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Is competition to attract businesses harmful?

State and local governments often use incentives such as tax cuts, rebates, promises of government services and the easing of regulatory restrictions to induce new or existing businesses to locate in their region.

But this strategy raises some important questions:

  • Do these policies work, or do they cost more than they gain?
  • Do the policies simply redistribute economic activity from one region to another, what economists call a "zero-sum game," or do they create a positive aggregate effect from easing tax burdens and other restrictions?
  • Finally, if it is a zero-sum game, would the U.S. benefit from banning this sort of competition for businesses at the state and local level because it lowers the tax revenue needed to fund critical services and erodes regulatory protections?

These questions are addressed in a recent San Francisco Fed Economic Letter by Daniel Wilson. First, he noted that the research indicates that these policies are effective in altering business location decisions. As a recent example, he cites the decision by electric-car maker Telsa (TSLA) to locate in Nevada its factory for producing the batteries needed to power its cars. But that's just one example among many, many others of such behavior.

Second, Wilson argued that determining whether the benefits exceed the costs for state and local governments that engage in this type of competition is very difficult. The problem is that the costs and benefits are not easy to measure, and the research is inconclusive on this point.

Third, research on this topic reveals that it does appear to be a zero-sum game. That is, the incentives that are offered to businesses are successful in shifting where firms locate, but there is no net, aggregate effect. To say it another way, the size of the economic pie does not change, but the size of the pieces each region gets changes as these incentives are offered.

Last, if this competition has no positive effects but simply redistributes where business is conducted, and if the tax and regulatory competition reduces the ability to fund critical services and undermines regulatory protections, it seems states and local economies would be better off if they were shielded from this competition by a federal law banning it. While that may appear logical, Wilson explains there's something else to consider:

"an opposing view comes from a classic public finance theory known as the Tiebout model (Tiebout 1956), which posits that people and businesses 'vote with their feet' by moving to jurisdictions with the mix of taxes, spending, and regulation that best matches their preferences. This residential mobility provides a competitive pressure on local governments to be as efficient as possible in order to charge the lowest possible tax rate to finance public services. ... Forcing all jurisdictions to have the same tax policies would shut off this ..."

Thus, a ban on this sort of competition -- which would effectively harmonize taxes and regulation across state and local governments -- would have the benefit of preventing competition for businesses that forces state and local governments into a downward spiral of reducing taxes and regulation just to keep the business they have.

But it would also reduce competitive pressures to provide the best mix of taxes and services for state and local jurisdictions. In Wilson's words: "Optimal policy from a national standpoint ... must weigh the benefits of local choice -- individuals and businesses selecting jurisdictions that match their preferences -- against the cost of how changes in one area might negatively affect competing jurisdictions."

Proponents of lower taxes and reduced regulation generally favor this type of competition, while those who worry about the social services government is able to provide and want to maintain regulations that enhance their quality of life are generally opposed.

When governments propose these types of incentive policies, the battle between these groups can be fierce, but the bottom line is that there are no easy answers about the consequences of allowing state and local governments to compete with each other to attract businesses or residents.

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