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Corporate Welfare: It’s Not Just a Drain on the Federal Budget; It’s a Drain on Innovation

RISING GOVERNMENT SPENDING and huge deficits are pushing the nation toward an economic crisis. There is general agreement that policymakers need to find wasteful and damaging programs in the federal budget to terminate. One good place to find savings is spending on corporate welfare.

A recent Cato Institute study finds that federal business subsidies total almost $100 billion annually. That is a fairly broad measure of subsidies to small businesses, large corporations, and industry organizations. The subsidies are handed out from programs in many federal departments including Agriculture, Commerce, Energy, and Housing and Urban Development.

However, there is no precise measure of corporate welfare. As part of the national income accounts, the Bureau of Economic Analysis calculates that the federal government handed out $57 billion in business subsidies in 2010.

There are several obvious upsides to ending federal subsidies to businesses: It would help reduce the federal deficit; it would reduce the amount of money taken from taxpayers and given to big corporations; and it would reduce the incentives for political corruption. A less obvious, but no less important, reason to end corporate welfare is that an economy that doesn’t depend on subsidies from government is a more entrepreneurial economy that will grow faster.

Government Is Not a Good Investor

Some people think that subsidies are needed to help U.S. businesses compete in the world economy. But the more we subsidize businesses, the more we weaken the market’s profit-and-loss signals, and the more we undermine America’s traditions of entrepreneurship and gutsy risk-taking by the private sector.

People argue that business subsidies are needed to fix market imperfections. But subsidies usually don’t work as intended, and they often distort markets rather than fixing them. Journalist Robert Novak once said that “the mind-set underlying corporate welfare is that of the central planner,” and yet we know that central planning does not work.

Consider the energy industry, which Republicans and Democrats have been manipulating with subsidies for decades. An early subsidy effort was the Clinch River Breeder Reactor, which was an experimental nuclear fission power plant in Oak Ridge, Tennessee in the 1970s. This Republican-backed boondoggle cost taxpayers $1.7 billion and produced absolutely nothing in return.

Then we had the Synthetic Fuels Corporation (SFC) approved by President Jimmy Carter in 1980, who called it a “keystone” of U.S. energy policy. The government sank $2 billion of taxpayer money into this scheme that funded coal gasification and other technologies before it was closed down as a failure. The SFC suffered from appalling mismanagement, huge cost overruns on its projects, political cronyism, and pork-barrel politics in dishing out funding.

Both parties have backed dubious “clean coal” projects for decades. The Government Accountability Office found that many of these projects have “experienced delays, cost overruns, bankruptcies, and performance problems.” In a review of federal fossil fuel research, the Congressional Budget Office concluded: “Federal programs have had a long history of funding fossil-fuel technologies that, although interesting technically, had little chance of commercial implementation. As a result, much of the federal spending has not been productive.”

With the poor record of energy subsidies over the decades, it is no surprise that the Obama administration is having trouble with its green energy activities. The administration’s failures keep piling up—Solyndra, Raser Technologies, Ecotality, Nevada Geothermal, Beacon Power, First Solar, and Abound Solar. These subsidy recipients have either gone bankrupt or appear to be headed in that direction.

Why don’t business subsidies work very well? One reason is that political pressures undermine sound economic choices. The Washington Post found that “Obama’s green-technology program was infused with politics at every level.” The decision to approve the Solyndra loan, for example, appears to have been rushed along by high-level politics.

Perhaps more importantly, subsidies change the behavior of businesses. An economist once quipped: “I don’t know whether the government is better at picking winners rather than losers, but I do know that losers are good at picking governments.” When the government starts handing out money, businesses with weak ideas get in line because the businesses with the good ideas can get private funding. Enron, for example, was able to grab huge federal support for its disastrous foreign investment schemes.

At recent House of Representatives hearings on green energy subsidies, most witnesses lined up in favor of Department of Energy loan programs, except for one witness who heads a solar power firm that does not receive federal subsidies. James Nelson of Solar3D said subsidizing green energy commercialization “is a wasteful mistake because it doesn’t work.” Here are some of the problems he pointed to:

Firms that receive subsidies become spendthrift. Nelson contrasted his firm’s lean operations with Solyndra’s wasteful ways, which included building a fancy factory in a high-cost location. Nelson noted that the “most powerful driver in our industry is the relentless reduction in cost.” Yet government intervention rarely works to drive down costs in any activity.

Subsidies aren’t driven by actual market demands. Nelson noted that U.S. adoption of solar energy lags behind several other nations. But he said, “this should not bother us if it means that the other countries are investing in technology that is not economically viable.” In other words, if other countries are misallocating resources, that won’t hurt us. The good news, he said, is that America is the leader in market-driven private venture capital for “clean tech.”

Subsidies distort business decisions. Nelson noted that “giving companies money to set up manufacturing in the United States may doom them to failure by financing them into a strategically uncompetitive position.” In other words, if subsidies induce U.S. firms to put more production in the United States than is efficient, it will disadvantage them in the marketplace.

Venture capitalists have already funded the best projects, leaving the dogs for the government. If venture capitalists “reject a project, it is difficult to believe that the government could do a better job of picking a winner,” argues Nelson.

The House hearing included testimony from green energy firms that had received subsidies. Their comments reveal how subsidies erode the focus on the bottom line. The firms stressed how many jobs they were creating and how their supplier chains covered many states—and thus many congressional districts. One solar firm bragged that it is “creating and maintaining jobs locally and across the nation,” while it is “procur(ing) from a supply chain that stretches across 17 states.” Another solar firm bragged that it “spent more than $1 billion with U.S. suppliers in 35 states.”

Another problem with business subsidies is that they can encourage investing in very dubious projects. That is the story of Enron’s international investments, which played an important role in the implosion of the firm. According to a Washington Post investigation, Enron received $2.4 billion in federal aid through the Export-Import Bank and the Overseas Private Investment Company between 1992 and 2000. A study by the Institute for Policy Studies puts total federal government subsidies to Enron for its foreign schemes at $3.7 billion. Enron also received subsidies from international agencies such as the World Bank. All of these subsidies made possible Enron’s excessively risky foreign investments, which came crashing down at the same time that the firm’s accounting frauds were being revealed.

Suppose that the government was capable of channeling subsidies only to well-managed companies with sensible ideas. Then the subsidies wouldn’t be needed because they would simply crowd out private investment. That seems to be the case with much of the $7 billion in subsidies for rural broadband in the 2009 stimulus bill, as one detailed study by Jeffrey Eisenach and Kevin W. Caves found.

Or consider the Department of Energy’s Advanced Technology Vehicles Manufacturing Loan Program, which provides subsidies to companies to develop green cars. A former executive with Tesla Motors, which received subsidies, concluded that “private fundraising is complicated by investor expectations of government support.” Subsidies distort the venture capital market, having “a stifling effect on innovation, as private capital chases fewer deals and companies that do not have government backing have a harder time attracting private capital.”

Most of our long-term economic growth has come not from existing large corporations or governments, but from entrepreneurs creating new businesses and pioneering new industries.

A final problem with corporate welfare is that it can create broader distortions in the economy. For more than a century, the federal Bureau of Reclamation has subsidized irrigation in 17 western states. About four-fifths of the water supplied by the Bureau goes to farm businesses, and this water is greatly underpriced. Because farmers receive water at a fraction of the market price, they overconsume it, which threatens to create water shortages in many areas in the West. Subsidized irrigation also causes environmental damage.

Long-Term Growth Depends on Entrepreneurs

Most of America’s technological and industrial advances have come from innovative private businesses in competitive markets. Indeed, it is probably true that most of our long-term economic growth has come not from existing large corporations or governments, but from entrepreneurs creating new businesses and pioneering new industries. Such entrepreneurs have often had to overcome barriers put in place by dominant businesses and governments.

Economic historians Nathan Rosenberg and L.E. Birdzell found that “new enterprises, specializing in new technologies, were instrumental in the introduction of electricity, the internal-combustion engine, automobiles, aircraft, electronics, aluminum, petroleum, plastic materials, and many other advances.” We can update that list to include cell phones, personal computers, biotechnology, and all kinds of Internet businesses.

If policymakers want to get U.S. economic growth back on track, they should put entrepreneurs frontand- center in their thinking about policy. Here are some of the ways that entrepreneurs generate growth:

Entrepreneurs are radical innovators. Their advances are usually unexpected and disruptive to existing businesses. Personal computers were pioneered in the 1970s by new companies such as Apple. The opportunity was missed both by leading computer firms and by government planning agencies such as Japan’s MITI. Big corporations were focused on mini- and mainframe computers, while the U.S. government was subsidizing supercomputers. Governments and big companies often overlook niche products that later become revolutionary. In the 1970s, microcomputers were an obscure hobbyist activity, and software for microcomputers— which Bill Gates helped pioneer—was a niche within a niche. The small-scale innovations of entrepreneurs in niches often create huge, unforeseen changes.

Entrepreneurs generate competition. Another crucial role of entrepreneurs is that they challenge dominant firms and governments. One great story is the rise of MCI Corporation in the 1970s and 1980s. MCI helped destroy the AT&T monopoly, which paved the way for the modern telecommunications revolution. Another innovator was Fred Smith of Federal Express. Today we take overnight letter delivery for granted, but it was Smith who battled federal regulatory roadblocks in the 1970s and provided new competition for the U.S. Postal Service by proving that there was an untapped demand for rapid delivery.

Entrepreneurs turn inventions into innovations. America’s long-run growth is often portrayed as a steady process of accumulating new inventions. Many people seem to think that the government can simply pump money into research and the economy will grow. But that “science push” theory of growth is incorrect. Economies grow because of innovations, which are inventions that are packaged and tested in the marketplace by entrepreneurs.

Entrepreneurs are the economy’s guinea pigs. They have the guts to act in the face of uncertainty, and they learn from their mistakes and keep trying until they find ideas that work and generate profits.

The modern economy is steeped in uncertainty. No one can predict the future, not even the best scientists, engineers, and economists in big companies and the government. Many experts have made hugely off-base prognostications about the economy. Two decades ago, many pundits and policymakers were convinced that Japan was taking over the global economy. Professor and pundit Robert Reich thought that “chronic entrepreneurialism” was undermining the U.S. economy. And past predictions about the computer industry have been laughable, such as this comment in 1977 by the founder of Digital Equipment Corporation: “There is no reason for any individual to have a computer in his home.”

Luckily, expert predictions don’t drive the economy. Rather, successful market economies work by having swarms of entrepreneurs freely testing new ideas. Entrepreneurs are the economy’s guinea pigs. They have the guts to act in the face of uncertainty, and they learn from their mistakes and keep trying until they find ideas that work and generate profits.

By contrast, government plans to stimulate the economy are often based on ideologies and rigid ideas. Some policymakers believe that particular energy technologies are the solution to America’s problems, and they support subsidies year after year regardless of marketplace realities. By contrast, in competitive and unsubsidized markets, mistakes usually are quickly exposed and businesses cut their losses short and change direction.

The government tends to work at a turtle’s pace, which doesn’t sync well with the fast-paced modern economy. We saw a comparison of the government turtle with the private-sector gazelle during the first sequencing of the human genome in the late 1990s. The government’s lavishly funded Human Genome Project was a lengthy multi-year research project, but it was upstaged when entrepreneur Craig Venter launched Celera Genomics to complete the job at a fraction of the time and cost.

What are the policy lessons from America’s great entrepreneurial history? One lesson is that because markets have high levels of uncertainty, government agencies and dominant companies cannot be relied upon to secure our economic future. Instead, we should remove hurdles to entrepreneurship every way we can—by tax reforms, by repealing barriers to entry into industries, and by reducing financial industry barriers to private risk financing.

While it has become fashionable to criticize Wall Street, the financial industry has been crucial to funding waves of innovation in the U.S. economy. Risk capital was integral to the railroad and telegraph booms of the 1800s, and the radio, electricity, and automobile booms of the early 20th century. J.P. Morgan Chase garnered negative headlines for a $2 billion quarterly loss earlier this year, but J.P. Morgan was the company that provided seed capital for Thomas Edison’s Edison Electric Illuminating Company, which became General Electric.

In recent decades, high-yield bonds, venture capital, and angel investment have played key roles in growing new industries. Today, U.S. venture capital and angel investors pump more than $50 billion annually into young companies. Tax policy influences investment flows, and funding for high-growth ventures is affected by the tax treatment of capital gains in particular. Extending the 15 percent federal capital gains tax rate would make it easier for firms and investors to plan for the future. Also, the corporate tax rate should be cut to spur greater capital investment—new capital equipment usually embodies technological advances.

Policymakers should put aside the idea that some sort of big intervention can permanently “win the race” for some particular goal, such as energy independence, solar power dominance, or beating China. In recent testimony before the House of Representatives, an energy consultant said: “[C]lean energy has been targeted by our major international competitors (including China and Germany) as a critical, and perhaps the critical, future growth and export industry … whether the U.S. wins or loses in this race matters because the outcome will have a large impact on future U.S. employment and economic strength.” At the same hearing, a solar company executive said that America could “win in the long run” with a particular solar technology.

New Zealand ended virtually all its farm subsidies in 1984. Farm productivity, profitability, and output have soared since the reforms. The farmers cuts costs, diversified land use, sought nonfarm income, and developed new markets.

However, those sorts of prognostications are refuted by U.S. economic history. There is never any final “win” in the marketplace. Look at how leadership in cell phones and smart phones has shifted from firm to firm and country to country, from Nokia, to RIM Blackberry, to Apple, and to others. Technologies and markets are always changing, so the only way for America to permanently “win” in the struggle for economic growth is to have the best climate for investing, innovating, and building entrepreneurial companies.

Subsidies to new industries like green energy aren’t the only ones that distort the economy. Withdrawing corporate welfare from older, established industries could spur innovation as well. Consider farm subsidies. New Zealand ended virtually all its farm subsidies in 1984, which was a bold stroke because that country is much more dependent on farming than is the United States. The changes were initially resisted, but New Zealand farm productivity, profitability, and output have soared since the reforms. Faced with new financial realities, New Zealand’s farmers innovated—they cut costs, diversified their land use, sought nonfarm income, and developed new markets.

Thus rather than looking for new ways to subsidize businesses, policymakers should be looking for places to withdraw subsidies and deregulate in order to spur innovation. For example, just as the break-up of the AT&T monopoly in the 1980s helped to generate growth in the telecommunications industry, ending the U.S. Postal Service monopoly today would spur innovation in that industry. Europe is moving in that direction, with Germany and the Netherlands already privatizing their postal systems.

The transportation sector is another area where innovation could be spurred by the reduction of federal subsidies. For example, Amtrak is doomed to inefficiency as a government-run business pumped full of subsidies and shackled with regulations. It should be privatized. Other countries are ahead of the United States in privatizing transportation infrastructure, or at least in bringing private investment into infrastructure.

The United States subsidizes its air traffic control system, but it doesn’t need to. Canada privatized its air traffic control system in 1996, and it operates as a self-funded nonprofit corporation. It has been a big success. Space flight is another area that could benefit from cutting subsidies and letting the private sector operate. The recent success of the SpaceX flight and the 2004 success of SpaceShipOne indicate that the private sector is entirely capable of bold and risky technological ventures.

To sum up, the way to spur economic growth is not through business subsidies, but through breaking down barriers to entrepreneurs. Let’s give entrepreneurs a crack at postal services, air traffic control, passenger trains, and other monopoly industries. Let’s pursue tax and regulatory reforms to maximize the flow of financing to new and growing businesses. And let’s stop demonizing entrepreneurs who succeed and the financial system that allows them to grow. If we want to exorcize some demons, we should end the corporate welfare system that is corrupting our government and the American economy.

Mr. Edwards is Director of Tax Policy Studies at the Cato Institute. Mr. DeHaven is a budget analyst at the Cato Institute. This article is adapted from their testimony before the Committee on the Budget of the U.S. House of Representatives, June 1, 2012.