Which Economic Development Policies Work: Determinants of State per Capita Income

Abstract Economic development policies add to state economic efficiency and welfare if they compensate manufacturing firms for the positive externalities they produce. Incentives which try to alter business behavior, but do not produce positive externalities greater than their costs may, however, distort the market-place and result in reduced state economic efficiency and welfare. This article reports the results of a pooled cross sectional time series analysis that was conducted to estimate the influence of different types of economic development policies on one measure of overall welfare, change in state per capita income, for the years 1979 through 1995. Results suggest state development policies which offer tax breaks to all manufacturing firms, and programs which offer state loans and loan guarantees for all manufacturing firms, are positively related to growth in state per capita income. Programs which attempt to elicit specific firm behavior, such as incentives for new investment and incentives to create jobs, were negatively related to growth in per capita income. Demand side entrepreneurial state policies had no significant influence on per capita personal income. Introduction State policy makers invest in economic development policies as a means of reducing unemployment, attracting new capital investment, and building a larger tax base. But states have often invested blindly, not knowing which economic development policies actually achieve these goals. Proponents have made plausible cases for competing economic development policies, including: tax breaks for industry, tax breaks and/or subsidies for firms locating in the state, tax breaks and /or subsidies for existing plant expansion, and even social programs recast as investment in human capital. At the same time, critics have questioned the efficacy of economic development programs, suggesting states are competing against themselves in a zero sum game. The critics make an equally convincing case that converging state economic development programs cancel each other out, and only succeed in plundering state treasuries without any real benefit. Hampered by a lack of consensus on a theoretical model to explain economic development and the lack of a consistent body of evidence about which, if any, economic development policies have an impact on economic growth, states have been forced to rely on educated guesswork when adopting economic development policies. Economic development policies can be theoretically justified on the grounds they improve economic efficiency and therefore the welfare of state citizens. Yet a lack of a clearly reasoned and empirically tested economic development strategy may cause states to squander scarce public resources on projects which cost more than the benefits those projects will deliver to its citizens. Inefficient economic development spending may reduce, rather than enhance, the efficiency of the state economy and the welfare of state residents. This study will first differentiate industrial development policies by what type of incentive they offer to encourage industry. Second, this study will test which strategies contribute to economic efficiency and welfare, and which do not. If economic development policies can be justified on the grounds they improve economic efficiency, then a positive sum game is possible. State intervention may improve the efficiency of the market and total welfare because the market does not take externalities into account when setting prices and the quantity produced (Feiock, Dubnick and Mitchell, 1993: p. 61). The argument for state involvement in economic development is similar to that used to justify public aid to higher education. The state supports education because it generates positive externalities. Externalities occur whenever a private transaction creates either costs or benefits to a third party not involved in a transaction. The positive externalities which occur when a student receives higher education include: the student becomes a more informed citizen, a more productive employee, and is likely to contribute more in taxes during his/her lifetime. …