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Location Incentives Are Effective: False Deductions from the Dog that Didn’t Bark

A New York Times article on tax competition styles it this way, “Tax incentives to lure companies tend to help politicians, but they don’t really make economic sense.” Au contraire. That governments offer tax incentives makes perfect economic sense – pathological sense, but sense nonetheless – and politicians can’t help but offer them whether they help their careers or not.

Government tax-incentive programs reflect the Tantalus-like sense of the prisoners’ dilemma: tangible rewards for offering incentives are right there, within easy grasp. Those benefits evaporate only when one reaches for them, which one must, or else someone else will. In game-theoretic jargon, the possibility of deriving net tax revenues from incentive programs certainly exists, but never in equilibrium. It’s a tragic incentive structure, but a well-known one.

The intellectual puzzle of tax incentive programs derives from three empirical observations: First, firms pretty much end up locating in the same places with location incentives as they would if no government offered any incentives. Secondly, net tax revenue from incentive programs drive net revenue benefits toward zero for the “winning” government. Third, despite the first and second empirical observations, politicians continue to offer the programs.

The puzzle exists because we observe equilibrium behavior and do not observe out-of-equilibrium behavior. That’s what generates the NYT’s headline claim that incentive programs “don’t really make economic sense.” They make perfect sense, though, once we understand how out-of-equilibrium outcomes – outcomes we observe with zero probability – serve to enforce the equilibrium outcomes we do observe.

As with the dog that didn’t bark, we need to deduce implications of what we don’t observe. To do so, first consider this counterfactual: What if no local government offered firms (specifically, mobile capital) tax incentives to locate within its jurisdiction. Firms would naturally locate facilities where they enjoy least-cost production; local governments would realize tax revenues and development gains generated by the firms’ location choices.

It’s obvious, though, that having all governments refuse to offer location incentives cannot be equilibrium behavior: If all governments refused to offer any incentives whatsoever, then one government deviating from that universal refusal could offer a location incentive, an incentive that would both alter the firm’s location decision and leave the deviating government better off.

Say there’s a neighboring city to the city where a firm initially plans to locate. The neighboring city is not quite as good for the locating firm as the original city. Still, it’s pretty close. If the neighboring city only threw in a few incentives, it would make it profitable for the firm to locate within its jurisdiction rather than in the city it initially considered for its location.

In our counterfactual world in which no city initially offers location incentives, the neighboring city’s deviation is unique. Because the other city has no competing incentive program, the neighboring city can offer modest incentives, attract the firm away from its original location, and still realize net tax revenues.

The original city will obviously respond. Before getting to that, however, we need first stop to consider what we just saw. In a world with no incentive programs, a city could gain by offering even modest location incentives. The program would affect the location decision of the firm, and the city would realize next tax revenues from the program.

Therefore we know that counterfactual in which no city offers an incentive program cannot be an equilibrium. It is not an equilibrium because incentive programs can be extremely effective in influencing location decisions.

The story is unfinished, however. The original city will not sit idly by as the neighboring city lures the firm away. Given the firm would realize least-cost production in the original city (tax inducements aside), the original city need only match the neighboring city’s incentive to induce the firm to stick to its original location plans.

The original city responding with its own incentive program also does not end the story. The cities offer the firm ever more-lucrative location incentives. We now have “competition” between the local taxing jurisdictions. The equilibrium is this: The neighboring city offers incentives just equal to whatever benefit it would receive from the firm locating in its jurisdiction, the original city matches the neighboring city’s incentive offer, and the firm locates in the city it originally would have located in.

Note the empirical observations associated with the equilibrium. The firm locates in the same city it would have located within had neither government offered an incentive program, the net tax revenues of the “winning” city are driven toward zero, yet politicians in both cities can’t help but offer incentives to the firm because incentives could extremely alter the firm’s location decision.

To be sure, if there were only two competing jurisdictions, they could perhaps gin up some sort of oligopolistic collusion to maximize joint tax revenues. But the possibility of collusion becomes increasingly difficult with larger numbers of competing jurisdictions. Simply consider the difficulty OPEC has colluding on oil prices among themselves with just twelve members.

The welfare implications of competition between governments are not as clear as those flowing from market competition (in which price competition induces firms to dissipate economic profit in a fashion analogous to tax competition driving down tax revenues). Indeed, solving particularly pathological competitive dynamics among the U.S. states served as a, if not the, major stimulus for adopting the U.S. Constitution. Still, whatever the welfare implications of tax competition, tax competition between cities, states and nations make perfect, if perfectly pathological, economic sense.

Reader Discussion

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on June 12, 2018 at 07:40:34 am

Two jurisdictions competing to have the lowest cost (taxes) with the highest quality of services. I wouldn't call that pathological, that seems like a good idea. In fact it is hard to design a better system .

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Devin Watkins
on June 12, 2018 at 12:39:48 pm

Two jurisdictions competing to have the lowest cost (taxes) with the highest quality of services. I wouldn’t call that pathological, that seems like a good idea. In fact it is hard to design a better system.

Agreed, as far as that goes—but you have underspecified the criteria for this optimal system. An optimal system would have the best mix of services as taxes for whom?

Sure, jurisdictions seek to create some optimal mix of services and tax levels required to pay for the services. But to lure the new firm (or to retain the old one that is threatening to leave), the jurisdiction is tempted to offer lower taxes for that firm only.

This practice has various pernicious effects. First, any existing competitor to the favored firm is now placed at a competitive disadvantage, which distorts the market. Second, in the long run this dynamic results in higher taxes for all OTHER firms/households than would otherwise be the case to compensate for the incentives offered to the favored firm. Third, because jurisdictions typically offer incentives in a secretly-negotiated manner, this practice creates opportunities for government corruption: government officials offering sweetheart deals to their businessman friends in exchange for campaign contributions or promises of future employment, etc. Fourth, even if the system could be conducted with compete transparency, it undermines public faith in the fairness of the taxing system because it results in different tax rates applied to otherwise comparable firms.

Nice job, Rogers, in noting the game theory involved.

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nobody.really
on June 12, 2018 at 15:21:29 pm

Interesting; how does this apply to tax incentive/abatement of residential property; this has been, or is becoming a common practice within urban cities, for attracting residents out of the suburbs and back into the city, especially in filling-out occupancy in newly constructed "downtown" high-rise residential condo units.

In this situation, the abatement is offered to all residents of new construction condos, across the board, and, excludes pre-existing residences, on an average, over a period of ten years. In this instance, the competition is market based, derived by locational/price/amenity variances among condo project buildings.

Here is where I would anticipate occurs greatest, what Nobody asserts, as an "undermining public faith in the fairness of the taxing system", whereas, owners of pre-existing residences may benefit generally in the term, from increasing market values, they will also often experience short term stagnation, even reduction of market prices, due to increased competition with high surpluses of new residences, this while not reaping any of the short-term benefit of corresponding property tax relief. The end result (a major complaint of so-called, "gentrification" is that certain segments (usually the less affluent and/or elderly) of home owners are priced or taxed out of their homes. Renters, often lacking personal means of transportation, are driven deeper into more dense and/or sub-standard housing. or further outside the perimeters of the city's downtown.

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Paul Binotto
on June 12, 2018 at 15:25:41 pm

Meant to write: "owners of pre-existing residences may benefit generally in the LONG term,"

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Paul Binotto
on June 12, 2018 at 17:59:23 pm

nobody:

Agreed AND let me add to your list of possible corrupt practices:

"...because jurisdictions typically offer incentives in a secretly-negotiated manner, this practice creates opportunities for government corruption: government officials offering sweetheart deals to their businessman friends in exchange for campaign contributions or promises of future employment, etc. [and / or by offering to the family members of the politico rather attractive investment opportunities, or in the case of nations seeking commercial advantage ./ footholds, providing "exclusive patent rights for a number of designs (dresses,etc). Gee, who knew that Chelsea Clinton was a gifted dress designer. We all know that she was an expert political commentator BUT also a designer. wow, man, "that Old clinton Magic.!!]

Ha!

But I agree. These tax incentive deals are corrosive of public trust, unfairly penalize existing firms and quite often DO NOT recoup the loss of tax revenue gifted to the "threatening" firm.
Nope, a better way is to simply have lower tax rates all around - which is what I suspect that Devin Watkins was really asserting in the opening post.

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gabe
on June 12, 2018 at 18:31:42 pm

1. Nice analogy! I haven't had the same aversion to such residential subsidies, but perhaps I should.

2. Welfare economics addresses how to create a standard for evaluating the merits of a policy. And from a policy perspective, generally we try to avoid “bugger thy neighbor” policies—that is, policies that appears beneficial merely because they shifts the location/timing of benefits and burdens such that we end up counting the benefits and ignoring the burdens. To take some archetypical examples, business incubators (designed to CREATE new businesses) generate benefits, while tax abatement programs (designed to lure a business from elsewhere) incur social costs to merely shift benefits around.

That said, there are always exceptional circumstances; the devil (and angel) is in the details.

Real estate reflects a typical potential for finding socially beneficial policies because of the weaknesses of property rights. In short, I have no property interest in my neighbor’s property, yet the value of my property depends to a large degree on what my neighbors do with their property.

So, if government subsidizes the construction of new houses around mine, the supply of other houses may make it harder for me to find a buyer for my house. But is might have the opposite effect. After all, my house, surrounded by acres of vacant lots full of burnt-out building shells and broken glass, may not attract a lot of buyers, even if there are few competing houses. Conversely, if my neighbors all build mansions next to my house, it’s likely that my house will rise in value. This reflect the fact that (a) humans, as social animals, like having neighbors, (b) having the land developed gives potential buyers greater confidence that the neighboring lots won’t be used as a toxic waste dump, and (c) the value of neighboring real estate influences the value of mine. In this case, a government subsidy to develop the vacant lots around me may actually benefit me AND benefit the government that seeks to gather more property taxes.

That said, the subsidy probably drew potential developers away from building in other locations. So those other locations may suffer as a result. It doesn’t necessarily follow that a subsidy program will generate aggregate social costs that exceed aggregate social benefits—but that’s the way I’d bet.

3. Gentrification can arise with or without government subsidies. So, while people who feel hurt by gentrification may have cause for feeling aggrieved if government subsidizes their pain, they may feel aggrieved whether or not government has a role in their pain.

Gentrification is just a part of “neighborhood succession,” a standard dynamic whereby affluent people move out of traditional neighborhoods, and a series of less affluent people move in. Historically, this was urban “low-income housing”: the houses of the formerly rich, now re-purposed and carved up into multi-family units. Later in the cycle, demand for housing in a neighborhood increases, and long-time residents finds that they can no longer afford the rents. Richer folks move in and renovate/rebuild/replace the housing stock. It’s just the circle of life….

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nobody.really
on June 12, 2018 at 20:43:08 pm

Not sure if you speak from applied/practical or theoretical experience, but having appraised thousands of properties over twenty-years in an urban market, your observations are pretty spot-on in line with my practical experience.

I wouldn't say I have an aversion to residential subsidies, only that I see they definitely create winners and losers; I do appreciate the rationale for and behind them, but empathize especially with the less fortunate and elderly who may/are most apt to, experience displacement.

Good discussion!

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Paul Binotto
on June 13, 2018 at 18:33:20 pm

Yep - and what is often overlooked with gentrification (or any rapid rise in real estate valuations) is the adverse effects of HIGHER property taxes upon the elderly residents who are paying a higher monthly tax rate than their mortgage payments (at the extremes, of course). One of my golfing buddies, who has lived in the same "minority" (but not low-income housing) neighborhood for 40 years confronts just such a dilemma - move (away from family and convenience) or see his pension monies siphoned off to the county for property tax payments.

So yep - there are winners and losers (and a good deal of whiners as well).

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gabe
on June 13, 2018 at 18:48:06 pm

Yep, and winers...

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Paul Binotto
on June 13, 2018 at 22:05:16 pm

(*Snort!*)

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nobody.really

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