Partners, Volume 15, Number 3, 2005

Attracting Economic Development—At What Cost?

Vast amounts of resources are dedicated to economic development at the local, state and national level. The strategies employed to generate economic growth and create jobs vary, but tax incentives have emerged as one of the most popular and often debated tools.

Southern states have traditionally relied more heavily on incentives, which are often cited as one of the important factors in the migration of manufacturing jobs from the Northeast to the South. As use of tax incentives has increased, debate has intensified over whether these incentives are a wise investment of public resources.

What is economic development?
Economic development is usually defined as economic growth that leads to increased job opportunities and wealth generation at the city, state or national level. The public sector has a critical role in economic development because it can use public resources to reduce risks and costs that could prohibit private sector investment and job creation.

Different interests and goals must be accommodated in forming an economic development program. Business leaders are concerned with improving the business climate and economic competitiveness of the region. Labor leaders want a strategy that leads to more jobs, higher wages and more worker training. Community leaders think economic development should alleviate poverty and reduce inequality. Public officials want to see overall economic growth in their communities.

While all of these goals are important, different theories exist about the best use of limited public resources. Trade-offs between the different goals may be unavoidable. Devising a comprehensive strategy for economic development that incorporates the different goals and accommodates trade-offs is challenging.

Economic development strategies and assistance
In the past, economic development strategies focused on programs that impacted the traditional factors of production: land, labor and capital markets. However, as businesses have become more willing and able to move to a wide variety of locations, many states and cities have adopted economic development strategies that emphasize reducing the cost of conducting business.

Economic development strategies are characterized by two approaches: An externally focused approach generally directs resources towards new business recruitment and relocation incentives. An internally focused approach directs resources towards a “grow your own” strategy. There is no “one size fits all” approach, and states must develop a strategy to meet their particular strategic goals and economic needs. Regardless of which approach is emphasized, assistance should aim to fix a market failure rather than serve as a substitute for private investment.

Economic development assistance is generally divided into two categories. The first approach uses the tax code and offers tax incentives such as capital investment tax credits, jobs tax credits, sales tax credits, property tax abatement and tax increment financing. Tax incentives for economic development were once more heavily used in the South and Midwest, but now they are offered in at least 40 states.

The second category of development assistance provides non-tax incentives, such as infrastructural improvements, subsidized financing, direct cash grants, loan guarantees and other forms of business assistance. These may be offered in conjunction with tax incentives.

Do tax incentives work?
The effectiveness of tax incentives is a common debate in economic development circles. Proponents of incentives, including many public officials and corporate leaders, say they are a necessary tool for attracting business and promoting job creation and retention. They argue that states or cities that do not offer tax incentives are at a competitive disadvantage when attempting to recruit or retain jobs that could migrate to another state or country.

Proponents argue that tax incentives pay for themselves by generating additional revenue as businesses expand and jobs are created. Supporters of this view point to several economic studies that show the multiplier effect of tax incentives and indicate the return on investment exceeds the actual cost of the incentive.

On the other hand, widespread criticism of tax incentives exists among economists, policymakers, community leaders and even some business leaders. Critics contend that tax incentives are an inefficient use of scarce public resources, that they do not produce the same return on investment as other forms of direct public investment.

Critics of tax incentives further claim they deprive state and local governments of revenue needed to fund education, infrastructure and other public services. They point to studies that show spending on education and public infrastructure also encourages economic development and argue that tax incentives force spending cuts in these very areas.

The role of tax incentives in a company’s investment decisions is also hotly contested. Proponents of tax incentives believe they play a critical role. Critics on the other hand cite studies that indicate the quality of the workforce, geographic location and the overall business climate are more important than tax incentives in a firm’s investment decision.

Measuring effectiveness
Assessing the effectiveness of tax incentives is difficult for a variety of reasons. First, determining the true cost of tax incentives is challenging because these costs are not typically captured in a state’s budget.

Second, there is no consistent method for assessing the cost-to-benefit ratio of tax incentives. For example, incentives may encourage the creation of new jobs in an area, but these new jobs may create additional public costs such as increased traffic congestion and public service needs. Often these additional costs are not included in the analysis of the incentives.

On the other hand, the cost of incentives may seem to outweigh the benefits, but there may be other long-term social benefits associated with the investment that can not be easily measured. A uniform cost-benefit analysis that includes immediate and long-term costs and benefits as well as the social costs and benefits should be developed to evaluate the effectiveness of incentives.

Third, it is difficult to determine the impact of incentives because it is impossible to know what might have happened without the incentives. For example, it is hard to determine if a company would have located in the same area or created the same number of jobs even without incentives. In high-growth areas where new companies are locating and all companies are growing, it is particularly difficult to isolate the impact of the incentives.

Finally, lack of long-term monitoring makes it difficult to measure the effectiveness of incentives. Cities and states usually focus development resources on new investment and job creation rather than ongoing supervision to ensure that corporations follow through on the commitments they made in return for the incentives.

What is the future of tax incentives?
The use of state and local tax incentives is clearly controversial. Businesses now almost expect incentives when they announce plans for a new location or expansion of their current facilities.

Incentives are often criticized for...driving the “economic race to the bottom.”

However, a broad range of groups are voicing concern over the use of incentives in light of the tight fiscal situation facing state and local governments.

Incentives are often criticized for fueling a bidding war between jurisdictions and driving the “economic race to the bottom.” These critics argue that in an effort to win the big deals, states and local governments are giving away their tax base and would be better off if they competed with different economic development strategies.

Since nearly all states offer incentives, it is virtually impossible for one state to end its incentive program unilaterally. Thus tax incentive opponents are calling for action at the federal level to end incentive competition between the states. The federal government usually defers to the states regarding economic development policy at the local level, but a recent court decision in Ohio indicates that could be changing.

In September 2004, the U.S. 6th Circuit Court of Appeals declared that part of an incentive package offered to DaimlerChrysler by the state of Ohio was unconstitutional. The business community and state economic development agencies quickly introduced federal legislation to protect a state’s right to grant economic development incentives to private corporations. On September 27, 2005, the U.S. Supreme Court agreed to review the 6th Circuit decision, causing the federal legislation to be delayed.

To ensure more efficient use of tax incentives, greater transparency and accountability are essential. Disclosing the full value of incentives and conducting a cost-benefit analysis that includes both short- and long-term costs and benefits would lead to a more informed public debate over the use of incentives. Making corporations more accountable for the incentives they receive is also important. More states are starting to include performance standards that tie incentive offers to certain job or investment benchmarks.

What are the alternatives to tax incentives?
In addition to tax incentives, investment in education and workforce training, promotion of policies to assist entrepreneurs and investment in other forms of business assistance are all strategies to spur economic development. Some states are also considering making their tax codes more business friendly overall while reducing reliance on incentives.

An effective economic development program must balance many different interests in light of both short- and long-term goals. It should help the state improve all of the factors that create a strong business climate: an educated workforce, good schools, adequate public services, good infrastructure, housing and a competitive tax system.

This article was written by Jessica LeVeen Farr, regional community development manager in the Atlanta Fed’s Nashville Branch.

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