How to End the Incentives Arms Race

July 16, 2018

Professor Aaron Chatterji proposes new economic development model

Professor Ronnie Chatterji With Students

As Apple and Amazon choose locations for their next facilities, attention is focused on the billions governments spend to keep or lure large firms and the economic growth they bring.

Recent analyses have found states alone spend at least $40 billion annually on incentives, in the form of tax breaks and even cash handouts. But Aaron Chatterji, a professor of strategy at Duke University’s Fuqua School of Business, believes there’s a better way to foster successful entrepreneurship. In a policy proposal for the Brookings Institution’s Hamilton Project, Chatterji suggests creating a Main Street Fund that would move policymakers away from incentives and toward helping smaller businesses get off the ground.

Chatterji expands on his idea in this Fuqua Q&A.

What’s wrong with incentives for large firms? Why can’t governments just stop offering them?

Governments at all levels spend money to promote entrepreneurship, but they spend significantly more on incentives for existing firms. Voters seem to like incentives, as research shows voters tend to reward politicians we think are fighting for jobs. But a lot of economists are skeptical about the benefits of this approach to the overall economy. Evidence suggests younger, smaller firms drive job growth, and giving out incentives to individual companies disadvantages new firms. Also, the lost government revenue can do significant harm to the U.S. economy, leading to less spending on schools and health care.

But suppose one governor said they were no longer willing to spend tax revenue to reward a single company, especially when they would have to keep offering more over time to compete with other states. If only one governor does that, it’s just one less competitor for other states who can sweeten their own incentive deals and lure that company away. The governor who took a stand could easily end up being punished by voters for losing jobs. So no single governor can commit to not offering incentives. We need a different approach.

Instead of playing this game of incentives, many policymakers and economists are looking for a new way to do economic development. And we need one: the rate of new business starts has been declining for most of the past three decades, even in the high-technology sectors that we tend to think of as the most dynamic.

How would your Main Street Fund proposal work?

It’s a simple idea that would start at a relatively small scale – $5 billion in the first year – and ramping up only after careful evaluation and satisfactory results. The Main Street Fund would reward states for taking money out of economic incentives for large companies and investing them in evidence-based approaches for improving the grass-roots environment for entrepreneurship – policies and procedures that are proven to work, and which don’t just reward single companies, but create a level playing field where anyone can start a company and succeed.

Each state would be allocated funds based on population, demographics and economic activity. States would have their Main Street Fund payments reduced if they provided any new incentives to single firms, and they would receive extra credit if they canceled existing incentives. The total cap on Main Street Fund spending, as well as each state’s individual cap, would contain the risk for the federal government.

The fund would be housed in the Department of Commerce and administered by the Economic Development Administration, which already does a lot of work on regional economics.

What kinds of programs would the fund support?

There are four categories of programs to which states could apply their Main Street Fund allocation, categories with programs that have been evaluated, or are measurable. A percentage of funding would be set aside for continued monitoring and evaluation.

The first category is investment in management training. Research is showing firms with better management practices have superior performance. The second is enhanced reciprocity across states for licensed workers. Occupational licensing impedes worker mobility and has been shown to affect startup rates. The fund could reimburse states for recognizing out-of-state licenses.

A third category is investment in broadband infrastructure, which is associated with economic growth. Access to high-speed internet is essential for many entrepreneurs, especially as they increasingly depend upon cloud-based software programs to save time and money.

Finally, the Main Street Fund could offer customized initiatives for new firms by supporting state programs that explicitly target firms that are less than five years old, have high growth potential, and possess certain attributes that have been linked to growth in prior research.

What’s to stop states from gaming the system by providing incentives under a different name to avoid losing their Main Street Fund dollars?

The program is designed to mitigate this problem, because states have two reasons to report any such behavior by other states. First, no state wants any other state to be spending money on incentives that would give them an advantage. But more importantly, states have a reason to police one another because the cap on a state’s allocation from the Main Street Fund is increased when other states receive smaller grants. If we can invest in the Main Street Fund, we can create more opportunity for all.

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