Fisher and Peters (1998) are interested in two issues:
1) Measuring the benefits to firms of state and local economic development incentives, and
2) Examining the spatial pattern of economic development incentives, i.e. do poor locations use incentives more intensively?
They review the two main justifications for the use of incentives:
Political -- they are necessary to remain competitive in attracting investment
Economic -- the new investment (and its multiplier) will enhance local incomes
They review criticisms of incentive use:
1) Indirect (growth-related) costs may increase cost or decrease quality of local public services
2) Direct costs may exceed benefits
3) Mobility of labor may prevent localworkers from receiving the benefits of the incentives
3a) Benefits may accrue to land owners (immobile resource)
4) Incentives may cause inefficient location decisions.
They review "revisionist" research -- research finding incentives to be beneficial:
1) Incentives allow firms to bid business taxes down to the benefit level -- increasing economic efficiency
2) Incentives may offset other market imperfections
3) To the extent they attract foreign investment, they don't just move domestic investment from place to place
4) Increased employment (resulting from incentives) can lead to increased local labor force participation and decreased unemployment rates; these effects persist over time (Bartik, 1991)
Item (4) implies that economic development policies are more likely to be cost-effective in areas with high and persistent poverty and unemployment.
Brief lit review
Issue 1 - Do incentives effect business location decisions?
They review the strengths and weaknesses of several methods: survey, case study, econometric, general equlibrium, and hypothetical firm (their choice).
Issue 2 - The spatial distribution of incentives
The literature is inconclusive about whether poor locations use incentives more heavily. Possible reasons:
Poorer jurisdictions may be under more pressure to "do something," but have fewer resources with which to do it.
There is inertia in the policy process; even after prosperity returns, the programs will likely continue.
Hypothetical firm method: What is it and why use it?
This method attempts to measure the value of the incentives to the firms that receive them; the effect on firm profitability of the incentives. It is that effect that will influence firm locations.
Common mistake in valuing incentives is to just add up nominal values. This has two problems: it ignores tax effects (reducing state taxes often increases federal taxes) inflating the value; it compares apples and oranges (a $1 million grant is different than a $1 million loan).
They build "typical" financial statements of large and small firms in 8 fast-growing industries. Then they use those financial statements to estimate the value of the "standing incentive offers" of various states.
They examine the 24 states with the most manufacturing employment (accounting for 86% of all manufacturing employment).
Brief review of incentive typology: what incentives do they include in their model?
Supply-side vs. Demand-side -- they are concerned only with supply-side
Tax incentives
There are two broad types of tax incentives:
1) Economic development tax expenditures (credits, exemptions, etc.) aimed specifically at stimulating private investment. Three types of incentives fall into clearly into this category:
a) investment and employment credits against income or franchise taxes
b) sales tax exemptions provided to enterprise sone firms
c) property tax abatements for new investment
2) General tax policies aimed at not discouraging investment. Avoiding Shannon's (1991) six "sore thumbs":
a) high overall tax burden
b) heavy and progressive individual income tax
c) business tax burden out of line with other states
d) heavy property tax on business real property
e) any property tax on business personal property (machinery or inventory)
f) sales tax on a substantial share of business purposes (mchinery, fuel, utilities)
Their model simulates overall burden of corporate income taxes, property tx on business real and personal property, sales tax on major business purchases, and federal corporate taxes.
They note that most tax incentives tend to be entitlements, or non-discretionary; all firms that meet certain criteria automatically qualify.
Non-tax incentives
Non-tax incentives tend to be discretionary and subject to negotiation.
They describe three broad categories of non-tax incentives:
a) General-purpose financing programs
b) Customized job training and wage subsidies
c) Infrastructure subsidies
The preceding covers Chapters 1 and 2. Chapter 3 provides more detail about the hypothetical firm method.
Chapter 4 reviews the variation in tax systems and incentive programs across states and cities.
They discuss features of income, sales, and property taxes and geographical targeting that can be varied to change their effects on business.
They note the difference in basic tax systems and tax incentives. Tax incentives have a clear economic development purpose (investment or job credits, enterprise zones, etc.) Variation in basic tax systems (apportionment, sales tax exemption of machinery, etc.) may have an economic devlopment motivation, but don't have as clear a purpose.
Table 4.5 (p. 125) shows the value of various tax system features and incentives (relative to a worst-case, high-tax state) for six of their hypothetical firms. Table 4.5 indicates that some tax incentives or features are more valuable than others. In some cases, value varies according to the type of firm.
For example, property tax abatements are much more valuable to firms than are investment or job tax credits. Property tax abatements are more valuable to plastics, auto, or furniture manufacturers than they are to drug or instrument manufacturers.
Deductibility of federal income taxes is more valuable to drug, soap, and instrument manufacturers than to plastics or auto manufacturing firms.
They note the relative importance of state vs. local taxes and incentives.
States set the overall rules for the state and cities alike. There is wide variation in state and local incentives across geography. However, the variation is reduced when state and local taxes and incentives are combined. Where local incentives are limited, state incentives are larger and vice versa.
Non-tax incentives
They model non-tax incnetives as a $100k cash grant. They estimate the after tax value of the grant and find that multistate firms see 60-62 cents on the dollar in actual benefits; single state firms 58-73 cents. The rest is dissipated in transfers to other jurisdictions, especially federal income tax.
Table 4.9 (p. 141) indicates that in most cases non-tax incentives contribute more to the overall incentive package than tax incentives. The effects vary over industries. Training incentives tend to be the most important incentive. Infrasturcture and training incentives are more important for large plants than for small plants.
Then they address several aspects of the spatial pattern of taxes and incentives
They rank the 112 cities in their model from worst to best tax and incentive packages. They find a relatively large difference between the best and worst locations, but, except at the extreme ends of the distribution, a change of several positions in the distribution of locations has little substantive effect on firm profitability. However, when converted to an hourly labor equivalent, the difference between the best and worst locations was less than a dollar an hour. In other words, it wouldn't be hard for differences in labor or other factor costs to outweigh differences in tax and incentive packages.
They also make comparisons just among the best or worst locations and find that incentives accentuate rather than attenuate differences. In other words, the best locations before incentives are even better after accounting for incentives. Same for the worst.
But there appears to be no relation between basic tax system and incentives. It is not the case that areas with poor tax systems offer consistently better or worse incentive packages.
So why don't high-tax areas offer bigger incentives (and vice versa) to remain competitive? F&P suggest that competing communities don't know the actual impacts on firm profits and merely try to match nominal subsidies of their competitor cities. [Info asymmetry between firm and city -- advantage: firm]
They find a wide variation in city rankings -- even within states -- but their analysis shows that states are important in determining city rankings.
They examine the spatial distribution of after-tax and after-incentive returns. They find that tax systems skew returns in a pervers direction; areas with low unemployment produce higher returns. [They are doing a point estimate; perhaps the high return is the reason for the low unemployment]
Incentives are distributed as you might expect: poorer performing areas ofter incentive packages with higher returns.
They summarize:
These results are consistent with the theis that state and local economic development incentives are adopted for a variety of reasons -- high unemployment being but one, simple imitation of other states being another -- and that such incentives are likely to persist even if state economic performance (and state unemployment rates) improve.
Concluding chapter: Incentive Competition and Public Policy
Are taxes and incentives decisive in firm location decisions? They conclude that it depends on other factors costs. Differences in tax and incentives aren't trivial. They note that cities with extremely poor tax and incentive packages may be excluded during the intial screening (as in the "sore thumbs" referred to earlier?)
They also note some deficiencies in reporting on tax incentives:
1) reported figures show gross cost to state and local gov't, not net value to firm
2) future tax subsidies are added without discounting
3) subsidy packages often include features of basic tax code, for which firm would have been eligible even without negotiation.
What are national benefits of industrial competition?
There is little, if any evidence, that competition is efficiency enhancing, in the sense of directing growth to high unemployment areas.
Posted by Chip on May 25, 2004 at 01:41 PM | TrackBack