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Critics have long charged that federal regional development subsidies for Atlantic Canada are poorly targeted, ineffective and prone to political influence. This Commentary evaluates the case for regional development reform and argues that business grants should be replaced by measures to reduce existing tax burdens on business investment.

The Study in Brief:

This Commentary makes the case for a fundamental reform in the delivery of federal development assistance to Atlantic Canada.

It argues that the federal government should replace existing grants and tax credits to businesses with a broad-based reduction of corporate taxes in the region.

Existing grant programs are well intentioned, though poorly targeted. Governments are usually not good at picking winners but losers tend to be very good at picking governments. As well, grants may serve political, rather than economic objectives. This paper contains a quantitative analysis of the allocation of federal grants in Atlantic Canada in the 1988-to-200 period, providing evidence that supports this contention.

Since direct grant programs are ineffective, we recommend federal business tax reductions for the region.

A tax cut for Atlantic Canada could be implemented in a variety of ways; we consider two of them. A federal corporate income-tax rate cut of 6.5 percentage points on Atlantic income could be provided to replace about $250 million of existing grants. Alternatively, incentives for capital investments could be provided to encourage new activities in the Atlantic. This Commentary argues that a broad-based tax credit at a 10.5-percent rate should replace cash grants, as well as the existing federal Atlantic Investment Tax Credit, which is seriously flawed in design. Under this proposal, we estimate that the effective tax rate on marginal investment projects in the Atlantic region would be almost eliminated for many investment projects.

The Commentary:

Since 1988, the federal government has transferred nearly $billion to businesses, governments and non-governmental organizations in the Atlantic provinces through the Atlantic Canada Opportunities Agency (ACOA). Recently, a number of critics have called for a re-examination of the agencys mandate and a fundamental reform in the way that regional development assistance is delivered, including substituting corporate tax cuts for Atlantic businesses for ACOA grants. This Commentary evaluates the case for regional development reform. It argues that Ottawa should replace business grants with tax measures directed towards investment, while revamping federal Atlantic investment-tax credit that has been poorly structured in the past.

ACOA is just one of a handful of federal agencies that direct subsidies to businesses in all regions of the country. We focus on ACOA because its expenditures in per capita terms for the Atlantic region exceed those made by other agencies and the federal government in other parts of Canada. At the same time, we do not question the important role of the federal government in contributing to public services in have-not regions using, for example, the Equalization program. [underlining added]. Rather, our analysis is directed more narrowly at direct subsidies to local businesses for the purposes of regional development. Certainly, some of our analysis could equally apply to other regional development programs.

Regional development grant programs exist in many countries.

Their aim is typically to help fledgling businesses obtain financing that private lenders do not provide the idea being that many lenders are insufficiently knowledgeable about profitable opportunities for investment or are unwilling to take on the risks. A further aim of regional development programs is to help regional economies get over the hump, to use the vernacular to establish sufficient investment in productive capital and infrastructure to enable a region to become a magnet for other businesses and for a skilled work force.

While the road to development in Atlantic Canada has long been paved with such good intentions, poor design and implementation of policies has created some significant potholes. Several deficiencies can arise that undermine the usefulness of regional development grants Grants often appear to be directed to infra-marginal investments projects which would have been undertaken even in the absence of government support. As well, the grants create more demand for land and capital components, resulting in higher rents and capital goods prices, without generating the new activity that was originally intended. Even when grants spur truly new investment, little evidence can be found to support the conclusion that such projects can be made sustainable and profitable in the long run. At worst, inefficient businesses favoured with grants drive out competing profitable businesses that are not given the same assistance. Because of the cost of raising taxes to fund grants, the lack of benefits would be a very serious concern to taxpayers who have to ultimately fund the activities.

Because the Atlantic provinces have been catching up to Canada in per capita income in the past two decades, it can be argued that the regional development programs have helped improve the economy. On the other hand, the Atlantic region may be showing vigorous growth through its own entrepreneurship as well as benefiting from significant investment in energy with regional development programs reducing, rather than improving, productivity by keeping inefficient businesses in operation.

Losers Choice To some extent, these failures reflect the inevitable problems facing any government agency that lacks sufficient information to target its finds at areas where they can be most useful. Governments are unlikely to be very good at picking winners but losers tend to be very good at picking governments. However, targeting failures may also reflect other non-economic objectives of governments: cash transfer programs like ACOA may be used to reward political supporters, to buy votes in swing ridings, and for a variety of other political objectives, as well as for their legitimate role as a tool of regional industrial policy. Political scandals have dogged ACOA and the other federal and provincial regional development agencies on a number of occasions in the past. Below, we present some preliminary evidence on how political considerations may have influenced the allocation of ACOA funds.

If, as we argue, direct grant programs do not work well, then what is the alternative Some critics have proposed eliminating federal regional development programs entirely, which would be a radical departure from past practice that we do not evaluate or take a position on here. Instead, we focus on the narrower question of how the federal government might best deliver a specified level of support to the Atlantic region. A number of Atlantic politicians have raised the possibility of replacing ACOA spending with a cut in federal business taxes of equal value for the region. Replacing direct grant and loan programs with tax cuts would eliminate some of the problems in targeting development assistance, and we believe the alternative deserves serious consideration.

What Does ACOA Do Anyway ACOA was established in 1987 with a broad mandate to increase opportunity for economic development in Atlantic Canada and enhance the growth of earned incomes and employment opportunities. The agency interprets this mandate liberally, offering loans and non-repayable contributions to a wide variety of businesses, non-governmental organizations, and provincial and local governments for a wide variety of purposes. Recipients must apply to the agency for funds and eligibility is determined on a case-by-case basis according to a set of criteria that include incrementality, economic viability and related considerations Whats Right and Whats Wrong With ACOA The core of ACOAs strategy for the Atlantic region has been to award company-specific investment subsidies, either in the form of outright grants or repayable contributions. Proponents argue that subsidies often play a useful role in encouraging investment, transferring technologies, developing markets and ultimately, raising wages and increasing standards of living in the region. Critics point to informational and political failures in delivering the subsidies and the inefficiency that may result. Here we offer a brief review of the case for and against ACOA.

Investment Subsidies and Capital Market Failures:

The economic argument for government intervention in the regional development arena, as in other areas, is that government policy may succeed where banks, entrepreneurs and other private organizations do not. In this case, the usual story is one of capitalmarket failures. Fledgling businesses may find it difficult to obtain private financing if banks worry about default risk and local sources of finance are undeveloped. If investment subsidies are to be an effective use of scarce government resources, however, then they must be targeted at investment projects that would not be undertaken in the absence of such assistance. However, there are many reasons to believe that a significant fraction of projects financed through ACOA is not incremental in this sense The actual success of ACOA in this regard [incrementality] is difficult to gauge because there is little real cost-benefit analysis of the grants. ACOA itself estimates that 84 percent of jobs funded under its flagship Business development program are incremental.

But that figure is calculated by comparing employment growth of assisted companies to a sample of other companies in the region.

Since ACOAs aim is to finance economically viable enterprises, however, it is not surprising that assisted companies grow faster than average, and the approach tells us little about what would have happened to these companies in the absence of grants. A full study would have to use a methodology to account for the potential displacement of resources to subsidized from unsubsidized sectors of an economy. ACOA also provides estimates of the net impact of its activities on Atlantic GDP, using a macroeconomic simulation model. But evidence from other sources indicates that the number of new jobs created is relatively small, and that the cost per job created are high. One government study examined the Cape Breton Investment-Tax Credit, a federal program established in 1985.

While this program was delivered as a tax measure rather than a spending program, companies were required to apply for assistance and eligibility was at the discretion of program administrators. In other words, CBITC operated in a way that was quite comparable to ACOAs company-specific grants. The government study estimated that only about 20 percent of investment projects funded by CBITC were truly incremental. As a result, the cost of the program was quite high relative to ostensible benefits the foregone tax revenues under the program were equivalent to an estimated one time payment of $700,000 per job created.

Even if funding is confined to projects that are truly incremental in this sense, they may still have undesirable economic effects.

These include:

Bad projects that receive support may drive good ones out of the market.

Inefficiencies in local production techniques.

Prices of land and capital goods might rise.

Administrative overhead and deadweight costs.

Some countries, particularly the East Asian Tigers like Singapore and Korea, have used industrial policy to expand successfully in the past, and have done so by targeting particular sectors and companies. B ut these have been very much the exception to the rule, and even in those cases, governments usually delivered assistance through the tax system, rather than through direct spending programs. Since the Asian financial crisis of 1997, some doubts have arisen about the success that the Tigers have really had in using targeted tax cuts or subsidies to achieve economic development.

4.11. Infrastructure Grants and Agglomeration Economies A special challenge for development in have-not regions is that they lack what is known as agglomerations of skilled labour and capital, and the access to consumer markets that help make new investment profitable. An old justification for government industrial policies, lately somewhat resurgent, is that they can help underdeveloped regions to exploit a virtuous cycle of growth, in which initial strategic investments create an environment in which investment is more profitable for all. Rosenthal and Strange (forthcoming) provide a good survey of current research on the role and extent of such agglomeration economies in urban growth. The initial evidence is intriguing and contains some lessons for the role of industrial policy.

For one thing, if urban economies of scale are an important part of the growth phenomenon, then even greater agglomeration of economic activity is an inevitable consequence of growthenhancing policies That is, the best growthenhancing policies will probably also raise inequality within the Atlantic region, and will involve more, not less, movement of labour from rural to urban areas within the region. Viewed in this light, ACOAs propensity to direct much of its assistance to the poorest and least industrialized parts of the region must be seen not as part of a growth strategy for the region, but rather as a very inefficient kind of social policy.

For another, the existence of agglomeration economies indicates that certain investments in public infrastructure, particularly transportation, may play an important role in spurring growth. Infrastructure spending has been part of the mantra of Liberal politicians in Canada since the Red Book promises of 1993, and it is now a big part of the mandate of ACOA, too. Initially the federal governments emphasis on infrastructure received much intellectual support from research showing that public capital had strong positive effects on growth in local economies. But, as Crowley (20000 has argued, much of what is delivered [under] the rubric of federal infrastructure programs in Atlantic Canada and elsewhere is really about expenditures for current consumption and community development, and not at all about investment in productive public capital.

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