The TTIP and “Tax Incentives”

September 25, 2015 • Cato Online Forum
By Edward Alden

State and municipal governments in the United States each year offer some $80 billion in tax breaks and other subsidies to encourage large companies to do what they would do regardless — invest in new plants, office space and equipment in the hopes of turning a profit. The “tax incentives” game to lure corporate investment has gone from being a fairly small one played by a few southern states into a massive competition in which almost every state fears that it will lose investment — either to neighboring states or to other countries — unless it offers similar bribes. The Transatlantic Trade and Investment Partnership (TTIP) negotiations with Europe are an opportunity to begin clamping down on such distortions, and could be a first step towards global rules that would discourage this particular “race to the bottom.”

In a free market, companies should invest wherever the market opportunities and returns are greatest. But in practice, investment decisions are routinely distorted by a wide range of government subsidies and tax incentives that affect location decisions, but do nothing to enhance global or even national welfare. Washington state and South Carolina have offered some $13 billion for Boeing to build aircraft in those states; Mississippi has doled out $1.6 billion to entice Nissan and Toyota. Central and Eastern European countries have spent hundreds of millions of euros to attract auto companies as well. And while governments offer such handouts in the expectation of realizing greater economic returns, too often the promises made by companies to create jobs and expand their operations vastly exceed the actual performance.

The European Union, through its State Aid regime, is the only major jurisdiction in the world that has developed reasonably effective rules for discouraging such investment‐​distorting incentives. The United States should take the opportunity created by TTIP to negotiate similar rules, creating fair conditions for investment as well as trade competition across the Atlantic. And the EU and the U.S. should then work together to persuade other countries to adopt similar restrictions.

Investment “incentives” are the forgotten stepchild of global trade rules. Since the negotiation of the first subsidies code in the Tokyo Round of the GATT in 1979, trade negotiators have worked to expand the restrictions on direct government assistance to exporting companies. The WTO Agreement on Subsidies and Countervailing Measures has strong rules to discourage governments from distorting trade through subsidies, but with the notable exception of the ongoing U.S.-EU dispute over Boeing and Airbus, the application of those rules to investment incentives remains unclear. Both the United States and the EU have used their growing networks of Free Trade Agreements (FTAs) and Bilateral Investment Treaties (BITs) to tackle other sorts of investment distortions, such as local content or performance requirements on foreign investors. But incentives offered by governments to induce investments have been left out of this umbrella of rules.

This is a puzzling oversight, because the problem is far from new. Fred Bergsten of the Peterson Institute for International Economics wrote an article in Foreign Affairs in 1974 calling for the negotiation of a two‐​pronged international investment regime — one that would prevent discrimination against foreign investors, but at the same time would restrict government subsidies aimed at attracting foreign investors. He feared the outbreak of “investment wars” in which countries would compete through subsidies (mostly tax incentives) to attract investment. “Traditionally,” he wrote, “the United States has forcefully opposed policies which discriminated against foreign investors; now it increasingly finds its national interests threatened by policies which discriminate in favor of those firms.“1

Consider the semiconductor industry — a capital and research‐​intensive business in which an advanced economy like the United States would be presumed to have some comparative advantage. But China, Singapore and other countries are prepared to pay top dollar to lure those companies. Intel’s former CEO Paul Ottelini has said that the cost advantages of building a new facility in China, for example, have little to do with lower labor costs. Instead, 90 percent of the savings come from the Chinese government providing Intel with capital and equipment grants, tax holidays and other incentives.2 Similarly, Intel has invested more than $7 billion in Israel, but received $1.2 billion in subsidies from the Israeli government; in Vietnam, Intel received a four‐​year corporate tax holiday, a 50 percent tax break for the following nine years, and a permanent rate of just 10 percent after that.3 The range of incentives offered by foreign governments — including specific tax incentives, free land, and worker training — can shave as much as $1 billion off the roughly $5 billion cost of building a new fabrication facility, the company has said.4

Yet the United States has been unable, or unwilling, to take any initiative to discourage such practices. An effort in the late 1970s under the auspices of the International Monetary Fund and the World Bank came to naught — opposition was particularly strong in the United States from U.S. state governments that offered such incentives and the large companies that received them.

The EU is the only entity in the world that has created an effective system for discouraging such incentives. European rules on regional aid — which were adopted as part of the 1957 Treaty of Rome establishing the European Economic Community — were specifically designed to keep the member states from bidding against each other for investment.5 Member states are only permitted to give individual businesses a subsidy under certain conditions — if the subsidy benefits a region that is economically depressed, for example, or if it serves an environmental purpose. Most subsidies are preapproved by the European Commission (EC), which carries out a cost‐​benefit analysis of any proposed subsidies. Member states and local government have to list their subsidies online, along with the companies that are significant beneficiaries. Member states found in violation of the state aid law can face fines and other penalties.6 The EC is currently investigating some 65 state aid cases involving 15 member states, and has in the past levied stiff penalties for violations — including requiring some companies to pay back the benefits received. Tough enforcement has had an impact. Overall, European state aid fell from about 2 percent of GDP in the 1980s to just 0.5 percent by the end of the 2000s.7

Europe has made no real effort to export its state aid rules, but it would clearly be in the EU’s interest to do so. Since EU members states are constrained by the regime, they are at a disadvantage in the global competition for capital against governments — including U.S. state and local governments — that are not similarly constrained. The EU has also become aware of its vulnerability to international challenge over its state aid rules. Spain was recently sued under investor‐​state arbitration provisions for eliminating subsidies to renewable energy generators, while Romania was sued by several companies for eliminating promised tax incentives in order to comply with EU state aid rules in the run‐​up to its 2007 EU accession. In its most recent proposal on investment rules for the TTIP, the European Commission has called for the TTIP investment chapter to make it clear that companies cannot seek arbitration if states discontinue subsidy schemes.8

The politics of a deal to curb investment incentives would more challenging in the United States. Corporate interests would be sure to fight back, as would state governments like Texas, Mississippi Tennessee, and even New York, that have built their development strategies around such location incentives. Many states, however, have recognized the zero‐​sum nature of the competition and would like to stop, but would only be willing to do so if other states agree as well.9 One of the values of international trade agreements is that sometimes they can force governments to cease policies that are against the best interests of their own citizens. Investment incentives are one such case.

The timing is good in one other respect as well. As part of the ongoing WTO dispute between the U.S. and the EU over subsidies to Boeing and Airbus, the U.S. has been found in violation of WTO rules as a consequence of nearly $5 billion in tax incentives offered to Boeing by Washington state and the city of Wichita, Kansas. The case is now grinding its way through the WTO’s compliance process, and the EU has launched a new case regarding the $8.7 billion in tax incentives for Boeing to build the 777X in Washington. Those cases — and a related case in which the WTO has ruled against some $18 billion in European launch subsidies to Airbus — are headed towards a cliff in which both governments will be authorized to levy billions of dollars in trade sanctions. A negotiated deal under TTIP to constrain future tax incentives and other subsidies may be the best — perhaps the only — route for avoiding such sanctions.

Like other aspects of TTIP — such as the regulatory negotiations — the goal should not be only to set new rules for U.S.-EU trade but to encourage other countries to adopt similar measures. While U.S. states might be willing to do a deal with the EU, they are less likely to want to constrain themselves in competing with China or Singapore or Brazil. If they can do a deal with each other, the U.S. and EU should then work to extend the rules through the WTO, or at the very least through future BIT negotiations — such as the U.S. talks under way with China — and free trade agreements. Reducing such investment distortions would be a big step towards creating a genuinely free market in global trade and investment.

1 C. Fred Bergsten, “Coming Investment Wars?” Foreign Affairs, Vol. 53, No. 1, October 1974.
2 Richard McCormack, “Intel CEO Says U.S. Would Lose No Tax Revenue By Providing Companies With Tax Holidays To Open Plants And Hire Workers,” Manufacturing and Technology News, vol. 17, no. 17, October 29, 2010.
3 Robert D Atkinson and Stephen J Ezell, Innovation Economics: The Race for Global Advantage, New Haven: Yale University Press, 2012, pp. 174–75.
4 Noel Randewich, “Insight: As chip plants get pricey, U.S. risks losing edge,” Reuters, May 1, 2012.
5 Kenneth P. Thomas, Investment Incentives and the Global Competition for Capital, Palgrave McMillan, 2011.
6 Edward Alden and Rebecca Strauss, “Curtailing the Subsidy War Within the United States,” Council on Foreign Relations Policy Innovation Memorandum No. 45, May 2014.
7 Thomas, Investment Incentives, p. 135.
8 European Commission, “Investment in the TTIP and beyond — the path for reform,” Concept Paper, May 2015.
9 See Alden and Strauss, “Curtailing the Subsidy War.”

The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on The Economics, Geopolitics, and Architecture of the Transatlantic Trade and Investment Partnership.

About the Author

Edward Alden is the Bernard L. Schwartz senior fellow at the Council on Foreign Relations (CFR), specializing in U.S. economic competitiveness.