State Economic Development:

Are We Feeding Sparrows Through A Horse?

By Michael D. LaFaive

April 13, 2004

A version of the following remarks was presented in a speech by the author to the St. Johns Rotary Club in St. Johns, Michigan in April 2004.

Recent events involving manufacturing plants in Greenville and St. Johns have drawn attention to state and local governments and the roles they play to allegedly save or create jobs for Michigan citizens. I confess to being a frequent and sharp critic of such directed economic development efforts. My remarks today will explain the basis for my criticism and detail both the theoretical and empirical case for eliminating government-run economic central planning bureaus. I will conclude by offering alternative policies that would do far more to help spur economic growth and development in Michigan.

There has been a modern economic war raging between states in the U.S. for about seven decades now. The war has been fought over "jobs." States and cities have attempted to develop policy tools primarily to fight each other for economic bragging rights, and those tools are also being used to persuade firms not to leap over international borders.

(By the way, I described this as the "modern economic war" because the first war began in the late 1700s when New Jersey offered Alexander Hamilton tax advantages for locating in the Garden State).

This economic war between the states is not the healthy competition favored by most economists, whereby states attempt to attract businesses by improving their overall climate for enterprise and by making state government itself lean, unobtrusive, and inexpensive. That broad-based generalist approach, which plays no favorites among particular companies, affirms the truism that economies, to quote Irving Kristol, "aren't machines to be fine-tuned. They’re more like gardens to be watered and tilled."

Rather, this is a war of the industrial policy planners and their economic development bureaucracies. Their arsenals are composed of selective tax abatements and credits, outright grants to specific, high-profile businesses, job training subsidies, low-interest loans, tax exempt municipal bonds issued for private benefit and infrastructure spending that often goes beyond what state government would normally do as populations and the general economy expand. Each battle in this war brings with it the pageantry of ribbon-cuttings and photo opportunities for the politicians, who claim new mystical powers of distinguishing the winners from the losers in the marketplace.

There are four fundamental reasons why government-directed commercial ventures are usually counterproductive.

  1. The knowledge problem. Economic development officials are not endowed with a unique or specialized understanding of how the economy works. They cannot reliably predict which businesses will succeed and which ones will fail, yet officials consistently spend tax money under the belief that they’re doing society some sort of favor, that they know best how to improve our economic lives. This is called the "fatal conceit" of central planning.

    The term "fatal conceit" is from the title of a book by Nobel laureate F.A. Hayek. In the book, Hayek examines the idea that the human intellect can somehow survey society, grasp it in all of its nuance and detail, and then improve it through some central force. Hayek knew this to be impossible, yet it is something that central planners attempt daily. Allow me to put central planning’s difficulties in perspective.

    How many ways can you arrange three items? This is a simple factorial problem. The answer is six. Now, how many ways can you arrange 20 items? The answer is roughly all the seconds comprising 10 billion years. Let us extend this one step further. A deck of playing cards has 52 cards. It is very conceivable, even likely, that no shuffling of the deck anywhere in the world has ever or will ever produce an identically shuffled deck.

    Yet central planners continue to operate under the illusion that they can somehow create exotic policy schemes and marshal the information that is necessary to organize our economy and commercial concerns in such a way that it would improve our lives more than if we were simply left alone to purchase automobiles or invest in the firms that make them voluntarily.

  2. The Law of Beaker. Have you ever seen that skit on The Muppet Show where the terrorized lab assistant, Beaker, is always having experiments forced on him that end up being painful? Yet, his boss remains completely unaware of Beaker’s fear? That disconnect is similar to what happens when one person is in a position to take the resources of a second person and spend it on a third.

    Another Nobel laureate, Milton Friedman, accurately notes that there are only four ways to spend money. You can spend your money on yourself, your own money on someone else, someone else’s money on yourself, or someone else’s money on someone else. Under what circumstance would you be the least careful?

    Officials, however well intentioned, are still spending other people’s money on other people. They simply do not have the same incentive private citizens have to invest our money as wisely as we would invest our own. In addition, government expenditures often risk being used to curry favor with important constituents first, and to make wise expenditures second.

  3. Robbing Peter to Pay Paul. If a thief in Lansing stole money and spent the loot buying products in St. Johns, would we all just celebrate the increase in sales, or would we realize that people had to lose in order for St. Johns to gain? The same goes for government development schemes. Remember, government has nothing to give anyone except what it first takes from someone else. With respect to tax credits, handing them out to particular companies just makes it harder to cut taxes for all businesses. Everything has a cost. To make matters worse, the bureaucrats who devise and manage these exotic programs don’t work for free, which brings me to number four.

  4. The "Sparrow Effect." Have you ever heard of the expression "feeding sparrows through the horses?" Imagine that a central planner wanted to help sparrows grow and prosper. The central planner can dump feed on the ground evenly and let sparrows partake of it directly, or he can run the feed through a horse first, and let the sparrows pick through the pile that the horse leaves behind. The horse in our example represents the government bureaucracy created to maintain economic development programs. The bottom line is that it costs money to pay bureaucrats to take your money and redistribute it to someone else. Spending millions to support these programs just deprives entrepreneurs of the resources they could be using to create more jobs on their own accord.

Individual entrepreneurs face the same knowledge problem as government. No individual can divine the myriad ways in which society could organize itself. But their advantage lies in not having to.

The argument that states can create and/or retain jobs in net terms and over time through targeted policies is not borne out by the majority of empirical evidence.

In 2001, scholar Terry Buss published a literature review of more than 300 economic development studies. That is, he carefully dissected the work of other scholars to sum up their findings. He found that most of the tax incentive studies reported negative results.

In 2003 the Mackinac Center for Public Policy did a simple analysis of the relationship between what a state spends on economic development programs and its Gross State Product. Gross State Product is probably the number one indicator used by economists to measure. We found that there was no statistically significant correlation between the two. Indeed, Michigan’s GSP ranking among the states has fallen 10 places since state leaders have been working aggressively to create and retain jobs on our behalf (from 20 to 30 since 1994).

One highly recognized program employed by the state, and criticized by the Mackinac Center for Public Policy is the Michigan Economic Growth Authority. The MEGA is being used with regard to Federal Mogul and their decision to keep jobs in Michigan or move them out of the country.

In April 1995, the state created MEGA to issue tax credits to companies that promise to expand in or relocate to, Michigan. No company should be blamed for accepting a tax credit when it is offered, just as no individual should be faulted for taking a credit on his personal income tax form. But what makes these selective MEGA credits problematic is that they are both unnecessary and unfair. Businesses—and the economy generally—would be better off with a fair field and no favors, a climate of lower tax burdens for all and discriminatory treatment for none.

There are some obvious problems with MEGA. First, officials cannot prove that the companies involved would not have expanded or moved to Michigan without MEGA assistance.

Second, MEGA is also unfair. Most of the firms chosen by the politically appointed MEGA board to receive tax credits have in-state competitors that do not receive tax credits or other special treatment. Lacks Industries Inc. of Grand Rapids is one example. Lacks produces automotive plastic molding and plating. In 1996, the company was awarded MEGA tax credits, abatements, and "workforce development" money. As part of its application, Lacks submitted to MEGA a "Confidentiality Form" listing five reasons to keep certain data secret from the public. Three reasons noted that making public certain data would give an "unfair advantage to our competitors."

But MEGA credits themselves give unfair advantages to the firms chosen to get them. There are currently 1,365 companies in the state with whom Lacks shares Standard Industrial Classification (SIC) codes. SIC codes classify businesses by industry and economic activity. Businesses within the same SIC code produce similar if not identical products and also compete with one another to attract workers.

But if these targeted tax tools are bad policy, what policies should Michigan adopt to thwart a business exodus, and create more?

The Mackinac Center for Public Policy has always held that a fair field and no favors is the best route to a robust economy and new and better jobs. Instead of targeting tax relief, make it general tax relief. Instead of creating a bureaucracy to help business negotiate the labyrinth of Michigan regulations, cut regulation for all businesses. The state should also pass Right-to-Work legislation, and work to improve the education climate.

Even if these changes were made it has to be noted that we couldn’t save every job, nor should we. The very essence of job creation is job destruction. Jobs that are less valuable to the economy as a whole move elsewhere or cease to exist anywhere so that others can be created. Even in the best of times a dynamic market economy is shedding old jobs in favor of new ones. Consider the following facts from a recently published trade study by the Cato Institute, a Washington, D.C.-based think tank.

Total U.S. private-sector jobs increased by 17.8 million from 1992 to 2002, but to produce that healthy net increase a breathtaking 327 million jobs were added while 309 were lost.

Would anyone here suggest that the state should have subsidized buggy whip makers to protect those jobs when the automobile came along? There is little difference between job losses from improvements in technology (horse-drawn buggies gave way to automobiles) and job losses from trading with other nations, such as Mexico.

All of this is admittedly cold comfort for an Electrolux worker who has just lost his job, but government does not exist for protect the jobs of any workers or of any particularly company or industry, especially at the expense of other workers and taxpayers.

Michigan citizens need to recognize the limited benefits and inequities inherent in an economic development policy focused on giving tax breaks and subsidies to a select few businesses. Instead, they should look toward broad-based tax and regulatory reform to create a business climate that encourages statewide investment and job creation.

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Michael D. LaFaive is director of fiscal policy for the Mackinac Center for Public Policy, a nonprofit, nonpartisan research and educational institute. Mackinac Center President Lawrence Reed contributed information used in these remarks.