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
Despite the well-documented, widely shared concerns associated with corporate incentives, their use has persisted and even increased in the early 2020s. One reason is political: Voters tend to support incentives, and elected officials in different jurisdictions compete to win votes by attracting businesses. A second factor is that courts have been deferential to what elected officials define as “public purpose.” This allows legislators to circumvent anti-aid or gift clauses in state constitutions.
Most politicians and voters support incentives—especially when an opportunity becomes available to bring a large company into a community. For example, when Amazon staged a competition among state and local governments for the location of its second headquarters, an MSN poll found that 68 percent of Republicans and 55 percent of Democrats would “back government incentives to lure a big company.”54 In a 2014 paper, political scientist Nathan Jensen and colleagues polled 1,974 respondents on what would happen if their governor supported corporate incentives. They found that voters would be 2.4 percent more likely to vote for a governor who supported incentives.55 Interestingly, they note, the “vote bonus for offering greater incentives than competitors do is actually higher for a governor whose state loses the project (about 5.2 percent from all respondents and 10.7 percent from political independents).”56 However, “politicians are rewarded more strongly if they offer incentives in a losing effort, leading to a dominant strategy [of offering incentives] under certain economic conditions.”57 So, it seems that when corporate incentives are offered and investments are won, voters reward the incumbent governor more modestly.
The corporate incentives game creates a subsidies arms race among states and localities—one that is difficult to stop without an agreement among policymakers.
Voters’ preference for seen over unseen economic activity—and for politicians trying to subsidize the seen—is hardly surprising. As French economist Frédéric Bastiat explained almost two centuries ago in his essay “That Which Is Seen and That Which Is Not Seen,” we commonly recognize the visible benefits of government actions while ignoring their invisible costs. Thus, for incentives, it is natural for voters to reward elected officials for providing or attempting to provide incentives that generate clear and tangible outputs—factories, jobs, investments—while ignoring those same projects’ many hidden costs, especially opportunity costs.58
The behavior of elected officials with respect to corporate incentives is also a classic “collective action” problem when states and localities compete for scarce corporate resources—the factories, jobs, and investments involved. Economists frequently explain the issue in terms of the prisoner’s dilemma, a concept from game theory in which two guilty prisoners being interrogated by the police would go free if they stay silent, but, because neither can be sure that the other will do so, both end up confessing to minimize their jail time.59
Many economists and political scientists have applied this framework to corporate relocation incentives and two hypothetical legislators, A and B, from different states. The optimal outcome for both would be to withhold these subsidies. But because each legislator has no way of ensuring that the other will abstain, and because one’s support of subsidies will make the abstaining politician lose votes or political support, they both offer subsidies.60 This “game” is described in Figure 4.
The corporate incentives game creates a subsidies arms race among states and localities—one that is difficult, if not impossible, to stop without an agreement among policymakers to abstain from subsidies altogether.
Courts also regularly uphold the constitutionality of state corporate incentives through their interpretation of what’s known as the public purpose doctrine. And they do so despite the prevalence of constitutional anti-aid provisions in many states that are intended to prevent state funds from being used for private gain.
The public purpose doctrine states that public funds can be used only for public purposes. However, the term “public purpose” has been vaguely defined as anything that benefits the general public. Courts regularly defer to state legislatures in determining what public purpose means.
For example, Pennsylvania’s legislature in 1967 passed P.L. 251–102, now known as the Economic Development Financing Law, which provides subsidies to manufacturing plants in the state. The law declares that “the present and prospective … general welfare of the people of this Commonwealth require as a public purpose the promotion and development of new … economic activities.”61 The legislation contains six other references to the term “public purpose.”62 In 1968, the Pennsylvania Supreme Court dismissed a lawsuit that claimed P.L. 251–102 violated the state’s anti-aid provisions. In reaching this decision, the court opined that the legislature “is more responsive to the people and has more adequate facilities for gathering and assembling the requisite data,” and therefore “is in a better position to evaluate and determine public purpose.”63 And since the legislature had determined that P.L. 251–102 served public purposes, then “the Agreements entered into by the Authorities pursuant to the Act are for a public purpose.”64
Judicial deference to legislative conceptions of public purpose is not unique to Pennsylvania. In fact, by 1996, 46 states had upheld the constitutionality of economic development incentives.65 It is this judicial deference that allows elected officials to offer corporate incentives, enabling them to compete with other states in the subsidies arms race. (The Appendix details the history of how the public purpose doctrine evolved and led to the erosion of state anti-aid provisions.)
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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