Economic Incentives – Classic Prisoner’s Dilemma

I am concerned by the economic development profession’s unflagging reliance on incentives as a “must have” negotiating tool. In my mind, we are playing a game of iterated prisoner’s dilemma. Companies demand incentives and your community must provide them or jobs growth will occur elsewhere. After all, without a competitive level of incentive offerings, how can a community be expected to win The Second Moment of Truth?

In my opinion, the practice is similar to slotting fees retailers charge companies in the private sector. Research by Hans Jarie Kind, “Do Slotting Allowances Hard Retail Competition?”, published in the Scandinavian Journal of Economics (2008) demonstrates that slotting allowances are anti-competitive. But like the practice of paying incentives, slotting allowances are also shrouded in just enough controversy to make it challenging for a company to refuse to play.

Why is this the case? If a practice is questionable (incentives or slotting allowances) why does it continue to be embraced?

Prisoner’s Dilemma

“Two communities are competing for a Company, but the capital investor do not possess enough information for a clear choice. Following the RFP, the capital investor offer both a similar deal- if one Community sweetens the deal with incentive dollars regardless of ROI potential versus the competing community, and the other sticks with the current non-enriched offer, the community offering the incentive package wins and the fiscally responsible community loses the deal. If both communities remain fiscally responsible and do not offer incentive dollars, both risk competing solely on the strength of their business climate. If each community attempts to out-incentivize the other, each risks signing a deal that is bad for taxpayers. Both communities must choose to either be fiscally responsible or risk signing a bad deal; the decision of each is kept quiet. What should they do?

So far, communities have been electing to sweeten the deal with incentives and accept the risk that the ROI for the taxpayer dollars invested will be negative. No community is willing to be the one that decides to compete solely on the value of its business climate. It is the economic development industry equivalent of the arms race and nobody is willing to be the first to disarm.

Are Incentives Really an Effective Tactic?

The literature gives incentives a mixed review. In my opinion, no author is quite ready to step out and say categorically that the practice is maddeningly insane. But, after everything I have read, I personally believe many incentive programs do not make sound business sense, and taxpayers are the ones holding the liability of a negative ROI.

Here are a few references I found to be worth reading that you may also find helpful to understand the documented impact of incentives.

Federal Reserve Bulletin Volume 93 (2007) characterizes incentives as a zero-sum game.

“The Failures of Economic Development Incentives”, Peters and Fisher “reviews 30 years of political experimentation and hundreds of studies, concluding economic development incentives actually hurt a state’s economy”.

Finance Monitor concludes – “As a general proposition, most tax cuts and economic development programs do not “pay for themselves”.

Economic Policy Institute, Rethinking Growth Strategies (2004), Lynch claims – “An analysis of the relevant research literature, however, finds little grounds to support tax cuts and incentives—especially when they occur at the expense of public investment—as the best means to expand employment and spur growth.”

So Why Not Just Stop Using Incentives To Attract Capital Investment?

We are trapped in the Prisoner’s Dilemma. Nobody wants to be the first state or community to compete on the merits of its business climate alone.

Michigan’s Governor Snyder is trying to focus attention on finding alternative ways than tax credits to convince companies to invest capital in the Great Lakes State. He has challenged the MEDC to think it through. Hopefully, Michigan will be successful and establish a new paradigm for competing.  But, to the best of my knowledge Michigan is still using incentives as a negotiating tactic (if that is not true, lease leave a comment and a reference) to let me know.

I think a better understanding what the real needs of a company are and establishing a true partnership where the state/community and company’s interest are mutually reinforcing is a great place to begin the exploration of how to walk away from incentives as a negotiating tool. I would strongly advocate the development of different tools that help companies achieve higher peak profit on new investment, or that help shorten the time to peak profit. These would be tools CEOs would be very interested in and would likely be worth far more to the company’s 10-year project NPV. Communities also need to learn how to value non-monetary assets like unique partnerships that can be created and leveraged if a company chooses your location.

It seems like the time is ripe for alternative thinking. The public is losing their tolerance for high-risk or straight up bad choices on investing their tax dollars. Politicians at all levels are beginning to be held accountable for the delivered (versus promised) job creation and economic benefit results tied directly to the incentive dollars they’ve authorized investing. But, despite that, the practice of providing tax incentives is still going strong. For example, California just authorized incremental budget for tax incentives to protect its film industry. And Lilly’s CEO is to pushing for increased tax incentives as a way to stimulate job growth.

Stay tuned as states and communities lean into incentives as a way to “buy” themselves out of the economic challenges and unemployment levels they face.  Maybe the solution is an improved business climate AND incentives.

What are your thoughts about the role of incentives?

Is there a place for incentives in economic development, or do incentives provide a mechanism that allows public and private sector leaders to ignore the hard work of community improvement as a basis for competition? Is it a practice that we should be trying to wean the industry off of, or should we embrace it fully?

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Category FDI, Incentives, Promotion

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