Bad Tax Competition

November 23, 2009

Federalism is generally a good thing. States compete for business and residents, hopefully moving closer to some optimal level of governance. And if one thinks this optimal level of governance includes low and non-distortive taxation, and that other individuals think so too, then federalism can do good things. When a market is competitive one gets better products. Why should this not hold when governments compete?

There are differences between a market and the political. First, a government is not spending “their” money on a product. They compete with other states using funds taken by taxation. This means there is a chance, like with all government spending, that the interests of citizens and politicians diverge. It is wrong to assume that states always compete for the best business climate. They might compete for a single industry or special interest group.

It’s how you get bad ideas like ever generous (until possibly this recession) film tax credits. Or this latest hood ornament on the corporate welfare Cadillac GM has been leased:

General Motors Co. is promising to keep its headquarters in Detroit in return for expanded state tax credits.

The Michigan Economic Growth Authority on Tuesday approved extending the tax credits to include workers at GM’s Renaissance Center headquarters. A final agreement will be voted on next month.

The agreement says GM must keep 22,500 employees in the state rather than just 20,000 to get tax credits, including around 2,500 in the Renaissance Center. About 4,000 people work there now.

Why would Michigan not cut taxes for all business—what makes GM special? The answer is likely political. Having GM headquartered in Detroit is good for those 4,000 employees working now and possibly good for the other 20,000 or so employees GM promises to keep (assuming those workers would not find more sustainable employment than GM), and for whatever industries benefit by GM sticking around (again making some assumptions). But it is especially good for some backward looking politician clinging to a decades old image of Detroit:

Gov. Jennifer Granholm:

“From a symbolic and a real perspective, it is incredibly important,” she told reporters. “The city, obviously, benefits enormously from having those employees there in the Renaissance Center. It’s iconic. It’s a symbol. For it to abandon Detroit would send a terrible message.”

Michigan competes with other states not to have the most businesses or jobs, but for GM business and GM jobs. Government competes for a special interest; great for GM this time. It makes sense from a public choice perspective. Politicians might benefit more by satisfying a minority instead of all businesses and they surely get more attention by the minority.

One might suggest this behavior as short-term. During hard-times for government revenue or leaps in voter consciousness luxuries are discarded. In the long-term a state will stumble upon what is best for all residents. But I’m not sure I see why this is necessary—that some historical dialectic toward better tax policy must exist. As long as institutions and incentives remain how they are, states will be tempted to provide non-neutral tax policy and subsidize a minority. It is the same thing that happens within a state, but may be exacerbated by competition.

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