The Federalism Project
Issues Paper No. 5
INTRODUCTION AND SUMMARY
One of the problems which stands in the way of discussions of Competitive Federalism in Australia is that most State governments are prepared to compete among each other with subsidies and other discriminatory measures. Some States will go to extraordinary lengths to tempt an investor, a project or a spectacle away from another State. So, Victoria pulled off a "coup" in getting the Australian Grand Prix transferred from Adelaide to Melbourne. Or Victoria and New South Wales competed for a new film complex by bidding with hand-outs of government money. Or scarce taxpayers' money is offered around for a paper factory, a minerals processing plant, a computer software centre, a flight-training facility, or the honour of being the home base of the Australian Stock Exchange.
After the event, it usually becomes clear that such "coups" had a high price. The "victorious" State government has handed over a prime piece of real estate for next to nothing; has guaranteed to build some costly infrastructure; has offered a five-year holiday from payroll tax; or has promised to buy most of the product from the preferred company ... There are many variations on the theme.
Sometimes the voters are impressed -- or, if they are in the losing State, upset -- and sometimes they are not. Voters have perhaps become more cynical, since long experience tends to indicate to them that the benefits are rarely all they were cracked up to be. In the meantime, voters and established businesses have been paying the price for the politicians' initiative, and faith in the political process has taken another bad dent. When artificially-attracted ventures finally fold, the politicians tip-toe away from the wreckage.
But isn't this what competition is all about? Wouldn't we see a lot more of this if Australian federalism was more truly competitive?
The answer on both counts is: No. In fact, competition by subsidies to selected and well-connected new investors -- which one may call "bidding wars" -- is a product of the design faults which now plague Australian federalism. Those faults actually encourage administrative and political irresponsibility, and a better-designed system would tend to lessen this defect very considerably.
To clarify these issues, we shall first briefly repeat here the arguments put forward in an earlier paper, Competitive Federalism: Promoting Freedom and Prosperity, before making a case against "bidding wars" and discussing a way to end the practice.
This paper makes two major points:
- Competition between State and local governments serves citizens, fosters prosperity and helps to nurture the tax base. Many government functions should therefore be devolved to lower levels of administration where they are subject to the competitive discipline of inter-jurisdictional competition.
- Certain means of inter-State competition are ruinous: offering selective preferments and subsidies that discriminate between different firms and citizens should be banned.
* * *
Australian federalism has become more and more centralised since Federation; at the same time, governments competed less and less with each other. Fiscal centralisation was part of a set of inward-looking, dirigiste policies which became known as the "Australian Settlement". It failed; and most of its components have been progressively jettisoned since 1980. As of the mid-1990s, the cartel of non-competitive Federal, State and local administrations is the major remnant from the past, and it is one of the main impediments in the way of more successful Australian responses to the challenges of globalisation.
After Federation, governments developed a selective and discriminatory style of development policy, relying on hand-outs to specific investors, instead of concentrating on effective administration, nurturing a competitive cost level for the benefit of all comers and cultivating the long-term revenue base by fostering broad economic growth. They were able to do so partly because the country was isolated from world-market competition for such a long period. But here as elsewhere, such "picking the winners" policies frequently ended up with politically-picked losers. This style of policy corrupted politics, public administration and industry. In the 1990s, as the competitive forces of globalisation are becoming more pressing, such policies seem even less promising. Yet some State governments are resorting again, and more blatantly, to selective subsidy policies, even though this erodes their future revenue base and is grossly unjust to established residents.
Since the States claim that they are caught in harmful "bidding wars", this essay argues for a "treaty of subsidy disarmament" between Australian governments to ban selective hand-outs and to confine inter-State competition to general policy measures that offer competitive tax regimes and attractive public services to all comers without discrimination. Disputes over the implementation of such an inter-governmental agreement should be adjudicated by an expert body such as the Industry Commission and need to be enforced by the collective action of all Australian governments.
Given recent experiences, and Australia's culture of selective interventionism, a ban on secretive and selective subsidy policies seems necessary, if the nation is to reap the great benefits that Competitive Federalism has to offer.
THE BENEFITS OF COMPETITIVE FEDERALISM RESTATED
In an earlier publication in this series, I argued for a more competitive approach to the Australian federation by State and Commonwealth governments (Wood, 1995). I made the case for reversing the historic drift toward centralisation of fiscal affairs in Australia. To be sure, centralisation had been part and parcel of the "Australian Settlement", a compact that emerged early this century under which governments promised to provide Australians with material security and equality -- by tariff protection, central wage fixing, the White Australia policy and other dirigiste devices (Kelly, 1992). The "Australian Settlement" failed, and most of its elements have been discarded. As of the mid-1990s, the centralised "cartel" of government administrations seems the only pillar of the failed "Australian Settlement" which still remains more or less intact. It is now becoming a big hindrance to managing our national affairs in a more competitive, individualist manner and in a manner that allows us to take up the challenge of globalisation more successfully by trading and by attracting more capital, knowhow and enterprise.
A strong case can be made for devolving many of the tasks that the Commonwealth government has taken over, and to rely more on what has become to be known as subsidiarity, the maxim that the lower level of government should always carry out the tasks of governance unless there is a proven case for a higher level to take over -- if doing so, for example, reduces transaction costs or facilitates economies of scale (Wood, 1995). The basic reasons for preferring subsidiarity are that governments which are closer to the citizen find it harder to act against the citizen's interest, and that the knowledge necessary for citizen- and business-friendly government can be more easily marshalled and monitored within smaller, lower level jurisdictions. Moreover, decentralised government administrations are fairly open to horizontal competition with other local and State governments. This exerts cost controls, favours small government, nurtures accountability, and controls well-known agent-principal problems in governance. Should lower-level governments get captured by single-issue pressure groups and grant them preferment at the expense of the general taxpayer, this tends to be more readily exposed and controlled when administrations have to compete with other administrations than is the case when similar preferential deals are struck in distant Canberra. States that have to compete -- a condition not always given in present-day Australia -- are therefore less likely to fall prey to selfish interest groups and less likely to engage in costly, grandiose schemes that taxpayers do not really want.
In the literature on business economics, it has been established that agents who manage the principals' capital -- that is, the appointed managing directors in a firm -- may disregard the principals' interest and opportunistically pursue their own agendas. This is known as the "agent-principal problem". But it has also been established that competition in capital and product markets acts as a powerful control of the agents' self-seeking pursuits. Similarly, we can conclude that inter-jurisdictional competition of governments in a decentralised federation controls the self-seeking tendencies of the political and administrative agents and empowers the principals, namely the citizens and taxpayers (Kasper, forthcoming, 1996).
Subsidiarity has to be given substance by implementing a number of supplementary principles (for details, see Wood, 1995):
- Exclusivity: The government's tasks have to be assigned exclusively to the various levels of government to avoid shirking and duplication and to enhance accountability and clear responsibility. In Australia, the Federal government has usurped more and more functions -- in education, health, policing, environmental control and many other areas -- and now duplicates what the States are doing, often at great cost and with no improvement of service. Now governments are able to pass the buck, and the citizen, when faced with government failure, no longer knows whom to hold responsible.
- Fiscal equivalence: Each level of government is responsible for raising the revenues necessary to finance the tasks it has been assigned. There should be a ban on vertical fiscal transfers. This will avoid the "moral hazard" now observable, whereby State and local governments can initiate spending programmes without the discipline of having to raise taxes, and the "moral hazard" of voters who demand spending programmes and elect "generous" politicians without having to face the immediate tax consequences. In Australia, fiscal equivalence will require a more broadly-based tax regime that frees the States from the present strait-jacket of artificially narrow revenue sources.
- Rule of origin: In the interest of competition among producers in various States, it has to be ensured that a product or service which is legal in one State can be sold, without further ado, throughout the federation. This encourages a competition between regulatory orders and exposes government controls to the verdict of the market. It tends to lead to a streamlining of regulations, and would make Australia as a whole internationally more competitive.
We shall argue below for a further principle of policy that is needed to add substance to subsidiarity, namely, a ban on discriminatory interventions and subsidies to benefit selected beneficiaries, which are not available to all comers (universal measures).
Once such a system, which we call "competitive federalism", is in place, certain observed shortcomings of our present federation would be reformed. For example, competing jurisdictions would find it in their own self-interest to be more open and accountable, disclosing information and adhering to stable, transparent rules in reporting their finances. Once there is more leeway for competition, inter-State comparisons and public scrutiny of comparative performance would be carried out to a much greater degree than is the case at present, and the often secretive cartel of Australian governments would disintegrate.
In Competitive Federalism (Wood, 1995), we made the case that encouraging administrations to compete more independently with each other in providing the best administrative and infrastructural support services for citizens and producers, would produce a number of important advantages:
Governments would be forced, to a much greater extent than is now the case, to support productive efforts by people and businesses; they would have to nurture their own long-term revenue base by nurturing economic growth within their jurisdictions. This would make an important contribution to the general rise in living standards, a score on which Australia has not done well -- though not disastrously poorly either -- for most of this century.
In the present process of globalisation, in which free information flows and low transport costs have given highly-skilled people, capital and enterprises great mobility among nations and regions, Australia faces the novel challenge of having to become more competitive in attracting these mobile growth factors. If State (and local) administrations competed more with each other, they would learn better how to lift Australia's overall attractiveness and competitiveness. They would streamline cumbersome and costly regulations, find new administrative devices that attract productive people, capital and enterprises, and quickly imitate what works elsewhere, while jettisoning administrative solutions that will fail in the changing global climate. The whole "culture of governance" would become more business- and citizen-friendly as a result (Giersch, forthcoming, 1996).
Governments that compete with each other serve their clients: the citizen is king. Government powers to make arbitrary, opportunistic decisions are controlled. Under our centralised fiscal regime, Australian State and central governments have, as mentioned, often been able to act as self-seeking monopolies, frequently offering poor service at a high cost. When what has been termed "systems competition" among various jurisdictions is introduced into fiscal affairs, parliamentarians and government administrations will become more efficient, just as most private monopolists, when exposed to competition, discover how to offer better service and cut costs.
This point is clearly supported by historic experience. Post-mediaeval Europe was transformed for the better when absolute power was brought under control as the small, open states and provinces of Europe had to compete for footloose producers (Weber, 1927 [1981]; Jones, 1987). More recently, regimes with little innate respect for individual freedoms, the rule of law or democracy in capitalist East Asia, the socialist bloc and elsewhere have likewise -- and out of their very self-interest -- been induced to enhance liberty, to open up and to attract and foster mobile resources for growth. In the process, they discovered that inefficient bureaucracies and power-centred politics are liabilities which have to be reformed for the sake of better competitiveness. In a similar vein, the opening of the Australian economy after 1980 has led to some increase in the rivalry among Australian governments at State and local levels. This, in turn, has begun to improve the efficiency of governments, and led to some, albeit reluctant, streamlining of administrative procedures. But genuine Competitive Federalism is needed to ameliorate further the liberty of the citizen, to control corruption and insider dealing among political power-brokers, and to enhance the quality of our democracy.
Democratically-elected governments in virtually all Western countries have been making numerous promises which they have not kept. This -- and the presumed sovereignty of parliaments to hand out privileges -- has eroded electoral confidence and given rise to a degree of voter disaffection with politics. It could, in the long run, undermine the very stability of democracy. Governments and leaders now face an empirically well-founded credibility gap with the voters. While the disillusionment with government and democracy in Australia is less advanced than, for example, in Europe, Australian parliaments and governments will nevertheless have to earn public support for collective action and the voters' confidence. They can do so by competing successfully with each other, striving to offer voters what they, the sovereign citizens, really want. (1)
To promote these goals, Australia's fiscal constitution would need to strengthen fiscal self-responsibility in the various jurisdictions and subsidiarity (Wood, 1995, pages 31-44; also Walsh and Fletcher, 1994; Glaeser, 1995).
The arguments in Competitive Federalism (op. cit.), though generally well-received, dealt insufficiently with one question, which some correspondents -- and events during 1995 -- laid bare: What if State and local administrations compete with each other in attracting capital and enterprise by subsidising specific firms in "bidding wars", instead of getting the fundamentals of genuine competitiveness right? What if politicians and administrators, when confronted with the growing mobility of capital and enterprise, resort to secretive case-by-case preferment and discriminatory interventions, and use special deals to reap political benefits which undermine general efficiency and equity in ways that are only too well known from public choice theory and the literature on rent-seeking (Downs, 1957; Buchanan and Tulloch, 1965)? What if State governments "buy themselves companies", only to discover later that they "invested" in the wrong assets, reaping poor growth, job losses, weak future revenues and budget deficits? What if State governments grant specific suppliers a monopoly, on the condition that these suppliers set up production facilities in the State -- for example, by promising to buy all computer-support services from the one monopoly supplier -- only to rediscover the time-tested economic law that monopolies guarantee high costs and poor quality?
These questions pose serious challenges to the concept of Competitive Federalism. They are the focus of the remainder of this paper.
GLOBALISATION POLARISES GROWING AND LAGGARD STATES
Globalisation exerts new competitive pressures on ailing regions and States that may have been protected in a closed economy and in an era where fiscal transfers to ailing regions were quasi-automatic. Now, ailing States have to reform their approach, but frequently find it hard because they suffer from poor revenue, budget deficits and high debt burdens. The "ailing region dilemma" for governments in charge of such areas cannot be solved permanently by more government borrowing: nowadays, high public debts are seen by mobile investors as foreshadowing high future taxes, and thus become a direct competitive weakness. Governments of economically ailing States and cities then tend to resort to desperate and dubious measures, which increase the probability that their leaders will become mayors of ghost towns and premiers of backwater States. By contrast, prospering States and regions with competitive economic structures and good government attract more growth resources and become even more successful. Their tax base grows, so that administrative services and infrastructures can be provided at relatively competitive tax rates, a factor that further enhances their competitive position. This is the case in Queensland or in "growth poles", such as Singapore (see graph, page 7 below).
In flexible market economies, the polarisation between prospering and declining regional polities tends to be overcome naturally by the decline in land prices and real wages in the ailing regions, and price-rises for land and labour in overheating growth regions. Free markets eventually restore the regional balance in growth opportunities. Local political interests, however, tend to mobilise against land-asset price deflation and real wage declines, so that political interventions occur against the restoration of equilibrium by market forces. In the modern economy it takes bold leadership to rely on the self-healing forces of markets, instead of resorting to populist activism that deals with the symptoms, rather than the causes, of relative economic decline.
When a region or State is caught in a spiral of decline, and markets are hindered from reacting flexibly, unemployment results. Workers then have to follow the investors to the attractive regions. Their houses fetch poor prices, so that they suffer wealth losses. From a social viewpoint, this is very much a second-best adjustment mechanism, but one that is in evidence among the Australian States.
In such a situation, governments often try to stem the decline by handing out selective subsidies to attract new investments, risking the erosion of the future tax base or incurring untenable public debts (See Table 1, below). Experience shows that such political reactions to globalisation only add to future economic decline, but politicians and administrators are rarely that far-sighted -- or motivated to look that far ahead. This is the context in which desperate, ultimately ruinous bidding wars break out in federations.
Table 1: Selected Recent Bidding Contests
| 1993 | New South Wales bids successfully for the 2000 Olympic Games, with the costs and net benefits to NSW citizens far from clear. |
| 1993 | Victoria bids the right to stage the Australian Grand Prix away from South Australia. |
| 1994 | The South Australian government announces an agreement under which computer software firm EDS will make South Australia its Pacific region base in exchange for a promise that most South Australian government contracts will in future be allocated to EDS, rather than be put to the normal, cost-controlling competitive tender process. Subsequently, there are doubts about whether the deal will proceed. |
| 1995 (March/April) | The Victorian government identifies the Fox film studios, proposed for Sydney, as a winner and makes a bid. NSW responds successfully by granting pay-TV producer Foxtel a waterfront lease without the usual tendering. |
| 1995 (May) | The State of Victoria buys the rights to the Australian motorcycle Grand Prix from 1997, after the Greiner government in NSW had attracted the loss-making venture to a government-provided racecourse near Sydney. |
| 1995 | Westpac is induced by the South Australian government, reportedly with massive tax-breaks and hand-outs, to relocate its loan-processing centre to Adelaide. |
| 1995 (June) | American Express chooses Sydney as its Asia-Pacific regional operations centre. |
| 1996 (January) | Despite subsidy bids from a number of Australian State governments, Cathay Pacific decides to retain its flight-training operations in Hong Kong. |
| 1996 (January) | The NSW government offered $3 million to entice a defence aerospace project away from Victoria. |
We shall argue that, in such a situation, there is much gain all around -- both for the prospering and for the lagging States -- if all competing governments can conclude an agreement that ends ruinous bidding wars with secretive and selective subsidies and which confines inter-State competition to the general, non-discriminatory measures which make the State attractive to all comers. Such agreements are similar to industry agreements to ban ruinous competition. But, different from industry agreements, government arrangements to ban ruinous competition deal with tax-funded entities and entities that are not directly exposed to the discipline of going bankrupt when they persist with ruinous strategies.
BIDDING WARS VERSUS GETTING THE FUNDAMENTALS RIGHT
To clarify further what is at stake when State and local governments resort to rampant interventionism to pick specific "growth winners", rather than pursuing non-discriminatory strategies to get the fundamentals of competitiveness right, and to suggest policies which could shift the ground away from the interventionism of "bidding wars", we have to refer to some basic economics. (2)
What matters for the decision of the owners of mobile capital, knowhow and high skills and of entire enterprises when they consider a move to a new location, is the expected, long-term profit -- that is, the difference between sales revenues and unit costs (Wood, 1995, pages 22-27). During much of this century, governments in Australia and elsewhere have tended to focus in their economic development policies on lifting the revenue (or demand) side of the profit equation. They have tried either to secure the firms' income from sales (for example, through import protection), or to enable firms to lift their prices (for example, by granting specific producers a monopoly). Where governments tried to lift profitability on the cost side of firms, they have tended to concentrate on selective firm- or industry-specific measures, such as granting specific tax concessions or providing free or subsidised land, finance or energy, to selected companies. Universal supply-side policies, which lower costs for all producers across the board, have been neglected.
The fundamental problem with all selective policies to lift the profits of specific producers is that they require enormous amounts of detailed knowledge on the part of the policy makers and their bureaucratic advisors -- not only about the present, but also about a complex, changing future: Which industry should be given a preference at the expense of all others? Which particular enterprise in an industry should be given the preferment, and who should be refused? Should government, for example, promote the production of medical instruments, or the use of electronic sensors? If so, precisely what medical instruments and what sensors, and why not others? What if technologies and commercial conditions change, and expected winners turn into losers? The knowledge problem in a modern, fast-evolving, internationally-linked economy is such that no individual authority can ever hope even remotely to marshal and utilise all the necessary, useful information -- as Nobel Prize winner Friedrich Hayek showed many years ago (Hayek, 1945; 1963), and as the abysmal economic failures of socialism and central planning have more recently demonstrated beyond any reasonable doubt. Nevertheless, most Australian State administrations pretend that they do have the knowledge, and dish out selective subsidies to specific firms and industries as a means of developing their respective economies.
Such specific industry policies the world over have, on balance, turned into costly failures. Governments, in fact, tend to pick losers (Burton, 1983). Some readers might point to the fast-growing East Asian economies, many of whom have indeed engaged in selective industrial development policies. But formerly-poor, underdeveloped East Asian countries -- starting with Japan in the 1950s -- were simply able to emulate proven successes in economies further up the development ladder. Despite benefiting from this advantage of the late-comer, the record of picking-the-winners policies in East Asia is far from clear-cut. As Asian countries are approaching higher levels of technical and economic sophistication, they are now predictably shifting away from selective to universal, functional development policies. They now aim to mobilise production factors by fostering education, capital formation and resource development, and helping businesses to improve productivity all round, as well as focusing on macroeconomic stability. They have moved from selective interventionism to "getting the fundamentals on the supply-side right" (Kasper, 1994; Hughes, 1995). In any event, an advanced high-income country like Australia is not in a position to emulate what backward countries were once able to do. We are squarely faced with the knowledge problem, and our State and Federal administrations should drop the pretence of knowledge.
The best possible, albeit imperfect and uncomfortable, human device to utilise, develop and test useful technical knowledge and commercial-practical knowhow is decentralised competition in dynamic, open and diverse markets. Productive knowledge tends to be best found by competing, self-interested producers who seek to discover new knowledge and test its social acceptance through product and process innovation. This does not mean that governments should be passive, minimal players who are confined to pure laissez-faire. On the contrary, in the modern industrial world with a high degree of division of labour and division of specialised knowledge and high transaction costs, governments can do much to assist competitors in succeeding in the global market place:
- Governments should assist competitors with efficient, user-friendly infrastructures (for example, education, roads, ports and waste management), be it by operating these infrastructures directly or by facilitating the efficient, low-cost private supply of infrastructural services.
- Governments should provide simple, stable and transparent institutional rules which facilitate human interaction in markets and which lower the transaction costs of doing business; for example, by promulgating user-friendly laws and regulations. They must also enforce the rules convincingly and consistently.
- Governments have a role in ensuring macroeconomic stability, not least by providing non-inflationary money.
Governments that develop administrative systems which ensure a good supply of these "soft" and "hard" infrastructures to private industries and citizens will make a major contribution to overall economic growth within their jurisdictions. They become valuable partners in international and national competitiveness. They will help to attract increasing amounts of footloose capital and enterprise, thus further stimulating productivity and growth. Political leaders who fulfil this role will earn the respect and the support of the electorate. They will also discover that their tax base is growing, and that they are able to offer a good level of public service, whilst charging low tax rates.
Such a style of policy concentrates on the fundamentals of resource mobilisation, the protection of reliable institutions, stability and infrastructure support. Under this type of policy, government services are made available universally, that is, to all comers without discrimination. These policies are also called "functional policies". They tend to focus on the supply side of the profit equation of firms, focusing on low cost prices and favouring productivity growth. The key reason why such development policies have been highly successful -- as the East Asian evidence shows -- is that they require much less specific, technical and commercial knowledge on the part of politicians and administrators. Governments which act on the simple principle that education and training are worth favouring, and that saving and capital formation should be supported by the tax regime, have a much easier job and are much more likely to succeed than governments which bid against each other to buy themselves specific ventures, such as car races, airline companies, casinos, or computer-support services. Another advantage of the functional policy approach is that it offers politicians and bureaucrats much less temptation to engage in arbitrary discrimination and corruption. Once secret hand-outs are available and closed envelopes are passed around, both business people and politicians are subject to huge temptations, and public life sooner or later becomes corrupted.
The reason why the non-discrimination principle should be made a touchstone of judging inter-State competition is that governments are simply not equipped to succeed in case-specific promotion. Politicians and administrators simply do not have the incentives to take the proper business risks that are necessary to turn specific ventures into durable gains in employment and output. (3)
WHY AUSTRALIAN STATE GOVERNMENTS
SHOULD NOT OFFER SPECIFIC SUBSIDIES
When pursuing their legitimate interest in developing economic activity and jobs, State and local governments have a choice between
- making attempts to attract new businesses with up-front subsidies and similar measures for specific businesses, and
- concentrating on reducing the general costs and productivity impediments for the benefit of all comers, along the lines of universal, functional supply-side policy.
This is a genuine choice because a concentration on specific measures and "subsidy bidding" inevitably detracts attention and scarce political and administrative resources from improving the general business climate. The availability of government assistance also diverts business efforts from competing in markets (or "performance competition") into competing for political favours (or "rent-seeking"). Because of this conflict, the limited administrative and budgetary resources of State (and local) governments should be used to streamline and implement cost-cutting microeconomic reforms rather than to attempt the impossible task of outguessing markets as to which products and firms might in future be of greatest benefit to the State's economy and handing out privileges to known firms and groups.
As noted, there is a long, deeply-engrained tradition of specific interventions by Australian State (and local) governments and a corresponding neglect of functional policies. All State governments have, at one time or another, broken the maxim of non-discrimination, and have engaged in "picking the winners" interventions, bidding with subsidies or monopoly rights to attract specific producers or industries that they happen to know. Industry ministers or State premiers often even proudly advertise that -- by this tax concession or that subsidy -- they have "created" so-and-so many new jobs, only to become strangely reticent when the venture fails.
It is, therefore, important to list the detailed reasons why trying to pick winners and resorting to bidding wars for specific ventures will weaken long-term growth and job creation and why the -- often less glamorous and more onerous -- functional style of State development policy promises better long-run results. Firm- and industry-specific hand-outs by State governments should be abandoned in favour of functional, non-discriminatory development policies by Australian States for the following reasons:
Selective and discriminatory industry development policies have been a world-wide failure, as already briefly mentioned. This includes the Australian States, where firm-based assistance has been the dominant modus operandi of industry policy and where the States with the most interventionist industry policies in the past now have the weakest economies. By contrast, the predominantly functional approach of such economies as post-war West Germany, a growing number of East Asian countries, and -- more recently -- New Zealand, tends to deliver rapid growth and job creation (Kasper, 1996). This style of development policy is therefore being increasingly emulated -- and successfully so -- by some Australian States, in particular Queensland.
The investment of taxpayers' money in hand-outs to attract specific businesses should be assessed like any commercial investment or mortgage, not for short-term political gain but the long-term economic rate of return. State governments have often been tempted by "painless", "quick-fix" approaches to economic development. But this approach has frequently provided only transitory economic stimulus at the cost of mortgaging the State's future. As already noted, governments and administrators are simply not equipped to make commercial investment decisions. Without the capacity to collect and analyse large bodies of commercial and technical knowledge, policies designed to buy the State another enterprise depend on chance, the inclination of certain ruthless entrepreneurs to hunt for subsidies, and their access to credulous politicians and bureaucrats. Industry-specific subsidies are therefore often dominated by short-run political considerations at the expense of long-term economic and commercial objectives, with the inevitable outcome of budget losses, slower economic growth and poor job creation.
Even where government, by offering an investor a specific preferment, helps to create permanent jobs and revenues, it may undermine job growth in other companies. If, for example, a State government offers a monopoly contract for the computer services it buys to company A on condition that that company locates in the State, companies B, C and D, who were previously also competing for State government business, may shut down and quietly relocate out of the State. The gross gains in company A that politicians like to talk about are therefore seldom equal to the net gains to the State in terms of jobs and output.
Up-front subsidies to new ventures enhance the profitability of companies only temporarily. That may, of course, be welcome in the costly start-up phase of a new business. But such subsidies do nothing for sustained, long-term profitability and competitiveness. Indeed, as mentioned, they may boost cost levels by promoting rent-seeking and lessening the inclination of administrators and businesses in the State to address the fundamentals of profitability. Many well-managed companies -- including firms that were once attracted to certain States by forceful bidding and now regret it -- have learnt the bitter lesson that up-front subsidies only lure them into dangerous traps. Globally-competitive businesses therefore tend to avoid jurisdictions that readily offer them hand-outs. Instead, they search for environments where the profit fundamentals are sound. This is documented by the good correlation between the ratings in the annual World Competitiveness Reports, which measure the fundamentals of the business climate (IMD-WEF, passim), and subsequent investment flows and economic growth rates. This is also borne out in the close correlation between economic liberties and economic performance documented by a 1995 study published by the Fraser Institute in Vancouver, Canada. (4) In deed, the offer of firm-specific grants by government tends to signal widely that there is something badly wrong with the economic fundamentals in the jurisdiction which is making generous offers and shows great eagerness to engage in bidding wars. Nevertheless, most investors like to pocket a subsidy even if it is not decisive to their decision-making. Politicians are therefore rarely told by business that "settlement subsidies" are not effective!
Companies have learnt from bitter experience that political hand-outs are rarely free. Internationally-experienced business leaders now know that, sooner or later, they will be called on to reciprocate for government favours received. In today's information society, the practice of accepting hand-outs often leads to serious public-relations perils for subsidy recipients in that an increasingly sceptical public and press may, rightly or wrongly, suspect preferred firms of giving kick-backs when these businesses subsequently interact with the politicians and governments. We should also note that direct interventions are dangerous for politicians and bureaucrats. Hardly a day passes without the international press reporting the forced resignation of a politician or civil servant for reasons of illegitimate kick-backs and corrupt favour-selling.
There are other perils in "picking the winners" strategies for political leaders and administrators. The investment of taxpayers' money establishes a degree of political co-responsibility for a business. In the case of a subsequent failure of politically-preferred businesses and the dismissal of workers by politically-sponsored firms, activist politicians face public criticism. Subsidies can then easily turn into a political liability. In these circumstances, there is of course a danger that politicians and administrators will try to throw good money after bad, attempting to stave off the failure of uncompetitive ventures which they originally attracted by a subsidy and amidst much public relations fanfare.
Production facilities in a growing number of industries are highly mobile these days and cannot be pinned down for long. Much of industry has become very lightweight and footloose. Many a modern "factory" can be packed into a few containers and moved if local conditions no longer meet expectations, or if an establishment subsidy has been "harvested". (5) Another reason for the greater mobility of enterprises is the shift to service industries, which can easily unplug their computers and telephones. If the economic fundamentals are not right, and State governments merely rely on hand-outs to cover up the existing locational weaknesses, then businesses are now often able to pack up and go. Selective up-front subsidies may have made sense in the era of heavy industry and high relocation costs, but they seem fairly futile in the fast-changing, movable global economy of the twenty-first century.
Getting a hand-out from politicians or administrators normally imposes considerable compliance costs on business people. Normally, only firms of a certain size and with the necessary government-relations capabilities are able to respond to preferential policies aimed at picking winners. Small firms, who create most new jobs, cannot afford the lobbying and the form-filling; they thrive only where the fundamentals are right. For this reason, firm-specific development policies bias development in the direction of big enterprises and against small firms. Yet the world-wide historic trend is for big industrial dinosaurs to scale down and for flexible networks of small, agile producers to grow fastest (Naisbitt, 1994). That is where the most dynamic job and wealth creation occurs. Picking-winners policies therefore create a selection mechanism in favour of less dynamic types of firms. Government then discriminates against the profitable exploitation of the networking advantages, which the communications revolution now offers, and the innovation potential of the many small firms.
If an Australian State wants to attract dynamic small enterprises, and wants to become an oasis for the new brain-based service providers, it should not promote economic development through necessarily cumbersome, administrative approval procedures for subsidies -- a style of administration developed for the slow-moving steam age. It simply has to ensure a good general economic and regulatory environment for all comers, without cumbersome government agencies getting involved in the technical and commercial detail of specific businesses, and without all the apparatus of form-filling, slow-moving inquiries and committees.
Those responsible for designing policy strategies should be aware that reliance on universal, functional policies avoids a clash between the culture of small business enterprise and the culture of government administrations. Administrators are of necessity bound by accountability, consensus, precedent and orderly procedure. When they offer subsidies they have to impose this administrative culture on business people, whose normal modus operandi is to respond quickly to emerging market opportunities and to act on mere hunches. For this reason alone, specific subsidies often fail to attract the small, competitive businesses on which much of economic dynamism nowadays depends.
The ready availability of subsidies lures types of entrepreneurs to the State whom one might call "specialist subsidy-getters". They harvest hand-outs, but are not necessarily the best innovators, competitors and job creators. Selective "political entrepreneurship" may thus bias a State's entire business culture in the direction of subservience and compliance, and away from rugged self-reliance. Then, the impression easily develops that all businesses are naturally on the take and that economic development can occur only thanks to pro-active, selective economic development agencies! The long-term consequence is an ailing economy with a bias to political connections and establishmentarian back-scratching, full of protectionist sentiments and misgivings about the success of other, more openly competitive States.
Offers of up-front establishment subsidies to specific newcomers are widely considered an injustice by long-established firms who have been paying their taxes and who resent the fact that scarce budget resources are handed out to other firms. It is also considered unjust that government subsidies for the development of new industrial land depress the asset values of existing industrial sites, which established firms are using as asset backing or which owners may wish to sell.
In all business communities where specific favours are dished out by State or local governments there is considerable disquiet about the non-transparency of subsidies, about competitors being given an unfair advantage, and government agencies hiding all too often behind a veil of assertions of alleged "commercial confidentiality". This relates directly to the point made earlier that burgeoning specific interventionism leads to growing disaffection with electoral democracy and political leaderships.
Readers may object, by pointing out that subsidy grants to potential industrial settlers which reduce land, construction, transport or tax costs, are justified on the grounds that they make remote States more attractive by reducing the cost of producing in that location. Low unit-costs of the immobile production factors -- land, government administration, and labour, together with transport costs to the market -- are, after all, decisive in attracting mobile capital and enterprises (Wood, 1995). This argument can, however, be mounted only if the cost reduction by subsidy is available to all potentially interested firms on a non-discriminatory basis, including those who have not bothered to make themselves personally known to the Premier, the industry minister or some economic development authority.
OF BAD HABITS AND PRISONERS' DILEMMAS
It may be tempting to argue against the position taken here by saying that all national, State and local governments the world over violated have violated first-best non-discrimination principles, and that the elimination of specific subsidies is neither feasible nor desirable for the following reasons:
In a world of imperfect knowledge, the offer of preferments to new industrial settlers may be seen as an advertising tool to signal a State's interest in attracting business and to initiate negotiations about settling in the State.
There is some merit in this point, but it has to be weighed against the fact that competitive and experienced firms who would make a lasting contribution to a State's economy and tax revenue, almost never make long-term locational decisions on the basis of a government hand-out, indeed that "subsidy advertising" attracts industrial rent-seekers who are less focused on succeeding in open, global competition.
It may also be argued that each Australian State would be better off without offering subsidies, but that States which desist from matching the competition in hand-outs would lose out. In other words, it may be argued that a typical "prisoners' dilemma" arises: no State can afford to discontinue the harmful and costly practice for fear of losing out to other States. (6)
Prisoners' dilemmas (such as the post-war nuclear armaments race between the super powers) can be resolved by cooperation and direct negotiations of a framework agreement. In the case of State subsidies to industry, which many State politicians decry in public, there is indeed often a double prisoners' dilemma: businesses, too, may not wish to accept hand-outs, but they fear disadvantages as compared to other firms if they do not seek subsidies. Thus, both governments and businesses may be tied to harmful practices despite their better judgement. It should therefore be possible for Australian governments to agree on a set of rules that ban the harmful practice and allow the monitoring of violations of such a "subsidy-disarmament agreement" (see below).
Selective interventions may of course be in the interest of those ministers and government departments that administer them. In several Australian States, large economic development bureaucracies have been built up for the sole purpose of picking winners. They are likely to come up with elaborate rationalisations as to why a picking-winners style of policy cannot be abandoned.
Yet experience in East Asia also shows that the abandonment of discriminatory industry policies and supporting bureaucracies has regularly led to gains in competitiveness, investment and economic performance (Hughes, 1995).
If one starts from a tradition of firm-specific intervention -- as is the case in Australia -- and if there is a lack of confidence that a State's general competitive position is adequate, a case can be made for a gradual withdrawal from selective interventionism, as and when the fundamental cost conditions have improved.
It is often argued that the sudden shock of discontinuing specific subsidy policies could undermine economic performance and thereby harm long-term competitiveness. Given the strong, organised interests of industrial and bureaucratic lobbies with a stake in the status quo, gradualism may, however, become self-defeating. What is needed in cases like nuclear disarmament and weaning interventionist Australian governments from the picking-winners habit is a clear expectation of how the prisoners' dilemma will be resolved and how a better arrangement will be enforced. This requires a rational, negotiated agreement, monitored for violations and with clearly stipulated sanctions. All of this, of course, is predicated on the availability of transparent information about the dealings of government, an analysis of violations within a shared framework of rules, and an understanding of the importance of the non-discrimination principle in Competitive Federalism.
Picking-winners policies may be defended by making the point that any government intervention -- even of a general nature -- distorts specific industry structures and competitive conditions. If, for example, a State builds good roads, this benefits transport-intensive industries more than others, and good education policies are likely to benefit the knowledge industries more than low-skill activities.
Nonetheless, the effects of such universal, functional policies differ greatly from preferments for specific firms. A State may, for example, choose to subsidise all inter-State telephone costs from its budget to overcome the handicap of being in a peripheral location. The principle of non-discrimination is satisfied if all citizens or businesses in the State automatically get the telephone subsidy. It is violated, and should be proscribed, if the subsidy is handed out only to specific companies and people with political connections. In this context, there was much controversy in mid-1995 over the Queensland move to reduce stamp duties on share transactions, and over the South Australian move to subsidise the data processing centre of a big bank. In the first case, the criterion of universality was satisfied: all share purchasers got the advantage of lower stamp duties. In the latter case, the principle was violated: the (undisclosed) subsidy to the bank was only available to that bank.
An argument may be made in favour of selectivity and discrimination by Australian States, because their revenue bases are extremely narrow: most taxes have been earmarked for the Commonwealth government. Consequently, they simply cannot afford universal, non-discriminatory policies and have to rely on identifying and subsidising perceived winners.
There is some truth in this, and it would seem urgent to broaden State revenues (Wood, 1995). Nevertheless, States can do much to enhance attractiveness by streamlining regulations, by implementing development-friendly land and labour regulations, by enforcing existing laws equitably, and by disciplining bureaucrats, who are often anti-business, and forcing them to act in a responsible, expedient manner. Even casual conversations with business leaders quickly reveal that most Australian States have not exhausted the potential to enhance their locational attractiveness in general, functional ways, and that many State officials still live in a world in which industry was protected and capital outflows were controlled by foreign-exchange regulations.
It may be further argued that certain specific interventions, for example, State government subsidies to the gambling and the "eventing" industry, promise great external benefits to other industries, for example, tour operators and the hospitality industry.
The claim of externalities has of course always been the blanket excuse for all sorts of selective interventions. At the very least, a case has to be documented that the cost of administrative effort and public expense for such support is credibly outweighed by total revenue growth. Greater accountability is needed to expose such specific government activities to genuine scrutiny, using proper accounting principles and independent assessors -- and not the usual evaluations by hired consultants and project promoters.
Finally, it may perhaps be said in defence of selective subsidies that foreign governments will not abandon "dirty" subsidy competition and that, therefore, Australian States cannot either.
This is a variant of the prisoners' dilemma case. The argument is based on a fallacy familiar from the tariff debate of years past. Protectionists argue for limiting tariff cuts to cases of reciprocity, conveniently overlooking that the main tariff burden falls on fellow citizens! It should be realised that the biggest victim of State subsidies is the present and future taxpayer of that State. When States break with the subsidy habit, taxpayers and citizens are relieved of future tax burdens and begin to benefit from a more open, more competitive climate.
Much could be gained for overall business confidence in Australia if the underlying, first-best principles of genuine Competitive Federalism were better understood and if each successive tactical move to do away with State subsidies were explicitly related to the overall goal of "subsidy disarmament" and non-discrimination.
A STRATEGY FOR SUBSIDY DISARMAMENT
If the States are genuine in claiming that they are the victims of a vexatious prisoners' dilemma, they should readily come to the table and negotiate a ban on the ruinous practice of preferential bidding wars.
Prisoners' dilemmas exist only in closed environments and among few actors. The situation for inter-State subsidy competition has been changed by globalisation in general, and by the presence in the local market of one independent and subsidy-averse government, that of New Zealand, since the implementation of the Closer Economic Relationship (CER) agreement. To the extent that the opening of the Australian economy proceeds, subsidy addiction of State governments is likely to be increasingly harmful because durable gains from redistributive subsidy bidding are less likely.
Moreover, a cooperative agreement can protect the States from squandering future and present revenue on selective subsidies, or from granting costly monopolies to suppliers. Such cooperative agreements will, however, only come about when the States are made exclusively responsible for certain tasks of governance and for financing those tasks by the revenues which they raise themselves. How such responsibility can be achieved was discussed in Competitive Federalism (Wood, 1995). Once a fundamental framework of Competitive Federalism is in place, all States will have an interest in agreeing in principle on a ban against firm- and industry-specific subsidies and against licensing monopolies. An inter-State agreement to that effect could be concise and simple, stipulating openness and non-discrimination, possibly with some exemptions to allow interventions after positive externalities have been proven. The agreement has a better chance of working if it rules out certain types of government actions than if it prescribes positive guidelines as to how the States may legitimately compete.
Individual oligopolistic actors can, of course, expect gains from breaching a non-discrimination agreement. This is illustrated by the theory of industrial cartels. If one supplier can secretly break a cartel agreement, he tends to gain market share and profit. But the analogy with private industry is limited, since private competitors, such as cartel-breakers, are always exposed to the discipline of profit and loss. Governments, by contrast, can hardly go broke when they compete with selective subsidies. Moreover, industrial competition tends to foster innovation and bring other gains to society, whereas inter-State competition, if it is not conducted with universal instruments, tends to be socially harmful and destabilising of State finances. Therefore, breaches of the non-discrimination rule should be monitored and sanctioned by an inter-government agreement. In the Australian federal system, it would make sense to include the Commonwealth government in such an inter-State agreement to ban selective State subsidies, and to entrust a Federal agency with the power to monitor breaches. The most appropriate organisations in Australia to take on the monitoring task would seem to be the new National Competition Council or the Industry Commission, which already has the task of monitoring certain competitive actions of the States in implementing the Hilmer reforms (Hilmer et al., 1994), which is a repository of top-rate economic analytical talent, and which has a successful history of making complex economic issues transparent. An inter-State agreement against selective subsidies could simply stipulate that the Industry Commission, on its own initiative or when requested by a State government, investigate State-industry dealings to find out whether or not a proscribed subsidy was handed out. An alternative might be the new Australian Competition and Consumer Commission.
If the public and the press become educated and perceive selective State subsidies as ruinous and illegitimate burdens to the future budgets of the various States, mere findings by the monitoring agency would carry considerable weight. Different from the present situation, in which ministers brag publicly about having given handouts to certain firms, such actions would meet with instant public opprobrium and cost the subsidisers electoral support.
Nevertheless, enforcement of an agreed non-discrimination rule seems advisable. This could be done by the governments, on the basis of formal findings, possibly through the Council of Australian Governments (COAG). The instruments of enforcement could be direct financial penalties imposed on recalcitrant States (similar to such penalties payable to Brussels under arrangements now in place within the European Union).
END PIECE
There are strong economic arguments, and there is widespread public agreement in principle, that subsidising specific firms and industries is a dangerous political addiction. The habit is harmful to future State revenue. Such subsidies weaken a State's economic growth potential and they certainly violate principles of justice and equity. What is missing is a device which bans the harmful practice. If the States are serious in asserting that they regret being hooked on the subsidy addiction, it should not be beyond the capabilities of Australian statecraft to resolve that dilemma.
If we wean State governments from being selective and discriminatory, our Federation will be more worthwhile and serve our liberty and efficiency better than is now the case. Public support for collective action and respect for government and the law will be enhanced, because the citizens will consider State government actions to be in their interest -- rather than in the interest of some well-connected business or politician.
REFERENCES
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Giersch, H. (forthcoming, 1996), Economic Morality as a Competitive Asset (Sydney: Centre for Independent Studies).
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Hayek, F.A. (1978), "Competition as a Discovery Procedure", in F.A. Hayek, New Studies in Philosophy, Politics, Economics and the History of Ideas (London: Routledge Kegan Paul), pages 179-190.
Hilmer, F., M. Raynor and G. Taperell (1994), National Competition Policy (Canberra: AGPS).
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ENDNOTES
1. An example that should warn Australian leaders about the growing loss of confidence in government and spreading cynicism about political life, though distant in time and place, is the Weimar Republic in Germany after the First World War. Elected politicians engaged in blatant favouritism for their clients and thereby destroyed the underlying, shared institutions of society. The calamity of the Second World War began with the parliamentary and administrative disregard for the common law and genuine power control and with the politicisation of economic life by the political power brokers who used their monopoly to the fullest (Kasper and Streit, 1994).
2. We define "picking winners" here as an industrial policy design that discriminates between alternative economic activities, be it for political reasons, for reasons of perceived externalities or on the basis of an analysis of conditions that are seen in one part of the economic literature as amounting to "market failure". The opposite are "universal policies", that is, measures that apply generally to an unknown multiple of cases and people. Such universal policies enhance a growth-promoting economic order.
3. For the same reasons, post-war national governments based the international trading system on the non-discrimination principle through the "most-favoured nations clause", obliging national governments to treat all members of GATT as well or as badly as the nationals of the most preferred country. The principle has had enormous growth benefits for the world economy and the individual members of the agreement.
4. J. Gwartney, R. Lawson and W. Block, Economic Freedom of the World 1975-1995, Fraser Institute, Vancouver, 1995.
5. The story of the Hong Kong garment maker whose knitting machines have been attracted in sequence to three different provinces of China, then to Indonesia, then to Bangladesh -- each time with a subsidy -- may be invented, but it shows that government officials nowadays are under an illusion if they think they will be able to lock industry into a permanent location.
6. The term "prisoners' dilemma" derives from game theory which has studied the case of two prisoners held in isolation, each of whom may get reduced sentences when informing on the other prisoner. If they could collaborate and stay silent about their crime, they might even go free for lack of evidence. But fear that the other prisoner incriminates them will induce each to speak out and incur a sentence.
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