Money for nothing?

Johannes Van Biesebroeck, 10 February 2009

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On 21 December, 2008, the Canadian and Ontarian governments announced that they would provide the Canadian arms of General Motors and Chrysler with a combined $4 billion in loans. This represents 20% of a similar US aid package announced a day earlier by then-President Bush. As the firms have been flirting with bankruptcy, the “loan” terminology should not be taken too literally, and the widely used “bailout” is clearly the right term. This sudden influx of government support is not nearly as exceptional as often portrayed. Regrettably, the government has been unwilling to learn from the lavish subsidies granted to the automotive industry over the past couple of years and their bailout strategy has been totally ad hoc. The recent Canadian experience does hold some lessons to remember when devising a strategy for the long term.

The automobile industry is already subsidised…

While the current circumstances are certainly extraordinary, the provision of public money to the automotive industry has in fact become remarkably commonplace. In the 1980s, a total of $4.81 billion in constant 1983 US dollars ($10.14 billion in today’s money) was invested by foreign carmakers over eight US and four Canadian projects, creating 23,600 direct assembly jobs. The Canadian government provided incentives between $243 and $273 million, or a subsidy of between $49,591 and $55,714 per job. In the 1990s, six new plants were built in the US and another two were announced early in the next decade. While Canada received more than its fair share of the earlier investments, it attracted no new greenfield investments this time around. Political economy considerations of foreign owners, hesitant to antagonise the US, were one important factor. The Canadian government's stated reluctance to compete with incentives was another.

In April 2004, the Ontario government announced the Ontario Automotive Investment Strategy, plunging itself into the bidding game to attract new investments. A total of 500 million Canadian dollars was committed to subsidise up to 10% of the capital cost. The federal government immediately doubled the available subsidies for the automotive industry.

Firms can draw on a long list of programmes for investment support. As of January 2009, the Ontario government's web portal for initiatives to attract foreign investors listed 78 programmes offering subsidies or tax credits. Among the most important programmes are the Advanced Manufacturing Investment Strategy ($500 million over five years) geared towards innovation and advanced technologies, Strategic Manufacturing Investment grants (average annual budget of $63 million), and the Next Generation Jobs Fund ($650 million over five years) for green technologies.

Total support from just the four largest Ontario programmes has averaged a staggering $400 million per year, much of it for automotive investments. Van Biesebroeck (2008) summarises the largest programmes from Ontario, Quebec, and the federal government.

...but the bailout plan is different

The current bailout plan continues the habit of lavish subsidies. The explicit goal is to deal with short-term issues stemming from the global credit crises and the collapse in car sales. The highly leveraged operations of these firms, both in terms of trade credit from suppliers and consumer financing, make the industry particularly vulnerable to the credit markets chill. Moreover, the different carmakers and their suppliers are highly integrated. Bankruptcy of a large firm could easily create a domino effect, dragging many other firms down with it.

One departure from earlier provision of public funds is that the government is taking a more intense look at the actual operations of these firms. In particular, it has demanded a business plan showing their future viability, which should include labour cost reductions. While reducing salaries on the direct workforce is politically necessary for opponents (and the public) to stomach the bailout, it is unlikely to have much of an effect on these firms’ bottom line – salaries are simply not a big share of costs. It will also take a long time, at least 10 to 20 years, before the two-tier salary system that is being rolled out in the US and proposed for Canada will have any effect. It is also not clear how the government hopes to reduce pension and health care liabilities enjoyed by retired workers, which are responsible for about half of the salary gap with foreign competitors.

While different in form, the objective of the bailout plan is familiar. It aims to tide these firms over the current market difficulties, but guaranteeing a future for the Canadian automotive industry was central in the investment subsidies as well. The impetus for the Canadian plan was the US bailout and the risk that the firms would choose to concentrate their operations south of the border – much like subsidies are granted as jurisdictions compete for new investments.

Issues related to subsidisation

A recurring theme in the debate over subsidies is whether to favour a general or targeted approach. For example, automotive firms are lobbying to expand the Manufacturers and Processors Tax Deduction, which would effectively reduce their corporate income tax rates to 17% federally and 8% provincially. Rather than award this selective benefit, the federal government lowered income tax rates for all firms in its 2008 budget. Instead of subsidising one-off investments, it increases a Scientific Research and Experimental Development Fund.

Government discretion is often viewed with suspicion on political economy grounds, but a pure rules-based approach runs the risk of the winner’s curse if there is competition with other jurisdictions (Van Biesebroeck 2008). The largest subsidy package will be offered by the participant with the most upwardly biased information on potential benefits of the project. When the actual benefits become clear over time, the winner might regret having won. This problem is particularly acute when an uncertain level of benefits would accrue to any potential location. Ignoring the specifics of a project and basing subsidies on simple objective rules runs the risk of offering subsidies which are too low for unusually valuable projects, leading to a loss in the bidding game, and subsidies which are too high for dud projects, leading to the winner’s curse.

Governments should also be careful not to pay for the same benefit twice. Several programmes exist to address potential externalities – the main justification for the subsidies. In Canada, these include funds to subsidise R&D, technology adoption, research joint ventures, and training or apprentice programmes.

It is also clear that firms will try to enhance interjurisdictional competition for their projects in order to extract greater subsidies. Some of the money paid out under the Ontario Automotive Investment Strategy went to the new Toyota assembly plant in Woodstock that started production in December 2008, but the bulk of the money has been committed to refurbish existing General Motors, Ford, and Chrysler plants—so-called brownfield investments.

This highlights a dynamic. Once a jurisdiction acquires a reputation for subsidising investments, it will be tapped by existing producers to subsidise ongoing investments using the threat of relocating. In some cases, for example the Ford Oakville plant, it is possible that the plant would have closed without the new subsidies. In contrast, the incentive package for General Motors’ Beacon Project involved all its Ontario assembly and engine plants.

A related political problem is that large firms are able to extract subsidies for one project, while maintaining freedom to decide independently on other projects. Even though General Motors was the largest beneficiary of the Ontario Automotive Investment Strategy, it still announced the closure of two of its Oshawa assembly plants in 2005 and 2008, the first one only a couple of months after the government support was finalised.

To protect itself against this type of exploitation, the federal government insisted at times on a number of conditions. For one, incentives would be clawed back if subsequent investment and employment levels fell below a certain (undisclosed) level. This might have contributed to Ford’s decision to close its Michigan plant in Wixom in its 2006 restructuring rather than its Ontario plant in St. Thomas— both factories assembled full-size rear-drive sedans.

Another condition, pushed especially by the provincial government, is for subsidy levels to depend on factors other than just the amount invested. The five criteria for maximum Ontario Automotive Investment Strategy awards include innovation and R&D, infrastructure, energy efficiency, environmental technology, and training and skills development. Still, somehow each of ten beneficiaries managed to qualify for the maximum subsidy level of 10%.

On the day of the announcement, Canadian Press Harris-Decima completed a four-day survey showing strong popular support for a bailout of the carmakers. Supporters outnumbered opponents by a large margin – 56% versus 33% of respondents. This makes it easier to understand why the politicians stepped in. Ontario Premier McGuinty said "Our choice is to passively preside over the demise of the industry in Canada and observe its consolidation in the (US) or to act. We chose to act." Apart from slowing down the demise, they have not made it clear what they hope to achieve with their actions.

Reference

Van Biesebroeck, Johannes. 2008, “Bidding for Investment Projects: Smart Public Policy or Corporate Welfare?,” University of Toronto Working Paper 344.

Topics: Microeconomic regulation
Tags: bailout, Canada, Car industry

Johannes Van Biesebroeck

Professor of Economics at the K.U.Leuven, Belgium