HOW SOUTH CAROLINA FELL INTO GORDON TULLOCK’S “TRANSITIONAL GAINS TRAP”

At a recent debate sponsored by the Policy Council on the merits of taxpayer-financed “incentives” – the headline for the event was “Economic Incentives: Capitalism or Corporate Welfare?” – moderator Pete Calcagno of the College of Charleston referred briefly to the concept of “transitional gains.” The phrase was coined by the economist Gordon Tullock (pictured above, right) and illuminates the answer to one of the most persistent questions in the debate over incentives. The question is this: Why, after incentivizing particular companies and industries for decades, has South Carolina’s economy made so little improvement in relation to other states?

Tullock’s article, “The Transitional Gains Trap,” appeared in The Bell Journal of Economics in 1975. It’s a heady work of scholarship with far more detail and nuance that we can provide here, but its argument is essentially this: that government aid to particular entities in the private sector, while offering modest gains in the very short term, harms those entities in the long term.

This applies especially to permanent aid – for instance, tax favors written into the tax code. When the incentive is first offered – let’s say, a sales tax exemption on computer equipment for a certain company – the company enjoys a small, brief boost in profitability by virtue of not paying sales tax on the specified items. Once those small gains are made, however, the company “capitalizes” the incentive: that is, it incorporates the break into its balance sheet and yearly expectations. After a year or two, the exemption on computer equipment no longer does the company any positive good; its profits are exactly what they would be without the exemption, which is now merely a benefit the company can’t do without.

That’s when it becomes costly. Sooner or later – and this kind of thing is happening with increasing frequency in South Carolina – the exemption is called into question, either (a) by lawmakers seeking to reform the tax code, (b) by lawmakers seeking to boost government revenue, or (c) by the company’s competitors demanding the exemption for themselves or its abolition altogether. The aid-receiving company will be forced to defend the exemption, and that will require hiring lobbyists and other means of persuading lawmakers to preserve the benefit. And this will go on and on – thus making the well-intentioned exemption a long-term burden to the company and, by extension, the local or state economy.

As we’ve catalogued many times on this website (most recently here), South Carolina’s tax code is crammed full of these favors – so much so, for example, that the state frequently collects less in both sales and corporate taxes than it exempts. These exemptions are no longer helping the targeted companies and industries – is the state’s newspaper industry really helped by the sales tax exemption on newspapers? – but the companies and industries are nonetheless obliged to spend resources defending the exemptions for the excellent reason that losing them would be catastrophic. Aid-receiving companies now find themselves putting less time and effort into making a better product or supplying a better service, and more time and effort into defending privileges.

As so often in the realm of government policy, and in economic development policy particularly, tax incentives fall victim to the Law of Unintended Consequences. They sound like a great idea, and any company will accept them when they’re offered, but in the long run they hurt more than they help.

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