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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12 Comments so far

  1. Marc

    October 12, 2011

    Its a scam. Incentives don’t attract businesses; access to market, factor costs, access to labor, infrastructure, costs of doing business, access to suppliers all rank way way ahead of incentives in terms of decision making criteria for a business.

    What businesses do is that they identify the site they believe gives them the best combination of factors and THEN they begin to negotiate for incentives. They make it seem that they have a range of options, that they could go anywhere, blah blah – and they basically take politicians to the cleaners.

    To go a step further, I am sure they also contribute heavily to the politicians’ campaigns – or at least make promises to.

    Incentives by their nature are often short-term (10 years or less) – those firms that are swayed by incentives over other factors are typically short term investments – more than happy to pack up and leave by the time the incentives expire.

    What a investment area needs to do is get their house in order and forget the incentives.

  2. Cassim Nakkooda

    October 12, 2011

    In South Africa the Government is of the opinion that if a company locates in South Africa based only on an incentive, then that company is quite mobile and would most probably relocate in the short to medium term to another location if a better incentive were offered. The rationale behind the incentives that are being offered is that the company should locate in our market because it makes economic and business sense and not because we are offering a better tax incentive than a competing location. I remember an example where we lost an investment to another country due to the incentives provided and the investor only used the incentives to enrich themselves further in the short term and pulled out of the country when they had exhausted the incentives as the location was not an economically viable option in the long term.

  3. Skip Schoettmer

    October 13, 2011

    Its been a few years since I was in retail, so I called one of my old buddies to discuss and the bottom line is that P&G never paid any slotting allowance and the thinking was that the practice incented short term gain and drove decisions that were not in the best interest of the retailer. Brands were brought on that didn’t result in category growth. Retailers that focused on the practice, became underdeveloped versus the Retailers that focused on brands that drove category growth. Maybe the lesson is in the short term gain versus doing what is right for your business.


    October 13, 2011

    The nation is experiencing the largest gap in the talent pipeline (structural unemployment) in history. It might be an excellent time to move some the sourcing/recruiting expenditures to educating and training employees for internal positions. It also may make sense to really look at job requirements. For example: Does the position really require a Master’s Degree?
    The amount of people unemployed is about equal to the amount of jobs open. We are required to bridge the gap to improve the employment situation. It doesn’t make sense to create more jobs that may go unfilled due a lack of talent. Incent education and training of employees.

  5. Paul Alvarez

    October 13, 2011

    Be very careful if you offer incentives based on the wage bill. In South Africa, the original FDI incentives, back in the 1980’s, were based on expenditure, one of them being wages. The system was totally abused and resulted in some applicants creating fictitious employment contracts, to fradulently claim the incentives. I strongly believe that incentives should be based on investment and profitability, with a condition that employment numbers will be physically verified at agreed points in time, and that an obligation to employ a set % of locals must be met!

  6. Paul Mastilak

    October 14, 2011

    Paul Mastilak • Based on my on the ground experience, incentives really come into play when all the primary site location factors are basically equal between competing locations. They are very rarely primary factors in the decision-making process.

  7. Mark Barbash

    October 15, 2011

    My sense is that this is going to take some under the radar dialogue among key stakeholders (including the heads of major corporations who donate money to politicians) to find a new paradigm for creating and retain jobs that acknowledges the need for public sector investment, but in a way that catalyzes development, rather than subsidizes development.

    Here’s a really interesting start: Michigan State University is establishing a University based Center to support research in economic development innovation in a collaborative manner. The head of this, Rex LaMore is an experienced economic developer.

  8. Ed Burghard

    October 15, 2011

    Here is a perspective suggesting incentives do work to retain or attract jobs –

  9. Henry Loewendahl

    October 17, 2011

    While I agree that incentives are not the best economic development tool, one can argue that they substitute for lower tax. The US has among the highest corporate tax rates in the developed world (and the highest employer health care costs). This reduces the profitability of investing in the US for both foreign companies and US companies alike (just look at the cash pile of companies like Microsoft overseas). While incentives may distort the flow of government resources to larger, more mobile companies and most likely are higher than are actually needed to attract the investments due to competitive bidding by companies and states, the US needs to offer incentives to make the US a profitable place to do business. The fiscal problem is not that the companies are not paying enough tax but that not enough is being raised from the population. I would suggest taking a look at which tracks incentives being awarded across North America and other countries. It shows that a lot of incentives in US are being given to smaller companies, but also that other countries (e.g. Canada) are also giving similar incentive packages to the US – and also benefit from lower corporate tax. Other countries are also less concerned that the US in demonstrating that the tax revenue from the project will exceed the incentive value. The benefits of the project are defined more in terms of the volume and quality of job creation in strategic industries or activities. It would seem very risky for US states to stop giving or reduce incentives in the absence of either national or even international coordination of incentives when the US base rate of corporate tax (and healthcare costs) are already so high.

  10. JIm Samuel

    November 27, 2012

    The Arms Race analogy is better than the Prisoners Dilemma because as you stated, no one wants to be the first to “disarm”. But some of your examples mix levels of government/taxation. States are less likely to “disarm”, because of the tax disparity that can exist between states (most notably an income tax). As for the local level, I think that is were you see your biggest risk of negative ROI because the chances of “spinoff” growth might be so limited. In all, I have lost my “lust” for the incentive game and would much prefer a focus on a general better business climate. Ohio lost many of its incentives when we reformed our tax code in 2005, but did we really lose them? In reality we eliminated the tax on capital investments, and inventories and a host of other job-killing taxes that previously served as the “pot” for incentive dollars. I would argue we are better off without them. But that doesn’t mean all incentives should go away (at least not yet). Investment specific incentives, those that drive a particular desired activity may be beneficial to localities. For example, the CleanOhio program that focuses incentives on cleaning up brownfields incents the investment in capital into a previously undesirable location but that may induce other beneficial growth and a reduced ongoing tax cost to a locality if they would otherwise have to expand services into greenfield developments. (Such a big topic – thanks for trying to start the conversation. I am encouraged by the comments from/about South Africa.)

  11. Ed Burghard

    November 27, 2012

    Jim – I too prefer fundamental change to the business climate over tax incentives. Interestingly, at both the IEDC annual meeting and the LiveXchange event I attended, site selection consultants shared that rarely are incentives actually he reason for selecting a location. Don’t get me wrong, sometimes they are the difference. But, it is with far fewer occasions than the economic development professional community thinks it is. The counsel from the site selection consultants I spoke to was to “fix” the problems with your community so it is a more attractive location option for them to recommend to clients. Sounded like great counsel to me.

  12. vishwajeet s baghel

    June 4, 2019

    Hi ,
    I have always liked your blog and specially in this article i liked how you gave solution after making us realise the problem to which we were not giving attention earlier.

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