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STRATEGY

The New Civil War

This feature explains who pays the price for wasteful subsidies used to attract or retain businesses.
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Politicians and bureaucracies dangle irrational, wasteful subsidies to lure companies to relocate or stay put. At what cost?

When Parviz Parhami incorporated Scientific Applications and Research Associates (SARA) in 1989 in California's Orange County, he was surprised by the mail he received from officials in Nevada. "They sent me a condolence letter," he recalls. "It listed all the reasons that I should have incorporated in Nevada instead."

SARA has grown by 50% a year over the past four years and now boasts 30 employees and about $3 million in sales. Although Parhami believes he could not have built his company as rapidly anywhere else, he admits that Nevada's appeals and similar recruitment efforts from other states have him seriously considering moving his business in the future in exchange for an attractive subsidy package.

Parhami's experience is a minor episode in what might aptly be called a new civil war, an irrational and wasteful dangling of business-recruitment subsidies by headline-hungry politicians and the local bureaucracies that serve them.

You want a major episode? Consider Intel Corp.'s recent move to Rio Rancho, N. Mex. One of the nation's fastest-growing cities -- it grew from 10,000 residents in 1980 to 33,000 in 1990 -- Rio Rancho has offered some of the most aggressive relocation-incentive schemes in U.S. history. It is perhaps one of the new civil war's biggest casualties.

Rio Rancho made headlines in 1993 when it beat out cities in California, Texas, Oregon, and Arizona to become the new home for a prized $1-billion Intel semiconductor plant. Touting the need to compete with subsidized foreign companies, Intel had presented its multiple suitors with a 104-point "ideal incentive matrix" -- actually a set of tax, utility, workforce-subsidy, and regulatory-relief demands. Rio Rancho prevailed with a winning $114-million package. But almost as soon as the deal was signed, major problems surfaced.

Intel had been promised environmental regulatory relief as well as water (from what were billed as New Mexico's vast underground aquifers) to cheaply feed its water-hungry operations. When Intel applied for permits to drill several 2,000-foot wells, New Mexico officials belatedly discovered that the regional water table had precipitously fallen, forcing Intel to cut back its planned extraction by nearly 40%. What's more, noxious fumes traced to the plant caused skin disorders among local residents and led to sharp political conflicts with the community.

Rio Rancho again made headlines when it couldn't pay for essential public services, especially for schools for the many families it had lured to the sagebrush. In 1994, when the town created a new school district, it could raise only $27 million in taxes, far less than it needed to pay for its current, let alone future, educational needs. Rueful officials publicly admitted that they could have obtained 10 times more funding had Intel's decades-long tax holiday not been on the tax rolls. The new school board went begging for funds from an unsympathetic state legislature, using as props scores of local children wearing ribbons proclaiming, "We're desperate."

Eventually Rio Rancho announced that it had found a way to at least build a high school. In September 1995, after the community agreed to float an $8-billion industrial-revenue bond on behalf of Intel -- for an amount four times the entire annual state budget in New Mexico -- the chip maker offered to pay $28.5 million toward the new construction. Yet Intel's New Mexico external-affairs director, Bill Garcia, was careful to point out that Intel wasn't responsible for schools, noting that "we think that the state has to step up to its responsibilities."

Rio Rancho is hardly alone among communities dangling aggressive, potentially foolhardy incentive packages to lure businesses. Behind the most publicized incidents, countless cities, counties, and localities regularly undercut one another with alluring "economic development" campaigns. Despite the seemingly probusiness slant of those programs, the big losers are the very businesses and industries -- particularly in emerging sectors and growth companies -- such efforts are supposed to help.

America's multibillion-dollar new civil war shuffles industry from the country's most competitive high-skill, high-value-added regions to low-skill, less productive areas. It diverts political attention and resources from far more crucial public concerns and discriminates against existing businesses in favor of a handful of politically savvy, highly visible large enterprises. Above all, it creates an illusion of growth that conceals tremendous damage to the nation's overall welfare.

Today business incentives are themselves a big business. They have spawned an industry of private relocation consultants who pit mushrooming state-development bureaucracies against one another for their corporate clients. Reputable accounting firms rank each state's development bureaucracy so that everybody knows where to get the best handouts.

Then there's politics. Deals like the $250 million in public funds that lured the cellar-dwelling Cleveland Browns National Football League franchise to economically troubled Baltimore in 1995 make little economic sense.

* * *

A Winnerless War
Politicians and voters like business subsidies. And bureaucrats who get paid to run the programs and corporations that get the money like them, too. What's wrong with that?

Plenty.

The biggest problem is that most subsidies cost more than they produce. Studies of southern incentive programs, for example, show that as much as 75% of all payments went to projects that did not produce permanent jobs or produced jobs that the recipients would have done anyway.

What's more, American development officials are spending their billions without following any objective standards. Self-evident failures are just ignored.

One of the most obvious problems is that subsidy programs rarely produce jobs in the troubled areas for which they were originally targeted. The much ballyhooed Kentucky Rural Economic Development Act (KREDA), a leading business-subsidy scheme, was supposed to create jobs in the most backward Kentucky counties. Instead it funneled more than $1.6 billion in concessions to 173 corporations, almost all of which were located in the most urbanized, well-developed regions of Kentucky. That's typical of most state programs. They are initially justified to assist the particularly disadvantaged, but the money ends up in the pockets of those who don't need it.

Then there's the rising price tag. As the private relocation industry becomes more skilled at shaking down public-development officials, the cost per job has skyrocketed. In 1980 Tennessee paid $11,000 for each job in a new Nissan plant. At mid-decade, the price in an Indiana auto plant deal was $50,000 per job. Today the going rate ranges from $65,000 per job (BMW in South Carolina) to $200,000 per job (Mercedes in Alabama), comparable with the cost of generating employment through notoriously wasteful public-works programs.

The subsidy war is also a lose-lose proposition because it inevitably generates what Federal Reserve Bank of Minnesota senior officials Melvin Burstein and Arthur Rolnick describe as a surfeit of private goods. It induces states -- or communities like Rio Rancho -- to misallocate their total resources, neglecting the proper mix of public goods (which might include education, roads, and communication) in favor of wooing the private sector.

Further, subsidy battles are inherently stacked in favor of larger companies, which are able to mount continuous lobbying campaigns. Subsidies rarely help more creative, high-growth companies. Collectively, small to midsize companies produce many more high-quality jobs -- at lower costs -- than a typical giant company plant does. Politicians and bureaucrats, however, prefer to deal with larger, one-stop entities -- particularly those that can bring effective public-relations and lobbying machinery to the table.

That's why the huge majority and largest volume of business-development payments go to multinational firms that may actually be scaling back their total U.S. employment. Even worse, the growing tendency of bigger companies to hopscotch from one state-subsidy scheme to another severely disrupts business activity and confidence throughout the country.

The new civil war supercharges this disruption of the American economy. It fragments once-vital industrial regions into geographically disparate, isolated pieces.

Finally, the subsidy war diverts political and business attention from far more important government and economic concerns. Tired of dealing with crime, education, and inner-city social issues, politicians lustfully chase after sports franchises or take meetings with big-time companies looking for handouts. And instead of confronting Japanese competition or building technical skills for the future, many companies become obsessed with wringing the best possible tax or real estate deal from obliging bureaucrats.

* * *

The Would-Be Peacemakers
Given the stakes, America's incentive business has received surprisingly little scrutiny. But a handful of public-minded citizens have challenged whether the subsidy wars that state and local officials are waging make sense. Take, for example, the one-man crusade a small-town lawyer, Bill Maready, launched in North Carolina.

Maready was incensed by deals like a $1-million grant to PepsiCo Inc. to create 1,000 jobs that actually produced just 400 and the publicly funded construction of a $500,000 parking garage for mammoth R. J. Reynolds Tobacco Co. Calling such giveaways "corporate extortion," he filed suit, alleging that public subsidies to private companies violate the North Carolina constitution. To the horror of North Carolina's prosubsidy governor, Jim Hunt, last August a Winston-Salem judge agreed. Pending appeal, the suit threw the state's massive development bureaucracy into a panic.

But a truce in the new civil war will require more than well-intentioned efforts. At present, three serious proposals have been put forth to reign in a process that is out of control:

1. The most comprehensive proposal comes from Burstein and Rolnick. Deeply troubled in 1992 when Minnesota massively subsidized a professional basketball team and then paid incentives worth nearly $670 million to an airline that has yet to create the jobs it promised, Burstein and Rolnick last year cowrote an influential report calling for a federal ban on state business incentives.

When states compete to build libraries or schools, Burstein and Rolnick argue, the nation as a whole benefits because states are investing in public-sector goods that complement private development. When money that would otherwise be used for those investments is paid to individual firms, however, everyone loses -- including the region whose job and tax bases are depleted by the relocation and the firm's new home, which can't pay for needed public amenities.

The result is a classic "collective action" problem: all states together are hurt by business subsidies, but individually none is willing to disarm until everyone else does. The only way to break the subsidy addiction is to pass a national law outlawing subsidies altogether.

Opposition from governors and development bureaucracies to Burstein and Rolnick's proposal was predictable, but the proposal writers also took flack from an unlikely source -- archconservative congressional representatives who might have been expected to embrace cutbacks in inefficient government intervention. Many hail from states that vigorously pursue subsidies. Rather than offend interests back home, they recoil from pushing Washington to dictate proper conduct for state officials. Congress seems unlikely to end the new civil war.

2. Groups like the National Governors' Association take a different tack. Recognizing the antifederal mood in Congress, their notion is that if subsidies are inevitable, they should at least be made more effective. They advise that economic officials insist on measurable development goals before they make payments, that all funds be subject to recovery or "clawback" by the state if goals are not reached, and that performance standards for establishing program targets become much more precise.

Those initiatives still fail to solve some critical problems. For one, the usefulness of clawback provisions is highly suspect. Once a company opens up shop in a state, it's a bold public official indeed who is going to seek repayment for nonperformance and put the company's existing jobs (and the livelihoods of voters) at stake.

3. That leaves the courageous stand advocated by Ohio state senator Charles Horn: unilateral disarmament. "We're building programs that encourage easy solutions, not competition based on training, skill, or technology," he argues, "and for every winner, there's a loser. We're not financing schools, workforce development, and real wealth creation."

The answer, Horn suggests, is for Ohio and other enlightened states to just say no to subsidies, investing instead in research and development, and in knowledge-intensive industries. When others see how productive those efforts can be, they'll gradually wean themselves from the subsidy game and compete in more useful areas.

To pursue his vision, Horn is trying to set up a regional forum that will assess the record of business-development programs, providing objective data to convince state officials that they need to change. Last September he coordinated a statement from 100 economists in eight midwestern states, denouncing subsidies and calling for the immediate cessation of recruitment activity. Unfortunately Horn's objective is shared by few, if any, other American leaders.

* * *

The Casualties Fight Back
America's small to midsize growth firms, like SARA, have the most to lose from the new civil war. Small companies can sometimes secure a few subsidy crumbs left over by politically connected giant companies. Those crumbs hardly compensate, however, for the regional dislocation, added tax burdens, and political misdirection fostered by state business-incentive programs.

Start-ups and growing firms depend far more than larger companies do on the very public goods -- education, training, communication, and transportation -- that are put at risk by development giveaways. They require precisely the regional concentration of skills and business talent that the relocation game puts in jeopardy. Most small companies would benefit from access to cheaper capital, but billions of dollars are being locked up by state bureaucracies and their few lucky clients.

Entrepreneurial companies are far better off operating on level regional playing fields -- where resources are free to flow to productive investments -- than they are helping feed a national race to the lowest common economic denominator. Smaller companies have an interest, if not the highest stakes, in pressing for the national reforms that current business and political leaders can't, or won't, fight for.

If North Carolina is the model for change or if Rio Rancho is the shape of things to come, there is little hope that states can successfully rationalize their subsidy programs. The only effective solution is to impose uniform federal standards (yes, regulations) that all must observe. The alternative is far more unpalatable: wasting billions of dollars churning America's least promising assets while global competition intensifies around us. The new civil war is deceptively silent, but it could prove deadly to many of America's small businesses.

* * *

David Friedman is a Los AngelesÑbased urban economist and a research fellow at the MIT Japan Program.


FLINT, MICH., VERSUS OMUTA, JAPAN

How Two Cities Tackle Similar Challenges

When Omuta, Japan -- home of the mammoth Miike coal mine, in Kyushu -- and Flint, Mich., fell on hard times in the late 1970s, both cities hatched tourism-promotion schemes to rebuild their economies.

Led by the nonprofit Mott Foundation -- funded by GM scion Charles Stewart Mott -- local leaders in Flint decided to create jobs by building an amusement park called AutoWorld that would celebrate the city's unique industrial legacy. Omuta came up with GeoBio World, a theme park glorifying the hamlet's maritime and mining history.

But there the similarities end. Unable to resist political pressure to "do something" for Flint, an army of consultants, Housing and Urban Development and Michigan development officials, and private bond financiers pumped nearly $70 million into AutoWorld. The quixotic project closed less than one year after its gala opening in 1984 and today sits shuttered near downtown Flint.

In Omuta, local officials were able to secure commitments from a similar range of national, prefectural, and private-sector interests, but potential investors participated on the condition that the Japan Development Bank (JDB), a quasi-governmental entity with a history of savvy business judgment, make an independent appraisal. Lacking any direct stake in GeoBio World, the JDB nixed the project, almost certainly sparing Omuta an AutoWorld-like disaster.

The contrast between Omuta and Flint highlights the need for uniform, national legislation to end America's new civil war. Lacking independent legal standards or bureaucratic oversight, which the JDB provided in Japan, American proponents of incentive programs -- like AutoWorld advocates in Flint -- all too often steamroll public and private entities into spending money without adequate safeguards.


RESOURCES

The most influential report on the new civil war is by Melvin L. Burstein and Arthur J. Rolnick, "Congress Should End the Economic War Among the States," in Federal Reserve Bank of Minneapolis 1994 Annual Report, March 1995. (Call 612-340-2341 for information.)

For a policy statement seeking to end state business subsidies -- endorsed by more than 100 economists -- see "Joint Resolution on State Economic Development Policy," September 1995, released by the Buckeye Institute for Public Policy Solutions. (Call 513-224-8352 for information.)

Last updated: May 15, 1996




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