States and localities redistribute over $80B each year to businesses via economic development incentives. These incentives are used in the pursuit of job growth, increased capital investments, and, ultimately, improved standards of living in communities. But, how effective are these incentives in accomplishing these goals?
This article explores what economic developers and politicians get right—and sometimes wrong—about incentives. Find out how to improve the use of this economic development tactic and get practical tips on how to enhance the impact, and limit the waste.
1. Incentives are effective political tools
Politicians use incentives because they make political sense. They are rewarded for using incentives and use incentives to get more rewards.
Voters reward politicians for using incentives: Politicians receive favorable support from voters when incentives are offered to a prospective business, even if the incentives are offered in a losing bid.
Politicians use incentives to get more rewards: States with governors facing re-election prospects have been associated with higher levels of overall incentives spending. This practice of “politically motivated subsidy giving” has been documented by scholars.
2. Incentives can be effective economic tools in certain situations
“Governments cannot command businesses to invest, they must induce investments”
—Charles Lindblom, Former Sterling Professor Emeritus of Political Science and Economics at Yale University
The $80B question for economic development is whether incentives actually induce investments. The answer: sort of.
A 2018 study on economic development incentives found that small- and medium-sized establishments (<250 employees) who received incentives grew faster than non-incented establishments. However, incented establishments with 250 or more employees grew slower than non-incented establishments.
3. Incentives are ineffective economic tools when discretion is involved, probably because they are such good political tools
The same 2018 study mentioned above noted that the issues of fiscal excess and waste were concentrated almost entirely in incented projects for establishments over 250 employees. This was especially true for projects promising more than 1,000 employees.
Smaller establishments typically receive by-right incentives whose eligibility and benefits are stipulated explicitly by statute. But larger, more competitive projects often qualify for discretionary incentives where economic developers and political leaders have a wider allowance in defining the benefits.
On the bright side, the number of large-incented projects are small. 1,000+ employee projects have been found to make up less than 15% of incented projects.
On the down side, incentives are highly concentrated in large firms: Prior research has found the top 50 incentives recipients account for nearly half of all incentives awards.
The economic effects of incentives take years to materialize while the visible, political effects materialize immediately. For example, positive media coverage of the Amazon HQ2 announcements resulted in millions of dollars of free marketing for Northern Virginia specifically and Virginia generally.
4. Incentives can pay for themselves but, when they don’t, expect steep consequences
A recent study of Michigan’s Business Development Program (MBDP) found a net positive ROI of over $3 for every $1 spent. However, when opportunity costs were factored in, and all of the cuts were assumed to come from K–12 public education spending, the benefits were estimated at just $0.25.
While the assumption of spending cuts, especially to K–12 education, may seem aggressive, two reports found this to be a realistic case:
Cuts to critical spending categories. Research has found EDIs crowd out public expenditures in other productive spending categories like elementary and higher education, highways, and police and fire protection in subsequent years.
Damaging to overall public financial health. Two recent papers separately found incentives tend to negatively impact a state’s fiscal health, defined as a state’s ability to provide services to its citizens now and in the future, and can lead to increases in local government borrowing costs.
5. Incentives often don’t pay out to the companies
The announcements that politicians and economic developers use to boast of their successful efforts usually focus on promised jobs and capital investment, not actual jobs and capital investment. A number of recent reports have noted mixed results on whether these promises materialize into real jobs.
Because of the rising (positive) trend of incentives being paid out only after performance targets are met, many projects end up being announced to great fanfare and fizzling out behind the scenes. Wisconsin’s experience with Foxconn is just the most recent example of a widespread trend. For other examples of under-performance, see audits of Wisconsin: 2019, Michigan: 2017 and 2019, New Jersey: 2019, Virginia: 2016, and Utah: 2013.
What can be done to improve and how EDai can help
The use (and abuse) of economic development incentives is critically important to communities. If used well, they attract companies that create quality, well-paying jobs. If used poorly, incentives draw needed resources away from productive investments in a community’s human and physical capital.
Several tactics can improve effectiveness:
- Compete more intelligently. Communities and their leaders bid blindly in location selection processes. EDai’s LocatEDTM portal identifies the most competitive locations for a potential project, helping community leaders calibrate their incentives offers against their most likely competitor communities.
- Reduce the costs of information asymmetries. The practice of economic development is plagued by the high costs of information asymmetries typical in negotiations between communities and prospective companies. Economic developers do not have full insight into a company’s financial prospects and companies do not have full insight into a community’s business climate, public investment outlook, or available incentives. LocatED provides more transparency into each community’s strengths and their available incentives, creating a more efficient location search and negotiation process.
- Invest more sustainably. Incentives can have a net-positive effect but, other investments like those in infrastructure and training programs are far more efficient and effective in creating good jobs for residents.
The competition for jobs is not going away, meaning communities will continue using economic development incentives as tools to compete. Incentives can be used more effectively to stimulate job creation, and EDai aims to help decision-makers involved in the location search process—including political and economic development leaders—make better, faster, more impactful decisions.