States are swamped by subsidies — can Congress help?

All across the country, states are finding more and more problems with their economic development programs. Plenty of local leaders agree that these programs are destructive, but scaling them back is politically difficult. Congress may be able to help.

Last summer, for example, New Jersey Gov. Phil Murphy allowed the state’s economic development programs to lapse, saying, “the expiring programs are so flawed that this is actually the better alternative than continuing a broken and rigged status quo.” New Jersey Senate President Steve Sweeney agreed with the governor and referenced former Governor Thomas Kean’s characterization of economic development subsidies as “extortion payments.”

All three are right. Murphy’s January 2019 audit of New Jersey’s economic development programs found “inadequate monitoring, insufficient oversight, and non-existent policies and procedures.” That means the state is unable to fully verify whether companies actually satisfied the workforce and investment requirements to be eligible for the $3.4 billion in subsidies paid out from 2005 through 2017.

Sweeney offered a common rationale for subsidies: “Because New Jersey is so unattractive for businesses, you have to pay larger than normal incentives to get people to do business here.”

His analysis parallels Mercatus Center research. Peter Calcagno and Frank Hefner found that states with higher unemployment rates, budget deficits and higher individual income taxes are most likely to offer economic development subsidies. States with the weakest economies and worst policies seem to use corporate subsidies more. 

John Dove and Daniel Sutter looked at the question from another direction, asking whether economic development subsidies are connected with measures of economic freedom. Their findings suggest that states that offer more subsidies are less economically free, which leads to less economic growth over time. 

It’s hard to determine which came first — the economic development subsidies or the depressed economic environment. But it seems clear that the two reinforce one another. States with harmful policies and high taxes may feel compelled to make up for it with more subsidies, and states with more subsidies may have to impose higher taxes to fund them. 

Academic research finds that economic development subsidies generally don’t work and aren’t associated with improved community outcomes. A better approach is to create broad-based economic development policies that are available to every resident and business. That means reducing taxes for everyone, expanding the provision of genuine public goods, and improving regulations that unnecessarily restrict economic activity (similar to Idaho’s current regulatory reform that my colleague James Broughel has studied).

For example, my research with Anne Philpot found that Virginia, rather than offering Amazon $845 million in subsidies for HQ2, could instead have reduced corporate income taxes for all businesses by 5.6 percent.

To be sure, shifting away from a “subsidies-first” model of economic development is hard for policymakers because they’re trapped in what economists call a “prisoner’s dilemma.” Policymakers, and their constituents, see politicians in other cities and states doing it and feel like they have to follow suit to be competitive, even if it’s economically harmful. It’s an economic arms race, and subsidies are weapons of mutual self-destruction. 

But there are avenues for escape. 

Some are purely federal solutions. Congress could forbid such subsidies under the argument that they interfere with interstate commerce. Alternately, Congress could seize on an idea from former Rep. David Minge (D-Minn.) and economist Art Rolnick: Simply place a 100 percent tax on subsidies to forestall companies from pursuing them in the first place. But Congress does not lack for other issues to address and probably won’t turn to this one anytime soon.

Another is a state-centered solution offered by the Constitution: An interstate compact. So far, legislation has been proposed in at least seven states to get an anti-subsidy compact off the ground.

Interstate compacts require congressional consent if they intrude on the powers that the states have granted to the federal government. A compact seeking to address economic development subsidies would pass closely enough to the Commerce Clause that Congress could weigh in. It can offer preemptive consent, encouraging states to solve this problem on their own, and then go back to dealing with its own business.

Congress’ preemptive consent might even encourage more states to commit to the idea of an interstate compact and mutually disarm the economic development subsidy war. The best path forward is to leave corporate handouts in the past. 

Michael Farren is a research fellow with the Mercatus Center at George Mason University.