Chip Taylor

Economic development incentives and interjurisdictional competition

I thought it might be useful to talk about the relationship between economic development incentives and interjurisdictional competition before addressing criticisms of the incentives.

Economic development incentives are a manifestation of interjurisdictional competition, which is an unavoidable feature of a federal system. State and local governments rely on business investment to generate tax revenue that is used to provide public goods and services. When you have a system like ours, with multiple jurisdictions, each having a great deal of policy responsibility and autonomy, it's only natural that they choose policies with an eye toward getting a leg up on their neighbors.

Competition is beneficial to the extent that it encourages states and communities to improve the quality of their services and the efficiency with which they provide them. However, it can also encourage the emphasis of short-term gains at the expense of long-term success. But I'll leave that aside for the time being. At present I'm interested in definition, not evaluation.

There are three categories of interjurisdictional competition: active rivalry, implicit competition, and yardstick competition. Each type of competition affects state and local economic development policies.

In the context of economic development, active rivalry is the sort of competition that you read about in the news. A major manufacturer announces plans to build a new facility and then the states or communities on its short list of potential locations begin bidding against one another in an attempt to be the ultimate choice. The inducements offered by states and communities usually consist of a combination of tax and financial incentives, training assistance, and infrastructure investments.

Implicit competition occurs when states and communities adjust their policies in an attempt to provide a more attractive location for business investment than other states or communities. Sometimes the focus is on improving the quality of services or infrastructure, such as schools or roads. In these cases, the effect on business investment is often only one justification among many for whatever new spending is proposed.

Other times the focus is on improving the "business climate" by lowering the cost of doing business in a state or community. The cost reduction can be accomplished by tax or non-tax policies. Tax policies include: (1) tax expenditures specifically intended to stimulate business investment, such as employment or investment income tax credits or property tax abatements; and (2) general tax policies intended to maintain a low business tax burden, such as low corporate income tax rates or property tax exemptions for machinery and inventory. Non-tax business climate policies include business-friendly environmental and labor regulatory policies.

Yardstick competition occurs when citizens use information about policies in other jurisdictions to evaluate the policies of their own government. They compare the taxes they pay and the goods and services they receive to those of neighboring states and communities. If they find their own jurisdiction lacking, they apply pressure to elected officials, who presumably will respond out of a desire for re-election. Yardstick competition is likely to result in many of the same policies as implicit competition.

The distinction between implicit and yardstick competition is kind of subtle. It mainly relies on a difference in immediate motivations of the policymakers. Implicit competition is related to concern about the location decisions of businesses, that is, businesses "voting with their feet" (the Tiebout hypothesis). Yardstick competition, on the other hand, is concerned with citizens voting at the ballot box.

Another way to consider the distinction between the two is to recognize that implicit competition operates through the mechanism of exit and yardstick through that of voice (see Hirschman).