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Thursday, October 8, 2015

In Defense of Local Governments’ Corporate Subsidies

capitalist oppressor

It is commonly observed, and commonly criticized, practice of businesses when deciding where to locate a major new facility to demand subsidies from the localities. By playing the local governments of potential sites against each other, the businesses often manage to be granted substantial special tax breaks and other favors.

This is widely seen as disgraceful. Why should big corporations be able to bully local governments into granting them special favors that others in the area do not enjoy? Does this not require additional taxes on or reduced benefits for the unfavored? There are few practical proposals on how this practice could be eliminated—how could it be without eliminating the ability of localities to set their own tax policies?—but across the political spectrum there is agreement on the perniciousness of the practice and local governments are urged from all quarters not to give in to such demands.

This reaction is understandable and indeed many of the businessmen and politicians who engage in this practice do appear to be of more unsympathetic character than average for their respective species. But this reaction is also wrong. Under current legal conditions, this sort of rent extraction is often economically efficient and just.

Once a business has made a large investment in a facility, much of the cost will be sunk. Specialized plant, relocation, training of local workers; all of these would be irrecoverably lost should the business decide to move the facility again. Only the stream of profits generated by the facility can retrospectively justify the initial sunk cost. Moreover, if many facilities in the same industry locate in the same area, network effects can arise that would make moving somewhere else even more costly.

Local politicians are well aware of this fact and mercilessly, and usually to public applause, exploit it. They can pass taxes and regulations to appropriate to themselves and favored constituents almost the entire return of the sunk costs (as well as the benefit of network effects). In response, businesses cannot credibly threaten to leave as long as they can retain at least a sliver of the return. For moving somewhere else would mean losing all of the return. In effect, the politicians become the beneficial owners of the fixed assets; the businesses—while legally retaining ownership—are in practical effect merely the operators.

So the mayors and city councils of New York or Los Angeles can and do, without fear of adverse consequence, take a substantial chunk of the total return of the financial industry and the movie business, respectively. When, as likely in these cases, network effects are more important than sunk costs, the affected industries would be much better off moving to a low-tax jurisdiction like Houston or Miami, but due to the collective action problem, they cannot accomplish this transition.

Of course, both businesses and politicians are aware of this fact ex ante before building new facilities. The corporation knows it will be exploited wherever it goes, but it still has the power to decide who gets to exploit it. So the corporation in effect holds an advance auction among localities for the right to exploit the corporation later. If this market is competitive on both sides, as it appears to be, one should expect businesses to extract on average subsidies equal to what the localities will later extract from them. In short, for any business wise enough to hold such an auction, the net outcome is a wash.

This conclusion may justify these exchanges on average. But these exchanges are still quite unseemly and involve a large dead-weight loss of transaction costs on the parts of both businesses and localities. Would it not be better to just do away with both extractions?

Surely, yes. But that is nigh-impossible as long as localities retain the power to tax and regulate without compensation. Even if a local government sincerely promised neither to predate on a new business nor extend it subsidies, businesses would not be able to trust such promises because it is settled doctrine that no legislative body can bind later incarnations. As soon as the business made its investment, a new faction could come to power and openly renege on all promises made earlier.One potential solution, never implemented as far as the author knows, would be for localities to post a bond to new businesses. Against this bond the business could make a legal claim whenever the locality’s taxes or other regulations change and recover the costs of such changes, not unlike the sorely needed Constitutional rule requiring compensation for regulatory takings.

So the current state of tawdry deals and governmental predation is probably the achievable second best. Eliminating only the tawdry deals would render the situation worse, not better. It is unsurprising that the defense of such deals given here is rarely offered by the politicians who engage in them for it casts them in unfavorable, if accurate, light.