A New York Times article on tax competition styles it this way, “Tax incentives to lure companies tend to help politicians, but they don’t really make economic sense.” Au contraire. That governments offer tax incentives makes perfect economic sense – pathological sense, but sense nonetheless – and politicians can’t help but offer them whether they help their careers or not.
Government tax-incentive programs reflect the Tantalus-like sense of the prisoners’ dilemma: tangible rewards for offering incentives are right there, within easy grasp. Those benefits evaporate only when one reaches for them, which one must, or else someone else will. In game-theoretic jargon, the possibility of deriving net tax revenues from incentive programs certainly exists, but never in equilibrium. It’s a tragic incentive structure, but a well-known one.
The intellectual puzzle of tax incentive programs derives from three empirical observations: First, firms pretty much end up locating in the same places with location incentives as they would if no government offered any incentives. Secondly, net tax revenue from incentive programs drive net revenue benefits toward zero for the “winning” government. Third, despite the first and second empirical observations, politicians continue to offer the programs.
The puzzle exists because we observe equilibrium behavior and do not observe out-of-equilibrium behavior. That’s what generates the NYT’s headline claim that incentive programs “don’t really make economic sense.” They make perfect sense, though, once we understand how out-of-equilibrium outcomes – outcomes we observe with zero probability – serve to enforce the equilibrium outcomes we do observe.
As with the dog that didn’t bark, we need to deduce implications of what we don’t observe. To do so, first consider this counterfactual: What if no local government offered firms (specifically, mobile capital) tax incentives to locate within its jurisdiction. Firms would naturally locate facilities where they enjoy least-cost production; local governments would realize tax revenues and development gains generated by the firms’ location choices.
It’s obvious, though, that having all governments refuse to offer location incentives cannot be equilibrium behavior: If all governments refused to offer any incentives whatsoever, then one government deviating from that universal refusal could offer a location incentive, an incentive that would both alter the firm’s location decision and leave the deviating government better off.
Say there’s a neighboring city to the city where a firm initially plans to locate. The neighboring city is not quite as good for the locating firm as the original city. Still, it’s pretty close. If the neighboring city only threw in a few incentives, it would make it profitable for the firm to locate within its jurisdiction rather than in the city it initially considered for its location.
In our counterfactual world in which no city initially offers location incentives, the neighboring city’s deviation is unique. Because the other city has no competing incentive program, the neighboring city can offer modest incentives, attract the firm away from its original location, and still realize net tax revenues.
The original city will obviously respond. Before getting to that, however, we need first stop to consider what we just saw. In a world with no incentive programs, a city could gain by offering even modest location incentives. The program would affect the location decision of the firm, and the city would realize next tax revenues from the program.
Therefore we know that counterfactual in which no city offers an incentive program cannot be an equilibrium. It is not an equilibrium because incentive programs can be extremely effective in influencing location decisions.
The story is unfinished, however. The original city will not sit idly by as the neighboring city lures the firm away. Given the firm would realize least-cost production in the original city (tax inducements aside), the original city need only match the neighboring city’s incentive to induce the firm to stick to its original location plans.
The original city responding with its own incentive program also does not end the story. The cities offer the firm ever more-lucrative location incentives. We now have “competition” between the local taxing jurisdictions. The equilibrium is this: The neighboring city offers incentives just equal to whatever benefit it would receive from the firm locating in its jurisdiction, the original city matches the neighboring city’s incentive offer, and the firm locates in the city it originally would have located in.
Note the empirical observations associated with the equilibrium. The firm locates in the same city it would have located within had neither government offered an incentive program, the net tax revenues of the “winning” city are driven toward zero, yet politicians in both cities can’t help but offer incentives to the firm because incentives could extremely alter the firm’s location decision.
To be sure, if there were only two competing jurisdictions, they could perhaps gin up some sort of oligopolistic collusion to maximize joint tax revenues. But the possibility of collusion becomes increasingly difficult with larger numbers of competing jurisdictions. Simply consider the difficulty OPEC has colluding on oil prices among themselves with just twelve members.
The welfare implications of competition between governments are not as clear as those flowing from market competition (in which price competition induces firms to dissipate economic profit in a fashion analogous to tax competition driving down tax revenues). Indeed, solving particularly pathological competitive dynamics among the U.S. states served as a, if not the, major stimulus for adopting the U.S. Constitution. Still, whatever the welfare implications of tax competition, tax competition between cities, states and nations make perfect, if perfectly pathological, economic sense.