Prisoner’s dilemma

Tax incentives risk actual benefits

Toyota and Mazda are looking for a spot to park their new joint assembly plant. The company issued a blind request for states to submit proposals for the $1.6 billion plant that is expected to employ 4,000 people. Arkansas and 14 other states responded by submitting preliminary bids of state assistance programs.

Despite the excitement surrounding the project, Arkansans should be wary of the prisoner’s dilemma that Arkansas officials have begun to play.

The prisoner’s dilemma is a famous game-theory example that compares cooperative and competitive strategies. In the iconic version, two suspects are interrogated in separate rooms. If both are silent, they are punished lightly. If only one confesses, he receives immunity while the holdout receives a severe punishment. If both confess, both are punished moderately. Each suspect has a strong incentive to confess, but this could result in both receiving harsher punishments.

This model can help us think more clearly about the decisions individuals may make under similar real-world situations. How does it work with regard to interstate competition for businesses? Let’s use a simple example. Assume that Mississippi and Arkansas are the only two states competing for business locations. Each state has two options—refrain from issuing incentives or provide them.

If Mississippi and Arkansas both refrain, each state will receive business investment based on the natural advantages of the state—without having to spend tax dollars or forgo tax revenue. However, Arkansas can capture a greater share of business investment if it offers special tax breaks and subsidies to companies while Mississippi refrains. In this case, Arkansas gets a little more than its natural share while Mississippi gets a little less. Similarly, if Arkansas refrains, Mississippi can capture a little more while Arkansas gets a little less.

The prospect of capturing a larger share of business investment leads both states to provide special tax breaks and subsidies. But doing so lands both states in a worse position than they would have been in if they had both simply refrained. Both Arkansas and Mississippi may now incur substantial fiscal costs to possibly receive no more than their natural share of business investment. The two states would have been better off by cooperating with each other to refrain from providing incentives.

This dynamic leads to costly arms races between states, with each state gunning to provide bigger and better incentives to attract more businesses. The W.E. Upjohn Institute, an employment research organization, estimates that the cost of targeted economic development incentives nationwide has more than tripled since 1990, reaching $45 billion in 2015. Even worse, business leaders—who are keenly aware of the problem—exploit it by pitting state governments against each other to drive up the value of their incentive packages. Consider the cost of luring an auto assembly plant.

According to data from Good Jobs First, an economic development incentive resource center, Kentucky taxpayers paid $109,297 per job (inflation-adjusted) to land a Toyota assembly plant in 1985. In 2007, a separate Toyota assembly plant cost Mississippi taxpayers $204,885 per job (inflation-adjusted). The 2007 price per job was nearly double the cost in 1985!

With costs rising, states increasingly risk overpaying for projects that fail to deliver the expected economic benefits.

Arkansas should resist this temptation. Most business location decisions are made for reasons other than for targeted economic development incentives.

Firms choose locations based on whether a locality has positive spillover effects from nearby firms (think Silicon Valley and tech firms), sufficient amenities for workers and owners, a labor force that meets the firm’s needs, labor unionization, and many other factors.

Some will reject this logic and insist that Arkansas must continue to play this game because other states do. But there are other ways to win at this game. The federal government could change policies to reduce the use of state and local incentives. After all, the majority of leading economists polled in the University of Chicago’s IGM Forum agree that the United States as a whole does not benefit when states compete with each other by providing economic development incentives.

But Arkansans don’t need to wait for the Feds. Arkansas officials could coordinate a truce among regional states, similar to the proposed truce between Kansas and Missouri. It would be a lot of work, but Arkansas could save tens of millions of dollars every year by cooperating with neighbors instead of competing with them.