economic Development

Remarks to the Heritage Foundation Resource Bank
Chicago, Illinois
April 29, 2004

Panel: "Moving Toward A Market Paradigm for State Economic Development Policy"

Introduction by Sam Staley, President, The Buckeye Institute for Public Policy Solutions: "Michael LaFaive is director of Fiscal Policy for the Mackinac Center for Public Policy. Michael’s work on economic development is pretty extensive. The Mackinac Center has been aggressive about covering this subject, and Michael has spotlighted economic development efforts in an issue of the Center’s Michigan Privatization Report. Michael’s work has also been featured in an American Legislative Exchange Council publication. Michael would outline an economic development strategy based on lower taxes, tax simplification, and improving the overall business climate."

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Thank you, Sam for your kind introduction. It’s great to be here today as I have long wanted to participate as a speaker at a Resource Bank function. That I get to address one of my favorite topics — economic development — makes this panel all the more enjoyable for me.

As Don Carrington skillfully noted, we are engaged in an economic war between the states that has and continues to lead to a misallocation of scarce resources, among other problems. Sam Staley has asked that I follow Don and offer a few thoughts on alternatives to state industrial policy. My remarks, entitled "Back to Basics: State Tax Policy and Economic Development" could also be called "Toward Fair Fields and No Favors" because the alternative to industrial policy involves much less intervention on any particular person or corporations behalf.

As Don has shown, the preponderance of empirical and anecdotal evidence does not support state-level industrial policy, where politicians and their lieutenants — at every subdivision of government — use a wide range of policy tools to centrally plan our economic lives.

This does not mean that states should not compete in other policy areas. Our 50 states do indeed remain laboratories of democracy, but should not act as dispensers of special favors. It is also useful to note up front that companies who pursue these favors are acting rationally in seeking to lower the cost of doing business. But ultimately that works against them because targeted relief from taxes and other burdens makes it more difficult for politicians to lower the burdens for everyone.

The impossibility of successfully planning whole economies was highlighted year’s ago by F.A. Hayek, the Nobel Laureate the Heritage Foundation has chosen to honor this year. Hayek, as I am sure you know, is the author of "The Fatal Conceit," among others.

The idea behind the term "Fatal Conceit" is that government officials somehow have the ability to survey the whole of society, grasp it in all its nuance and detail, and reorganize it in a way that would be better than if society had simply been left to its own devices.

State governments face extraordinary knowledge constraints when they presume to pick winners and losers in the marketplace. Of course, private actors face knowledge constraints, too. The difference, of course, is that private citizens — entrepreneurs, for instance — need only concern themselves with information particular to maximizing their own self interest, which in wonderful fashion, most benefits the common good. Which brings me to the policy alternatives that I alluded to earlier.

The phrase "a fair field and no favors" refers to the type of broad-based reforms that do far more to encourage the healthy competition favored by most economists, whereby states attempt to attract businesses by improving their overall climate for enterprise and making state government itself lean, unobtrusive, and inexpensive.

That approach, which plays no favorites among interests, affirms Irving Kristol’s observation that economies "aren’t machines to be fine-tuned. They’re more like gardens to be watered and tilled."

Instead of targeting tax relief to a favored few, states should lighten the tax burdens for all. In Michigan, we have over 100,000 businesses that pay our Single Business Tax, but less than 200 have enjoyed tax relief under our so-called MEGA program, which is designed to encourage firms to expand in or relocate to, the Great Lakes State.

This strategy of systemic changes could also be applied in other ways. For instance, targeted property tax abatements should be abandoned in favor of across-the-board property tax relief. Regulatory obstacles should be lowered to reduce barriers to market entry. Instead of providing job-training subsidies, states should cut the cost of government, which would allow employers to afford their own job training.

Current telecom policy is also a prime example of government missteps in economic development. State officials correctly recognize that businesses factor in the quality — or lack of it — of telecom networks in location decisions. Presuming to know best how to manage the market, state governments have assumed varying degrees of control over broadband deployment.

The federal government, meanwhile, continues to micromanage telecom rates and service offerings. But this regulatory interference has actually inhibited the very telecom investment and innovation that businesses increasingly depend upon.

In arguing for these changes, those of us working at think tanks have a mountain of anecdotal and empirical evidence to draw from.

For instance, in 2001 Terry Buss, the former professor of public management at Suffolk University in Boston, published a literature review of more than 300 economic development studies. The studies of various tax incentive programs reported mixed results, but Buss found that most economic development programs didn’t live up to their billing.

It is worth noting that very few of them addressed opportunity cost — that is, the cost of not cutting taxes across the board.

One study warrants mention because it dovetails nicely with Don Carrington’s remarks. The Boeing incentive package was put together just eight years after Washington’s Department of Revenue did its own study on the value of three incentive programs they had been operating — sales tax deferrals, job tax credits, interest-free loans and outright grants.

The state researchers concluded:

There appears to be little correlation between the amount of tax benefit received by participants in the tax incentive programs and the growth in employment which resulted. Therefore, these tax incentives may not be a major factor in influencing the location process for business.

Evidence does show that general tax policy reform is more successful than those using targeted strategies.

For instance, in his wonderful paper, "The Futility of Tax Competition for Business" Texas A&M professor James Rogers cites scholarly research as far back as the 1950s documenting how variation in general tax policies improve economic well being more successfully than targeted efforts. Rogers underscores the work of economist Charles Tiebout who emphasized the importance of competition among states with divergent tax policies.

Tiebout argued that people may want to choose a high-tax, high-public-goods state because they prefer more highways and parks, for example. But that must be qualified in light of today’s "economic war between the states."

That’s because high-tax (and high unemployment) locales often use targeted incentives more than low-tax locales to offset the inevitable migration of people and businesses to the low-tax locales.

In Michigan, the Citizens Research Council (CRC) years ago analyzed the use of local property tax abatements and found that tax abatements are more widely offered by local governments with the highest tax burdens.

In other words, tax abatements may be considered necessary to avoid business flight. Of course, other factors are also at play. Low-tax areas may also have great schools and low crime rates that play an important role in location decisions.

Do tax abatements work? Not as much as if local officials simply would have kept taxes low in the first place. CRC has also reported that greater economic growth takes place in jurisdictions where taxes are low and which consequently grant fewer targeted abatements.

CRC also found that "50 percent of high tax jurisdictions experienced low growth, whereas only 18 percent of the low tax jurisdictions and 19 percent of the medium jurisdictions experienced low growth."

This suggests that keeping the economic playing field level and offering no special favors yields better results than the government picking winners and losers through the use of selective tax abatements.

In a similar vein Alan Peters and Peter Fisher of the University of Iowa found that cities with high unemployment tend to offer the biggest economic development incentives, but that such incentives "serve only to offset the tendency of basic taxes to be greater in high-unemployment areas."

Ohio University Professor and Buckeye Institute scholar Richard Vedder points to research (his own included) that "a state wishing to increase economic opportunities and incomes for their citizens will have a low overall tax burden, or at least will lower it gradually over time."

Vedder’s study "Taxes and Economic Growth: Should states adopt a safe haven strategy of low tax burdens to foster growth, capital formation and innovation?" analyzed the economic performance of the 25 lowest taxed states versus the 25 highest tax states over a 40-year period. Vedder found that the lower the tax burden, the higher the rate of economic growth (as measured by changes in real total income and real income per capita).

All of this being said, what should state think tank executives and others do to thwart the type of inefficient, targeted economic development strategies championed by states? I would recommend a four-pronged approach.

First, continue to produce commentaries about counterproductive state and local governments efforts to create jobs. A steady stream of hard-hitting analyses not only keeps the press interested in our view on the subject, but it also keeps officials on the defensive.

Second, raise the fairness issue. Most states don’t have just one of a particular type of business. The greatest mileage we’ve gotten from our economic development work is when we have been able to show that existing businesses are harmed when their competitors get subsidies.

Third, be a skunk at the garden parties of the statists. Timing the release of critical reports and press releases in conjunction with ribbon cutting ceremonies or press conferences called to tout the latest state "economic development" efforts generates news coverage that might otherwise be harder to get. It also raises the political costs of staging such events. And as all good economists know, raising the cost will reduce the quantity demanded. It is our hope that politicians will be less likely to indulge in such mischief as the political costs of doing so increase.

Many of you may recall that in September 1995 the Mackinac Center for Public Policy and Buckeye Institute collected the signatures of more than 100 economists in 5 Midwest states and appended them to a joint resolution calling for an end to state targeted economic development strategies. We called it "End the Economic War Between the States."

This effort generated a great deal of media attention, and it could be repeated. We must hammer home the point that politicians everywhere swear they can’t "unilaterally disarm" but none of them actually proposed a multilateral disarmament.

Fourth, I would be remiss if I did not mention the use of public interest law to change public policy. There is increased interest in litigating for liberty in the economic development arena. The Mackinac Center for Public Policy and Institute for Justice have filed an amicus brief before the Michigan Supreme Court in defense of private property owners who are being threatened with property seizure by the city of Detroit for its own economic development purposes.

There is also Ohio case, Cuno v. DaimlerChrysler, that could make the use of many targeted tax incentives illegal. The Plaintiffs hold that incentives violate the Commerce Clause of the Constitution.

I will conclude my remarks by sharing with you something my late colleague, Joe Overton, wrote about economic growth and development in 1995 because it sums up in a few sentences what I’ve taken 20 minutes to explain:

Economic growth, productive employment, and economic development are the natural consequences of private enterprise in the free market economy. Free individuals and enterprises, acting to maximize their own self-interest, generate employment, development, and improved standards of living. It doesn’t require intrusive governmental intervention or exotic policy schemes, only unexciting, mundane protection of private property and free exchange.

Thank you.