Chip Taylor

Economic development tax incentives

In this week's Economic View column, Daniel Gross relates the findings of a study by the Economic Policy Institute concerning the effects of taxes and tax incentives on economic growth.

Economic development officials almost always are armed with data on state and local taxes, and with a portfolio of tax incentives. The amount of such taxes paid, they argue, can make a huge difference in a company's profitability and prospects.

But a study released this spring by the Economic Policy Institute, a nonprofit research group based in Washington, says that state and local taxes do not matter all that much to corporations. "The vast majority of the studies find that there is little or no effect of state taxes on where firms invest, and little economic effect in terms of job creation," said the study's author, Robert G. Lynch, an associate professor of economics at Washington College in Chestertown, Md.

State and local taxes paid directly by businesses - corporate income taxes, sales taxes on equipment, property taxes - account for 30 percent of all state and local taxes paid. But in 2000, Dr. Lynch concluded, these taxes were just 1.2 percent of total operating costs for companies. Because companies deduct the payments from their federal tax liability, state and local taxes eat up only 0.8 percent of total costs, or 80 cents of every $100 - hardly enough to mean the difference between profit and loss.

The executive summary of the report explains further:

All state and local taxes combined make up but a small share of business costs and reduce profits only to a limited extent. Indeed, the costs of taxes pale in comparison to many other location-specific costs, and numerous location factors—including qualified workers, proximity to customers, and quality public services—can be more critical than taxes. The availability of these vital location factors depends in large part on each state and locality's commitment to public investment—and their ability to pay for it. Research, in fact, substantiates that public investment plays a positive role in helping lower costs for firms.

He's correct. The factors he mentions -- particularly the nature of the workforce and access to markets -- are critical in identifying potential locations for a new firm or branch plant. I've read other research that indicates that state and local tax systems play a role in the initial screening also. States that have taxes that are way out of line with other states are more likely to be eliminated early in the process.

When the firm has whittled the potential locations down to the final short list of two or three is when taxes and incentives start playing a more prominent role. Ideally, the firm has shortened the list to communities between which it is indifferent; they are all equally sutiable -- or nearly so. The incentives that result from the final competition do no more than tip the scales between close competitors.

So why doesn't research show an effect? Well, actually some research does show an effect of taxes and incentives on location decisions, but it is of small magnitude. Furthermore, under the competitive theory described above the incentives come into play at the end of the process after the most suitable locations have been identified -- mostly on other criteria. Finally, some researchers suggest that since most communities are offering similar incentives and aren't necessarily showing a lot of savvy in how they negotiate, it is hard to pick out the incentive effect from among all the other factors.

So why do local governments keep offering incentives? Wouldn't they be better off if they just concentrated on providing efficient, reasonably-priced public services? Yeah, probably. But there are several reasons why it is hard for them to quit.

First, there are political considerations. Once a town has been selected as a finalist for a new branch plant, the local officials don't want to be seen as not trying to land it. What if they refuse to offer additional incentives and "lose" the plant to another community that does offer them. Politician's have a low tolerance for accepting blame. In most areas they'll catch much more flack for offering too little in the way of incentives and not being selected, than they will for winning the plant with a too-generous incentive package.

So communities (actually their officials) find themselves in a sort of prisoners' dilemma. They would probably all be better off if they didn't offer specific incentives. But if incentives offer even a small chance of tipping the balance in your favor, it's to your advantage to offer them -- especially if the competing communities don't. Consequently, they all tend to offer them.

There are some economic theories that somewhat justify the offer of incentives as a rational (if not necessarily wise) strategy for local governments. The one that I find most convincing has to do with the notion the local property taxes on business capital exceed the value of the benefits to business of the public services they fund.

I don't think that's too controversial; it seems to be fairly widely accepted that residential development doesn't generate enough additional tax revenue to pay for the services it consumes. Someone else must be picking up the slack.

In this case, the theory suggests, mobile firms (and there is no firm so mobile as one that hasn't yet selected a location) are able to use the competition between communities to bid their tax burden down to the benefit level. From the community's point of view this can be good, so long as two conditions are met:

1) the incentive was instrumental in tipping the firm's decision, and
2) they don't drop the firm's tax burden below cost of service.

Together, I think the benefit tax theory and game theory offer a good explanation of why industrial location incentives happen -- although they fall short of justifying them as a "good thing" in the sense that we are all better off with them than without them.

There are other economic theories -- such as agglomeration theory -- that I find less compelling as a justification for incentives. There are also theories that lie more in the political science field, mostly having to do with interest groups, with which I'm not yet really familiar. So my views may change as I get further in my research. But today, based on what I've learned so far, this seems to me to be the most compelling explanation of why incentives happen.