Monday, November 17, 2014

Can You Buy Economic Growth?

When you pose the question in that form, the answer should be obvious. Yet time and again we see well intended but mistaken people attempting to get something for nothing. Let’s take a hypothetical example that we see in real life quite often: a city offering a business economic incentives to invest in that city.

In this example we’ll assume the following:
  1. That Company XYZ is looking to create a new research facility.
  2. That the facility will be staffed with 20 new employees (not being relocated from elsewhere in Company XYZ's organization) who will earn on average $100,000 per year in total salary and benefits after taxes. $2,000,000 in NEW JOBS!
  3. That Company XYZ will build a brand new facility on what is currently raw land well within the heart of the city in which it ultimately chooses to locate.
  4. That the facility will be built by a local construction firm resulting in a $1,000,000 net profit to the construction firm.

It has narrowed the search down to Oklahoma City and Wichita, Kansas. From Company XYZ’s point of view and analysis the cities are essentially identical, but rather than flip a coin to determine the winning city, it will conduct a game where both cities compete to attract the investment.

The game involves both city governments coming up with incentives to entice Company XYZ, which essentially means each government taking resources from its citizens to give to Company XYZ’s shareholders. The first important point to make is that economically this is at best a zero-sum game and at worst a negative-sum game—at best the economic result is a breakeven; at worst (and likely) the game destroys resources. What is gained by Company XYZ’s shareholders is lost by citizens of the “winning” city. And IF there are economic gains to being the winning city, those gains are foregone by the losing city; hence, playing the game does not change the economic pie of the total economy. It is likely a negative-sum game because playing the game is not free. It takes resources to at the very least organize an incentive plan, tax the citizens to pay for it (or seize their land), and distribute the lucre incentive package to Company XYZ.

However, being the self-centered people advocates for the game playing must believe them to be, both cities* care only about its own economic gains. Thus, each will evaluate the game outcome only on the basis of how it affects its own city’s economy. Since I live in Oklahoma City, I will present it from the perspective of “us” being OKC.

So are there economic gains to be had? Well, let’s start with the construction of the facility. There is a $1,000,000 profit to be had there. Being the winning city is worth at least $1,000,000. In terms of aggregate economic gains for each city, we don’t care that the gain will go to a single construction firm (a concentrated benefit) at the expense of taxpayers in general paying for whatever incentive package is created (a diffused cost). We might care about the distributional effects (are we taking from poorer taxpayers to give to the richer construction firm?) and we should care that the construction firm might encourage an incentive package worth more than $1,000,000 (an effect of the concentrated benefit/diffused cost**). But the economic gains imply we should spend up to $1,000,000 to get the facility.

Of course, Wichita has the same incentive. How will this play out? It is likely the incentive package will be bid up until all the gain (or more) goes back to Company XYZ—the winning incentive package will be $1,000,000 (or higher). I hear your protest, "But wait, aren't there other economic gains? What about the 20 $100,000 jobs? Giving up the $1,000,000 related to the construction seems a small price for $2,000,000 in NEW jobs." Okay, let’s look at jobs.

Remember that jobs are a means, not an end in themselves. The economic gains from a new job is illusory. If we assume the 20 employees come out of the local economy, we have to consider that they came from somewhere. The personal gain to each is the difference between what they had before and what they have now in the new job (i.e., what total wages and benefits they were expecting to make before compared to the new job’s $100,000). Even if they were unemployed, it is bad economic reasoning to assume their gain is $100,000 annually. We need to compare their next-best alternative, which surely was not zero income for life. It may have been government assistance and family support, but it was more likely the prospects of another job very similar to the $100,000 one at Company XYZ. Why is this so?

Effectively workers compete for the new jobs by offering to work for less than competing workers.*** This competitive process tends to eliminate candidates starting with those who have the most to gain from the new job. In a moderately large economy the eventual candidate pool will be those who would only slightly benefit from taking the new job. Therefore, regardless of what they were doing previously, it is highly likely that the new jobs are only marginally better for the workers who get them.

To be generous, let’s assume the new workers all come from another city—might as well assume Wichita while we’re picking on them. Don’t these new entrants into the local OKC economy represent economic gains in the form of growth? Yes, they do.**** And we can roughly approximate the gross gains to OKC's economy as being $2,000,000 per year. The net gain will be somewhat smaller as these new entrants use city resources, etc. Let’s ignore those costs, though, and just stick with the $2,000,000 figure. Again we are back to the courtship competition between the two cities where each will pay Company XYZ the equivalent of $2,000,000 per year to be the winner.

Let’s tally winners and losers:

Company XYZ (it captured all the gains to be had from the winning city)

Both cities (they each used resources campaigning; the winning city gave up all the economic gains to Company XYZ)

People in the winning city who now have new neighbors

People in the cities from which the relocating employees left

Construction firm

Employees (but only marginally)

This analysis used precise assumptions about profits and jobs that are unrealistic. In reality these facts would not be known with certainty and would almost certainly be very out of analytical reach for the city governments. They are ill-equipped and ill-incentivized to discover and estimate these facts well. Notice we didn't talk about cronyism or corruption. We ignored any fanciful, magic multipliers that would imply a $2,000,000 new job infusion would create more than $2,000,000 in economic gains. The burden of proof is on those who would refute this analysis. Wanting it to be different is not the same as it being different. Quit basing economic and political decisions on hopes, good intentions, and "great" leaders performing miracles behind the curtain.

*Here is the first flaw in this line of argument advocates make. Cities don’t have cares or opinions. Only people within cities have cares, and those cares are not uniform or identical.
**See the late Gordon Tullock and public choice economics.
*** The transition mechanism for this is indirect; so don’t get caught up in the fact that you have never witnessed it directly. It is a market-driven process largely unseen to market participants just as the price of my iPhone accounts for the use of expensive elements like praseodymium, gadolinium, and terbium even though I didn't know those even existed until reading an article about rare elements in iPhones—and I still don’t know and don’t need to know what they do.
****I am assuming the cities want (there I go again) economic growth. It is not at all clear that all members of each city desire this. In fact a lot of behavior, from zoning laws to grumpy complaining to moving just outside of the city, demonstrates that people are not that keen on economic growth.