Business incentives – trade barrier or necessary economic development tool?

  • February 28, 2014

By Tom Syer

“Canada is a guppy in shark infested waters.” Sergio Marchionne, CEO Chrysler Group

With that remarkably candid assessment of Canada’s ability to compete with automotive industry incentives being offered by Mexico and various American states for a $3.6 billion manufacturing investment tentatively planned for the Chrysler’s Canadian operations, the company’s CEO ensured that his views hit the business pages of newspapers across Canada. And his comment was made after the Ontario government had already committed to significant tax incentives for the automotive sector and the federal government had just unveiled a budget featuring a half billion dollar Automotive Incentive Fund.

Elsewhere in Canada, the 2013 budget in Quebec saw the government of that province announce a 10 year tax holiday for major new manufacturing investments (several U.S. states have done the same in the past few years). And in the 2014 Quebec budget, the PQ government became an equity partner in early stage oil and gas drilling by agreeing to fund the majority ($115 million) of an initial drilling exploration program in the Gulf of St. Lawrence.

Also popular across Canada are a myriad labour (input) tax credits aimed at certain industries and intended to support job creation, particularly among small businesses. The more significant tax incentives in Canada have tended to centre on stimulating early stage economic activity in both the resource sector and for science/R&D projects. However, in the North American context, Mr. Marchionne may be largely correct in his comments on Canada’s ‘industrial incentives’ and the related policy objective to improve economic performance at the firm level.

In an intriguing piece of investigative journalism, over a year ago the New York Times sought to document business subsidies/incentives in American states, counties and cities implemented to date.[1] Based on an analysis of more than 150,000 data points and interviews with over 100 officials, the report found that at least $80 billion annually is being provided by state/local governments to companies across virtually every sector of the U.S. economy.[2] The findings were startling in terms of the magnitude and diversity of spending and tax incentives deployed by state/local governments keen to spur new investment, jobs and economic activity in particular industry sectors. States such as Oklahoma and West Virginia provided incentives valued at one-third of their annual budgets, while Texas, sometimes thought of as a bastion of free enterprise, led the overall charge with a stunning $19 billion in annual incentive programs.[3] The NYT’s detailed review of recent automotive sector incentives showed the remarkable degree to which U.S. jurisdictions have attempted to retain and attract investment in the shrinking automotive assembly and parts industry – perhaps confirming Mr. Marchionne’s view of Canada’s recent efforts in this area.[4]

Taking the automotive sector as a case study, recent investment numbers appear to support the observation that Canada’s automotive sector is getting ‘swallowed’ by generous incentives provided by ‘sharks’ to the south. Between 2010 and 2012, Canada received only 5.4% of the $42+ billion in North American automotive sector investment, with the lion’s share of the new capital flowing to Mexico and a number of relatively low-cost U.S. states. Part of the explanation for this disappointing performance undoubtedly lies in the fact that governments in Canada have been unwilling to match the rich state/local incentives available in the United States. The automotive sector is not unique in this regard. Similar tax incentive-fuelled competitive challenges exist in other sectors such as film, video game production, and aerospace, among many others. Governments of all stripes struggle to deal with the mobility of capital and the corresponding potential to have jobs, investment and business activity lured away by other jurisdictions that are prepared to write bigger checks to prospective investors. For Canada, there are no easy answers to the policy conundrums presented by investment competition fueled by the seemingly endless proliferation of government incentive programs in the U.S. and elsewhere.

While some suggest that governments should simply abandon tax incentives and allow the market to operate in a ‘pure’ fashion, in the real world this first-best solution has proven elusive. Governments continue to see potential benefits from incentives, which in some cases seek to address legitimate issues such as: (1) structural/ transitional economic dislocation – often manifesting in job shortages and unused infrastructure/ excess capacity (2) medium/longer term threats to future productivity improvements in existing industry clusters, sometimes stemming from insufficient R&D and/or inadequate human capital development; and (3) weak or under-capitalized businesses in potential growth sectors that are characterized by large start-up costs.

This is an area of public policy that is fraught with peril. Even the most cleverly designed incentive programs can go astray and/or outlive their usefulness. Too often industry is compelled, for competitive reasons, to ratchet up business incentive-seeking in order to stay abreast of suppliers operating in other jurisdictions. Unfortunately, as seen in the U.S. the end result can be a bizarre patch-work of business incentive programs that exhibit little policy coherence, impose heavy costs on taxpayers in general, and sometimes reflect the workings of old-fashioned pork-barrel politics. The NYT investigative report referenced earlier illuminated this stark reality in the United States in excruciating detail.

Not all business incentives are the same. Used appropriately and in a tactically limited fashion with well-defined objectives, certain types of business incentives can be effective. Worthy of mention in this regard are some of the R&D tax credit programs that have fostered advances in technology development and commercialization (although the evidence on the impact of these in Canada is quite mixed). When carefully crafted, there is a chance that government business incentives can create short term stability and provide modest assistance with transitioning an economy to areas of higher growth and increased productivity. While most economists and policy makers would (rightly in my view) argue in favour of facilitating such transitions through other means – trade policies, infrastructure reform and human capital (education/skills laws) development – business incentives are not going to be eliminated from policy makers’ toolkit any time soon. It would be unrealistic to believe otherwise.

In their worst form, business incentives are nothing more than inefficient market distortions that create trade barriers with negative impacts on the economies of all involved. As a relatively small and open trading country, all levels of government in Canada will need to tread carefully in this area – showcasing our relatively strong fiscal position and broadly competitive business tax rates, rather than inducements that competitors with deeper pockets and more desperate politicians may choose to offer.

From a Western Canadian perspective, it is easy to characterize Ottawa’s Automotive Incentive Fund as a waste of taxpayer dollars. However, rather than dismiss this incentive fund outright, we need to look carefully at why Canada is not getting the automotive and other manufacturing-related investments that other regions of North America seem to be garnering – despite having a stronger fiscal and tax framework.