Ed Lotterman: Targeted tax breaks good for state or city, bad for nation

Governments have long used sundry tax breaks, in lieu of direct subsidies, to attract business or real estate developments to a particular state or locality. This also has been a perennial political issue.

In my hometown of St. Paul, the use or overuse of a particular type of business tax break called “tax increment financing” — which is also used by Boise and other Idaho cities — came up in November’s city council elections. In this scheme, government money funds some development, which is then paid off by the increase in real estate taxes due to the higher value of developed property relative to undeveloped, often nearly abandoned tracts. The real estate taxes don’t flow to local government treasuries, but instead to pay off bonds that financed construction on the tract. Similar real estate and sales tax exemptions have been used by states like mine to help finance various sports stadiums and other privately owned developments.

Film and television production in many other states outside of California and New York seems to wax and wane with the attractiveness of state tax rebates to producers relative to similar subsidies offered by other states and provinces.

In Boise, the Boise Valley Economic Partnership, the economic development arm of the Boise Metro Chamber of Commerce, says new tax-abatement incentives authorized by the Idaho Legislature are an important tool in drawing businesses to the area’s already vibrant economy.

These are just a few examples of a broader phenomenon that crops up as a tool — and an issue — in nearly every state and most large municipalities.

Nearly a quarter-century has passed since a Minnesota congressman and the research director at the Minneapolis Fed mounted a quixotic campaign to curb “the war between the states” — the competing use of such tax subsidies to poach certain businesses or to vie for commercial or sports-facility development. The congressman introduced a bill at the federal level. It never got a hearing, so their brave effort was futile.

Economists are unambiguous about such special tax breaks. There is near unanimity that they harm our economy as a whole. There is a similar consensus that ending them is politically difficult. If there is any upside, they are useful academically, because TIF deals, and the logic behind them, provide good classroom examples of bad economic policy.

Start with an easy one from Econ 101: “logical fallacies.” Take two statements: “Without real estate tax subsidies, my city would not have six businesses employing over 400 people on the site of an old asphalt plant,” and, “Most of the benefits of such tax rebates flow to a small number of already well-off people. These projects raise the tax burden of other existing businesses and household taxpayers.” Which is true?

The answer is that both are. This is an example of a “false dichotomy,” in which two propositions are presented as mutually exclusive, when in fact they are not. In the real world, this project probably would not have happened without TIF; and much of the benefit from TIF often does flow to a small subset of people, and the tax burden on many others is higher than it would be without it.

So which is more important?

That question brings us to the idea of “net benefits to society.” Any taxpayer-funded program, from subsidizing local real estate to the federal Medicare program, creates benefits for some people and hurts others. Setting aside the question of to whom exactly the benefits flow or costs accrue, if the value of all the benefits exceeds that of all costs, society is better off from the action. The net benefits to society are positive. But if the sum of costs exceeds the sum of benefits, society is worse off.

The benefits of TIF and other “tax incentives” don’t all go to property developers. There are, for example, jobs in many cities that probably would not exist without TIF-subsidized projects. We can’t know if these people would have found jobs elsewhere, so for St. Paul alone, the social benefits appear to exceed the social costs. Why isn’t this good?

The answer is that from the point of view of society as a whole, rather than one municipality, TIF involves a “fallacy of composition” — another helpful Econ 101 concept. This is an error in reasoning which assumes that what is true for an individual, or in this case a group receiving jobs, is necessarily true for a much larger group — say, society as a whole. If you stand up at a basketball game, you can see the action better. Therefore, if everyone stood up, everyone could see better — not.

If TIF or other targeted subsidies increase economic activity and employment in one neighborhood, one city, one county or state, why don’t all such jurisdictions make themselves better off by implementing such measures? The answer is that such subsidies do little to increase the total amount of property development or employment for the nation as a whole. They just move it from one location to another. Offer subsides in one city and you may pull businesses away from other cities. But if all cities get into the game, there isn’t more overall economic activity.

So why do it at all? The answer is that cities and states are in a “prisoner’s dilemma.” This is the simplest form of what is known as game theory. Imagine two or more arrestees for the same crime, grilled separately. Each knows he will be hurt if his accomplices rat him out. Each knows he will benefit if he himself rats. Similarly, any city knows that if it does not offer tax incentives it will, indeed, lose new development to another city that does. As a group, the prisoners would be better off of no one finks out, but that is irrelevant. Elected officials, in either subsidizing or non-subsidizing locales, don’t think about U.S. society as a whole. Realities of “all politics is local” force their focus home.

When businesses choose a site for new development based, even if only in part, on competing incentive packages, this artificial factor reduces underlying business considerations that reflect true values to society of resources and products.

This is analogous to a distinction in international economics between “trade creation” and “trade diversion.” When England and Portugal lowered tariffs on each other’s products, British wool flowed south and Portuguese wine north. Resources were used more efficiently in both countries because Portugal had land and other inputs better suited to producing wine, while the same applied to wool in Britain. Growing trade was indeed “created.”

However, when the United Kingdom joined the forerunner of the European Union in 1973, it had to slash imports of food from Australia and New Zealand and instead buy dairy products, meat and wheat from fellow EU members. Australia and New Zealand produced these products with lower use of real resources of land, labor and capital. So stifling their production and boosting that of France and other European countries meant the world as a whole produced less food for a given use of resources. Increased U.K. trade with its new partners was “diverted” from existing, more efficient trade from within the Commonwealth.

In a similar way, property and business development motivated by tax incentives diverts these activities from other locales, but does not “create” any net new activity. And because these artificial incentives reduce the importance of true economic factors, total production of goods and services to meet people’s needs actually is less.

U.S. ecologist Garret Hardin, in his badly misnamed but famous essay, “The Tragedy of the Commons,” describes a large-scale prisoners’ dilemma in which an open-access resource is destroyed because no single user will stint as long as everyone else consumes. Hardin argued that the only solution was “mutual coercion, mutually agreed upon.”

The draft federal bill 25 years ago was a design for mutual coercion on which its authors valiantly strove to get mutual agreement. They failed honorably, but the odds of anyone else picking up the torch are slim to none.

That is too bad. For our nation as a whole, we are poorer as a result.

This story was originally published December 11, 2015 at 11:04 PM with the headline "Ed Lotterman: Targeted tax breaks good for state or city, bad for nation."