Concentrated Benefits, Diffused Costs
The Kansas City Star has some disappointing news:
A special legislative session offering incentives to Missouri’s automobile industry was transformed Tuesday into a tax-break boon for elderly homeowners, airplane makers and more.
The Missouri House passed legislation extending tax breaks to senior citizens, computerized data centers and manufacturers in a broadly defined transportation sector encompassing everything from bicycles to rockets and food-vendor carts to floating offshore oil platforms.
My colleagues and I have have been arguing voraciously against other companies that seek handouts from the Missouri state government. Other states are discovering that tax credits fail to deliver the results that they promise, and I have heard no convincing reason to believe that targeted tax credit programs will work any differently in Missouri.
From the perspectives of economics and fairness, these programs defeat their ostensible intended purposes: encouraging employment and helping states compete. In subsidy programs, the state government redistributes wealth to special interest groups in the form of concentrated benefits (e.g., sugar substitute manufacturers, data centers, ethanol producers, car manufacturers) and it diffuses the costs of these benefits to all those who remain unsubsidized in the marketplace.
Whenever the government subsidizes an activity, it comes at the expense of other activities. This is because time, money, and resources are scarce and finite. As a result of its decision to subsidize an activity, the state government incites individuals and businesses in Missouri to divert resources from other productive uses and invest them in activities for which they have a higher opportunity cost than others. By subsidizing these activities, the state gives up marginal levels of productivity. Missourians would be better off if each market participant specialized in the activities that they do well and profitably without the need of a subsidy, and left the production of other things — such as vehicles — to those who posess a comparative advantage in producing it. By focusing on profitable non-subsidized economic activity and then engaging in trade with others, overall levels of productivity and consumption will increase.
There are two systems within the unrestricted market that are better than tax incentive programs at promoting productive economic development: the price system and the profit-loss system.
The price system is a better means of achieving an efficient allocation of goods and services than targeted incentive packages. Prices coordinate individual action efficiently by communicating relative scarcities and preferences, but government officials knock the price system out of this equilibrium whenever they decide to subsidize or restrict an economic activity. This results in a misallocation of resources, and produces a market bubble that will eventually burst, as the subsidy ends. (Will Missouri host the first sugar substitute bubble? I hope not!)
Allowing the profit and loss system to allocate resources efficiently in a free market is better way to encourage economic development. However, when the government intervenes in the market through targeted subsidies, the “loss” signal is muted as a consequence because producers are at least somewhat insulated from risk. As an additional consequence, producers have less of an incentive to respond to consumer demand, which mutes the incentive for producers to target their operations efficiently. For example, as a result of agricultural subsidies and tariffs, much of the sugar that we consume in the United States is made from beets instead of from sugar cane. This is a less efficient process of making sugar, and consumers pay a higher price for it.
Government should focus on providing the basic institutions that foster reliable market exchange (e.g., enforcing contracts, backing currency, etc.), instead of favoring losers in the marketplace in the name of economic development.