Congress gave unemployed workers an early present — but Santa forgot states and cities

Congress approved the fifth coronavirus relief package in the nick of time, providing over $900 billion in direct grants, extensions to unemployment insurance and support for small businesses, educational institutions, health care providers and even arts and entertainment venues. Left by the wayside was the politically contentious idea of using federal grants to rescue states and cities from deep budget deficits.

When Congress revisits this idea next session, a unique idea could help conservatives and progressives find a fruitful compromise: Provide a one-time bailout in exchange for a ban on wasteful state and local economic development subsidies that would enable future annual federal grants to be reduced.

States and cities face a $330-470 billion budget shortfall through fiscal year 2022, but they also spend an estimated $95 billion annually on economic privileges intended to sway where companies relocate or expand. Such privileges include outright grants of money or property, tax exemptions, loan guarantees, provision of project-specific infrastructure or services and regulatory favoritism.

The quest for economic growth has become an interstate arms race, driven by politicians’ desire to take credit for the jobs that companies create in their communities. But the fact of the matter is that most subsidies don’t work — that is, they aren’t material to a company’s relocation or expansion decision. And when they do change a company’s decision, they reduce national economic growth. 

Subsidies don’t generally sway corporate location decisions because other factors, like the availability of a skilled workforce and access to natural resources, supply chains and customers, are far more important for their long-run profitability. Timothy Bartik, a leader in economic development research, has estimated that the average subsidy likely only sways one-in-eight corporate location decisions. In other words, almost 90 percent of public funds spent on subsidies are effectively wasted.

Furthermore, when a subsidy does entice a company to a different locale, it has motivated a sub-optimal economic outcome — one that results in less efficient production than would otherwise occur. As the old saw goes, with enough money, you could get oranges to grow in Anchorage, but that doesn’t mean it’s a good idea. The increased waste motivated by subsidies (Alaskan greenhouses don’t come cheap) leads to fewer resources available to other companies, reducing economic growth at the national level.

Local leaders can be forgiven for arguing that job growth in distressed communities is worth some risk of reducing America’s overall economic strength. But doing so commits a classic economic fallacy: the “seen and unseen.” Understandably, they focus on the visible effect of economic development subsidies — the jobs created by the subsidized company. They ignore the “unseen effect” of the local jobs lost or never created because of the higher taxes on other businesses and households, or the reductions in government services, which are needed to balance the cost of the subsidies.

Thankfully, this race to the bottom can be avoided. Arguably the simplest (yet hardest) solution would involve state leaders unilaterally exiting the arms race by ending all state and local subsidy programs. Academic research consistently finds that doing so is arguably in every state’s economic interest. But policymakers taking this enlightened approach face a prisoner’s dilemma: Political rivals can twist it into accusations that they have abdicated their responsibility to the local economy.

This is where Congress can help. Because economic development subsidies interfere with interstate commerce, their regulation falls under the auspices of the federal government. Simply prohibiting state and local governments from offering targeted subsidies might be the easiest way forward. A blanket approach would limit the likelihood that political entrepreneurs find an exploitable loophole and restart the arms race. 

If that’s not in the cards, Congress could offer preemptive “congressional consent” to an interstate compact to end corporate giveaways that’s already making its way through the states. Fifteen states introduced such legislation in 2020, and more are lining up for 2021. Congressional consent adds the weight of federal law to a compact, which would motivate wider adoption of the idea by giving the agreement greater credibility. 

Regardless of the means, it’s in federal legislators’ interest, if for no other reason than to improve the effectiveness of any federal aid. If Congress could reduce the annual federal grants provided to state and local governments by $95 billion, the repurposed expenditures could pay for all federal food aid programs and build two new aircraft carriers, every year. 

The latest coronavirus relief bill was truly a relief to workers who faced the end of unemployment insurance the day after Christmas. If Congress is feeling really generous, it will now turn its attention to the state and local governments locked in an unhealthy political competition for economic growth. Given the fiscal hole many governments face, ensuring their limited public funds aren’t wasted should be the first priority. 

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