State and local governments often offer economic development subsidies to attract businesses, but these incentives come with significant costs and questionable benefits. Our friends at the Cato Institute have published an excellent, in-depth study that breaks down the complexities of business incentives, exploring their impact on economic growth, budgetary costs, and the effectiveness of such subsidies in driving business decisions.
By examining recent trends and policy failures, Cato aims to foster a deeper understanding of how to reform these practices for more transparent and fiscally responsible governance. ITR Foundation published Cato’s study, with their permission, broken down into a series of articles. The full study is available on Cato’s website.
Cato Institute Policy Analysis No. 980
By Scott Lincicome, Marc Joffe, and Krit Chanwong
Ideally, state and local governments should eliminate all corporate tax incentives and subsidies, given their economic, political, and ethical drawbacks. Government is least disruptive to economic activity when it limits spending to essential state activities, avoids intervening in private, commercial markets, and finances its operations through low, broad-based, easily understood taxes. Corporate incentives violate these principles while enriching a select few—typically large and wealthy corporations—at taxpayers’ and other businesses’ expense. They should be avoided entirely, or at least dramatically scaled back.
However, since the political temptation to continue these economic interventions is so strong, their immediate abolition seems unlikely. For the time being, therefore, policymakers could make incremental progress in reforming state incentives by entering into compacts with other jurisdictions and seeking transparency reforms.
Compacts among states and localities to abstain from offering incentives would address arguably the largest political motivation and most common political justification for costly subsidy packages, the prisoner’s dilemma. By assuring local lawmakers that their cross-border rivals will not offer subsidies to entice companies to move to or remain in their own jurisdictions, interstate compacts can short-circuit the bidding-war problem that pervades incentives policy across the United States as well as politicians’ justifications for providing such subsidies.
As will be discussed next, subsidies compacts are rare in the US interstate context but common in international trade law. Most notably, World Trade Organization (WTO) agreements contain multiple subsidy discipline measures agreed on by all 164 member governments, including the United States and all other large, industrialized economies, and incorporated into their domestic laws. These disciplines (1) define subsidies and limit (or even prohibit) those that are most economically harmful and trade-distorting; (2) require member governments to annually report on their use of subsidies; (3) provide a venue for governments to discuss subsidies and negotiate new rules for their use; and (4) allow governments to challenge others’ use of subsidies through national anti-subsidy actions (called countervailing duty measures in the United States) or government-to-government litigation (dispute settlement) at the WTO. These rules are not perfect, but WTO member governments—including the United States, the European Union, and China—use them frequently, with some significant and notable successes in increasing disclosure of nations’ agricultural and industrial subsidies and reducing their use.66 As such, the WTO’s international agreements limiting government subsidies could serve as a guide for interstate agreements (compacts) seeking to achieve the same general objectives in the United States.
According to the National Center for Interstate Compacts (NCIC) at the think tank Council of State Governments, an interstate compact has been defined as a “contract between two or more states” that “carries the force of statutory law and allows states to perform a certain action, observe a certain standard, or cooperate in a critical policy area.”67 The Compact clause of the US Constitution (Article I, Section 10, clause 3) prohibits states from entering into compacts without congressional approval. However, the Supreme Court has adopted a functional interpretation, ruling in Virginia v. Tennessee (1893) that congressional consent is required only when the compact enhances the power of states at the expense of the federal government.68
The NCIC lists 192 compacts covering a wide range of issues.69 Widely adopted compacts include the Interstate Commission for Adult Offender Supervision, the Interstate Compact on the Placement of Children, and the Driver License Compact.70
An interstate compact (or series of regional compacts) prohibiting or strictly limiting corporate incentives is a reasonable way to stem interstate competition for corporate facilities.
Given the long experience with compacts and their acceptability at the federal level, an interstate compact (or series of regional compacts) prohibiting or strictly limiting corporate incentives is a reasonable way to stem interstate competition for corporate facilities.
There is some precedent for such a compact. Because the Kansas City metropolitan area is split between the states of Missouri and Kansas, companies sought to obtain job creation incentives by making a small move across the state line and retaining largely the same workforce. An incentive “border war” ensued, and in 2019 the two states took action to ease the conflict. First, the Missouri legislature passed SB 182, which prohibited the issuance of new tax credits or subsidies to companies relocating from Kansas border counties to Missouri border counties.71 The legislation was to become effective once Kansas took reciprocal action. Kansas governor Laura Kelly then issued Executive Order 19–09, which contained provisions similar to the Missouri legislation.72
As of early 2024, the interstate truce was still holding but with some setbacks. Tax incentive deals that were pending at the time of the truce were allowed to move forward.73 The Kansas legislature failed to pass legislation to incorporate Governor Kelly’s executive order into the state’s statutes.74 Finally, the truce does not prevent interstate competition over Kansas City’s professional baseball and football teams (the Royals and Chiefs, respectively). In 2022, Kansas City, Missouri, mayor Quinton Lucas tweeted that the city’s loss of the Chiefs to Kansas would “scuttle the entire truce.”75 But in June 2024, the Kansas legislature passed a plan to attract the teams by potentially issuing billions of dollars of stadium bonds.76
The Coalition to Phase Out Corporate Tax Giveaways, a bipartisan group of state legislators, made a more ambitious effort to stop corporate incentives through an interstate compact. Between 2019 and 2021, members in 15 states introduced legislation to prevent their respective states from offering “taxpayer dollars to induce a facility in another state that has joined the agreement to move to the offering state.”77 As of this writing, however, it does not appear that any state has enacted this compact, and the coalition is no longer active.
Over time, state and local governments should adopt consistent standards for incentive reporting. Such standards could be created and maintained by a recognized standards body.
Over time, state and local governments should adopt consistent standards for incentive reporting. Such standards could be created and maintained by a recognized standards body.
Nevertheless, policymakers looking to stem incentives should review the compact proposed by the Coalition to Phase Out Corporate Tax Giveaways. Arizona’s 2021 version of the proposed compact included provisions to create a National Board for Best Practices in Economic Development. The proposal would also have banned attempts to entice relocations from one member state to another, as well as improved data reporting and transparency for offered corporate subsidies.78 Since proposed compacts of this type appear to have lost momentum, it may be politically necessary to scale them back to a more modest objective, such as limits on the size and type of incentives that participating states may offer.
Finally, it is worth emphasizing that any such compact should be limited to company-specific incentives. States should not cede their ability to enact horizontal economic reforms that affect all companies equally—for example, reducing or eliminating corporate taxes—or to take other measures that broadly improve their jurisdiction’s overall business climate.
A better understanding of the budgetary and other costs associated with corporate incentives might help shift the debate on corporate incentive issues. GASB 77 and state tax expenditure reports provide a starting point for incentive transparency, but substantial improvements are needed.
Good Jobs First has developed model legislation that state policymakers could use as a starting point for enacting their own transparency reforms. One of their model bills calls for a unified economic development budget that would require state agencies to provide lists (in electronic spreadsheet form) of all tax expenditures, with dollar amounts by company, program, and agency. This model could be usefully extended by requiring the inclusion of incentives other than tax expenditures such as subsidies, loans, and contributed infrastructure.79 The WTO’s Agreement on Subsidies and Countervailing Measures contains a broad definition of a subsidy, which could be incorporated into legislative text.80 Another extension to the legislative model would be to include not only the annual cost of the incentive but also the accumulated cost to date, as well as projected future costs of the corporate benefit.
Another useful model from Good Jobs First is its Taxpayer Right to Know on Jobs Act. This legislative proposal requires subsidized companies to report the number of jobs they agreed to create as a result of the incentive versus the number they actually created, as well as any related reductions in employment elsewhere.81
Over time, state and local governments should adopt consistent standards for incentive reporting. Such standards could be created and maintained by a recognized standards body or an ad hoc group of academics, policy analysts, and practitioners.
Short of a compact to fully end the subsidy race, states should consider unilateral actions to rein in some of the worst practices. One option currently being considered in Michigan is to require legislative approval of incentive deals negotiated by the executive branch.82 While far from perfect, such a reform would at least encourage transparency, discourage abuse, and possibly check the costliest corporate incentives.
The best approach to local economic policy is to eschew special deals and provide a better environment for all companies by lowering taxes, reducing regulations, and accelerating permitting processes.
Of course, the best approach to state and local economic policy is to eschew special deals to individual companies and instead provide a better environment for all companies in the jurisdiction by lowering and simplifying business taxes, reducing regulations, and accelerating permitting processes. State-level rankings provide reference points and models for pursuing such reforms. For example, the Tax Foundation publishes an annual study that ranks the states’ business tax policies.83 Although states that do not have income or sales taxes dominate the top positions, the study also gives high scores to Indiana and Utah—two states that levy all major categories of tax but do so at relatively low rates and with relatively broad bases.
QuantGov, a project of the Mercatus Center at George Mason University, counts the number of regulatory restrictions imposed by most of the 50 states. In its latest ranking, QuantGov found that Idaho, South Dakota, and Alaska had the fewest regulations.
Politicians have powerful motivations to offer corporate incentives, and in many states, they face few impediments to doing so. This is unfortunate, as these incentives often fail to deliver promised jobs and economic growth while imposing heavy budgetary and nonbudgetary costs. During the Biden administration, the state- and local-level incentives race has coincided with large federal subsidies to usher in a new era of US industrial policy. One government-favored industry, electric vehicles, is already experiencing lower-than-expected demand, leaving some of the federal, state, and local investments in EV and battery production at risk.
To break the prisoner’s dilemma driving the proliferation of incentives, lawmakers should enter into compacts with other governments, starting a process of multilateral incentive disarmament. The Coalition to Phase Out Corporate Tax Giveaways has offered a model for such a compact.
In the meantime, governments should provide taxpayers and other stakeholders with more information than elected officials have provided to date about the costs of corporate incentives. That could be accomplished through greater transparency, possibly in line with model legislation offered by Good Jobs First.
The best approach to state and local business subsidies is simply not to offer them. Until this worthy outcome is achieved, however, incremental reforms could at least limit incentives’ worst abuses and reduce their economic harms.
State legislatures enacted anti-aid provisions to attempt to restrain state borrowing after the economic turmoil of the early 19th century. In 1825, the Erie Canal was completed in upstate New York with funds raised through bonds issued by the state government.84 Other states, inspired by the canal’s success, issued bonds of their own. However, as Mercatus Center scholar Matthew Mitchell and colleagues note in a 2020 paper, “The unsustainable nature of these public investments in private ventures was laid bare by the panic of 1837 and the significant recession that lasted from 1839 to 1843.”85 This panic resulted in eight states and one territory defaulting on their bond payments.86
Anti-aid provisions were also enacted as an attempt to restore the creditworthiness of state bonds. New York’s finances, for example, had been badly hit by the Panic of 1837. By 1842, New York’s credit was close to defaulting on its debt.87 To avoid default, New York’s legislature approved new taxes to maintain the state’s creditworthiness. Unsurprisingly, these new taxes were unpopular, so New York legislators proposed amending the state constitution to limit the amount of debt the state could incur. These amendments failed to pass in 1845, and thus a constitutional convention was called in the same year, leading to the addition of articles that limited the amount of debt the state could incur and banned the issuance of new debt for single projects.88
These provisions were not specific to New York. In fact, by 1857, all states had constitutional debt restrictions.89 A second wave of anti-aid provisions followed during the 1870s, as state legislatures attempted to rein in municipal and local borrowing.90
Initial state-level enforcement of these anti-aid provisions was generally strict. For example, in 1879, the Colorado Supreme Court ruled that the City of Boulder’s ownership of railway shares was impermissible under the state’s new anti-aid provisions. The opinion stated that Colorado’s constitution prohibited “all public aid to railroad companies, whether by donation, grant or subscription, no matter what might be the public benefit and advantages flowing from the construction of such road.”91
However, the authority and extent of anti-aid provisions was significantly undermined by the rise of public purpose jurisprudence in the late 19th and early 20th centuries.92 This doctrine was first clearly enunciated in the 1853 Pennsylvania Supreme Court case Sharpless v. Mayor, which held that “railroads are not private affairs. They are public improvements, and it is the right and duty of the state to advance the commerce and promote the welfare of the people.”93 As such, the Pennsylvania Supreme Court allowed the City of Philadelphia to circumvent the state’s anti-aid provisions and own shares in a railroad company.
The public purpose doctrine was applied at the national level in the US Supreme Court’s 1874 decision Loan Association v. Topeka, which struck down legislation that allowed Kansas’s county and city governments to issue bonds to fund private construction of infrastructure. In reaching this conclusion, the Court clearly endorsed the public purpose doctrine, stating, “We have established, we think, beyond cavil that there can be no lawful tax which is not laid for a public purpose.”94
Matthew Mitchell notes that “from the beginning, courts have shown an extraordinary tendency to construe ‘public purpose’ in as broad a light as possible.”95 In Sharpless, for example, the term “public purpose” was interpreted liberally to include any welfare gains from any publicly funded private project. By the early 20th century, the US Supreme Court also adopted a similarly liberal interpretation of the term. In the 1918 case State of Georgia v. Trustees of Cincinnati Southern, the Court held that Georgia’s 1879 perpetual grant of land to the railway company Cincinnati Southern was “[a] conveyance in aid of a public purpose from which great benefits are expected.” Because of this, Georgia’s grant of land was “not within the class of evils that [Georgia’s] Constitution intended to prevent.” Georgia’s perpetual land grant thus could not be revoked by invoking the state’s anti-aid provisions.96
The Mississippi Supreme Court, in upholding that state’s 1936 Balance Agriculture with Industrial (BAWI) program, marked a major development in public purpose jurisprudence. The BAWI program, often considered the start of the modern targeted-subsidies era, “attempted to minimize the effects of the Great Depression by coupling low taxes, cheap land, and low wages with tax abatements and other subsidies and incentives to entice northern industries to expand or relocate in the South.”97 BAWI seemed to violate the due process and anti-aid provisions of Mississippi’s Constitution.98 Nevertheless, in its 1938 decision Albritton v. City of Winona, the Mississippi Supreme Court upheld the constitutionality of the BAWI program, concluding that “the courts are without the right to substitute their judgment for that of the Legislature.”99 After the Albritton decision, state courts were more likely to defer to legislative bodies in defining the limits of public purpose.
Lincicome, Scott, Marc Joffe, and Krit Chanwong. “Reforming State and Local Economic Development Subsidies,” Policy Analysis no. 980, Cato Institute, Washington, DC, September 19, 2024.
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