Economic Development Deals Are a Curse, Not a Blessing

As states periodically consider renewing and increasing economic development incentives, they would do well to consider the problem of the Winner’s Curse. The Winner’s Curse is a common result of competitive auctions, where the bidder who “wins,” say, a used car, is overly optimistic about its condition and value and thus overpays for it. Congratulations, you have won the auction and must pay top dollar. 

Economic development incentives are states’ primary weapon to attract business and prevent them from locating elsewhere. To borrow an analogy, they are in a gunfight with other states. To abandon economic development incentives would be to lose the bidding war. The problem is, because of the Winner’s Curse, the winning state is poised to shoot itself in the foot.

The programs’ supporters insist that economic development incentives work. But their evidence is almost always flawed and anecdotal, with an emphasis on the jobs “created” by the businesses receiving incentives. An example in my own state is Alabama’s “winning” of a Mercedes plant in the 1990s. Given the evidence, that doesn’t look like a win to me, nor did it to The New York Times in 1996. Careful analysis shows that Alabama won the battle for Mercedes but ultimately lost by overpaying, as is usually the case with these programs. 

Proponents often cite economic impact studies in support of the incentive packages, but — and I cannot stress this enough — economic impact studies are not evidence, not even a little bit. They are predictions, often wildly optimistic, of the overall increase in economic activity based on a multiplier effect steeped in the Keynesian economic logic of circular flows. Enormous benefits are always predicted by these studies, but do they materialize? 

Based on simple division, each Mercedes job cost Alabama taxpayers roughly $170,000. If the incentives succeeded, there would be clear evidence that the benefits exceeded the costs, not for Mercedes and its suppliers, but for the taxpaying public. No such evidence exists. The evidence could be gathered, but lawmakers tend to lose interest in quantifying economic impact once taxpayers’ money has been spent. Such studies could be done with current statistical inference techniques, comparing economic growth in areas where new businesses have received economic development incentives to those where new businesses have located but did not receive the incentives. It would be irresponsible for lawmakers to renew or expand incentive programs without first gathering this information. 

Politicians often claim the incentives yield a high return on investment. The real question is whether those returns helped Alabama’s economy, or just politicians and their cronies. Existing research suggests the real benefits go to politicians, not the public. It also turns out that most firms do not choose to move because of the incentive packages. One study estimates that 75 to 98 percent of relocating firms would choose the same location with or without economic development incentives. Additional studies of incentive programs in Missouri, Florida, Michigan, and Arkansas, in addition to a thorough national study, have shown that the programs fail to generate comprehensive economic benefits. Economists have even written books about this topic, demonstrating and explaining the failures of these programs. If lawmakers are not aware of this extensive research on targeted incentives, they should be. Ignorance is no excuse for harmful policies. 

Caution is especially warranted in lower-income states like Alabama. Given the hundreds of millions spent on Alabama development incentives, and the large multiplier effects assumed in impact studies, Alabama should have experienced greater economic growth than the states with which it competes. According to Forbes, Alabama has ranked 40th out of all states in economic growth over the past 15 years. If this is winning, what does losing look like? 

Lawmakers’ support of these programs is unwarranted, and they should welcome a discussion concerning the value to taxpayers. Rather than complain about the objections from “dismal scientists,” they should weigh the overwhelming evidence in favor of economic freedom, and against the lackluster performance of development incentives.

This metaphorical gunfight is not best won; it is best avoided. “Winning” would be a curse. If states want to be attractive to businesses, they should make themselves attractive to all companies by simply lowering taxes and regulatory barriers across the board. Bribing businesses to locate in your state is not free enterprise; it’s a form of cronyism. It turns what should be a competitive process between firms into a political competition between states. The first step toward winning is to stop losing.