The Region

Business climate and the role of development incentives

Brian Dabson - President
Carl Rist - Policy Analyst
William Schweke - Senior Fellow, Corporation for Enterprise Development, Washington, D.C.

Published June 1, 1996  |  June 1996 issue

Rapid changes in the world economy have transformed national economies during the last 15 years. The insulation that national borders and federal policies provided have largely dissolved, exposing formerly protected state and regional economies to the challenges of the global economy. Today, a state government must act quickly to meet economic challenges created on the other side of the globe.

State policymakers often perceive that the most effective way to meet the new economic challenges is to improve a state's business climate. The term "business climate" generally refers to the perceived hospitality of a state or locality to the needs and desires of businesses located in, or considering a move to, that jurisdiction. This perception is fluid, however, and states endure constant fear that the corporate sector will shun them if their business climate fails to meet some elusive standard, and that specific areas will find it difficult to attract or foster new firms and the jobs they provide.

The business climate dilemma

The government's role in business climate has been attracting a great deal of attention in recent years. Indeed, government has a major impact on business climate, for it is that combination of public services, taxation and regulation that creates the context within which companies operate. Yet, the term "business climate" has become almost synonymous with the pressure to cut taxes, reduce services and remove impediments, particularly employment and environmental regulations.

Ironically, much of what is done in the name of business climate fails to help either a state's business community or its residents. Rolling out the red carpet and making government more customer-oriented makes a lot of sense. Yet, making penny-wise but dollar-foolish cuts in essential government programs does not. Exploring ways to create a cleaner environment in a more cost-effective fashion and enlisting industry's creativity in doing so is smart. Yet, rolling back necessary environmental protections and weakening enforcement actions against real law-breakers sabotage a legitimate desire to lower business compliance costs, make regulation more predictable and professional, and discover ways to prevent pollution problems.

Nowhere is the pressure to create a friendly business climate felt more intensely than in the competition to attract industry. Annually, states and localities spend hundreds of millions of public dollars on a variety of tax incentives and spending programs designed to attract footloose companies. As syndicated columnist Neal Peirce points out, however, the boom in business incentives could hardly have come at a worse time. States which are already under fierce anti-tax pressure are about to shoulder extensive new responsibilities devolved from a shrinking federal government. In this new fiscal environment, every public dollar will be needed for financing the basics required for survival in the new global economic order.

What states should do

Fresh thinking is required about the way economic development is heading in the United States. We have to move the debate about business climate away from simplistic notions of tax competitiveness or "getting the government off our backs" to focus on the real disincentives to economic competitiveness and opportunity. States and local governments interested in improving the business climate need to:

  1. Design policies that improve the conditions for profitability and job creation, and
  2. Increase the accountability of tax and other incentives, if they are used as part of the overall development strategy.

The policy components of a "positive" business climate

There are five key components of a positive business climate: education, physical infrastructure, regulation, taxation and modernization. Policymakers must give serious attention to these components and not shortchange them in an effort to appear "pro business."

Education

We have reached the stage where global competitive advantage is based primarily on the education and skills of the labor force. Other factors such as natural resources and proximity to markets and suppliers are clearly important, but the next leaps forward in productivity and innovation will require more flexible, articulate, thinking workers. Thus, wise investment in public education is an absolute must for creating a positive business climate. This is not simply about throwing more money at education, but rather getting the most value out of additional education spending. This means focusing attention on goals such as improved student outcomes and increased accountability on the part of schools.

Physical infrastructure and public services
Often neglected in the anti-tax debates is the importance of basic services, efficiently and cost-effectively delivered, to the creation of a positive business climate. The repair and maintenance of highways and sidewalks, the management and operation of schools, the prevention of crime, the safeguarding of public health and the care of public parks are all essential to a community's quality of life. The reduction of tax revenues to the point where these services can no longer be adequately provided signals a reduction in an area's competitiveness.

Regulation

The main targets of those wishing to deregulate industry are employment and environmental regulations, which exist both to guard the health, safety and welfare of the citizenry and to place some constraint on the more unacceptable aspects of the free market. Unfortunately, regulators have brought much of the present hostility on themselves. They have used overly bureaucratic procedures, focused on compliance rather than finding workable preventive solutions, and have applied uniform standards regardless of circumstances, cost or size of business. Business groups have shown that it is not the regulations themselves that cause them grief, but the way they are administered. A positive business climate is created by regulators who seek to work with business to achieve acceptable standards, whether in the workplace or in the environment, while at the same time not compromising their ability to enforce the law on behalf of public health and safety.

Taxation

There has been an overwhelming emphasis in recent years on tax competitiveness and tax rates. This has diverted attention, first of all, from the fact that our state tax systems are often outmoded, and no longer able to meet acceptable standards of adequacy, efficiency and equity. Because of this, the burden of taxation is being shouldered by an increasingly narrow slice of economic activity. Second, this overemphasis on tax competitiveness and tax rates obscures the fact that there are other, equally important goals of a tax system, including: reliability—stable and certain revenue generation and consistent rates; balance—a spread across a range of tax sources without over-reliance on any one; equity—a fair system which shields subsistence income from taxation, is progressive and imposes the same tax burden on households earning the same income; efficiency—easy to understand, minimal compliance costs, simple administration; and accountability—public information on sources and uses of tax revenues, and information about revenues effectively lost due to tax breaks. The best tax climate is one which addresses well each of these objectives, along with tax competitiveness.

Modernization and entrepreneurship

For years, much of economic development has also focused on the "homegrown economy" by providing financial support in the form of grants or low interest loans and advisory services to businesses. The focus has tended to be on retaining and modernizing businesses in a particular area or on encouraging successful entrepreneurial initiative. The challenge is to turn these programs into effective delivery systems. These must include public and private providers and address the pressing need for businesses to modernize and to upgrade their technologies so that they can be more competitive. What is needed are economic development efforts that pursue the high-road of greater skills, higher productivity and better wages, and deliver these development services with greater quality, customer friendliness, accountability and cost-effectiveness.

Making development incentives more accountable

The fundamental dilemma of development incentives is that, while most economists agree that they are not good development policy (due to cost, risk, questions of effectiveness, etc.), there seems to be no doubt that incentives can make a difference in the site selection process, particularly when the choice comes down to one of two similar locations. Thus, business attraction should not be seen as a worthless exercise. Rather, the challenge for state and local governments is to find a better way to respond to this dilemma and to act with greater fiscal integrity.

To do this, innovative state and local governments should act on the following five directives:

Strengthen accountability and disclosure
If incentives remain in a government's development policy portfolio, they must be accompanied by a range of accountability and disclosure provisions, including:

  • Full public disclosure of incentive costs. Some states even disclose how much an individual company benefits from the incentives.
  • Rigorous and standardized approaches for calculating the costs of each job created or retained.
  • Accurate tax expenditure reporting if tax-based incentives are used.
  • "Sunset" reviews to assess the effectiveness and impact of tax and nontax incentives.
  • Establishment of benchmark "return on investment" targets, if incentives are to be enacted or maintained.

Limit development incentives to strategic uses

Incentives must be designed much more strategically: They should be "custom-fit," not "copy-cat." They must create significant numbers of jobs cost-effectively and fit with the state's highest development priorities.

Policymakers should set clear goals and criteria for what sorts of projects deserve financing. For instance, after a careful evaluation of a jurisdiction's needs, priorities and opportunities, policymakers might focus on any of the following goals: overall job creation, job growth in slower growing areas, industry diversification, increased minority employment or the attraction of high-tech industries or "quality" jobs.

Pick the right incentives

Since not all incentives are the same, policymakers must give special attention to allocating scarce resources to the types of incentives that have the greatest potential accountability and that are likely to provide the broadest benefits beyond the company assisted. For example, investments in training or physical infrastructure accrue to the broader community and remain in a community, whether a particular company stays or not. Cash grants, on the other hand, belong to private businesses alone.

Link incentives and employment programs

States should also explore how to link "first source" hiring agreements with their incentive efforts. Such agreements require private companies that receive public monies to consider hiring displaced and economically disadvantaged workers through a public or non-profit operated job referral and training service. One strategy might be to encourage the use of first-source agreements in fast-growing areas of a state. This would ensure that recruitment efforts indeed help those most in need of jobs and would also "level the playing field" between high-growth and lower-growth areas.

Consider cutting incentives for capital investments and using these monies instead for employment-based incentives, such as for new hires, for training and for above average wages. This is essential if a state is focusing on employment generation more than productivity goals.

Show political leadership

Far-sighted state leadership should look for ways to slow the "arms race" by:

  • Working with other states to devise workable compacts for responsible incentive competition.
  • Exploring the feasibility of federal legislation to restrict these bidding wars as well. (See Burstein and Rolnick, "Congress should end the economic war for sports and other businesses," in this collection of papers.) Burstein and Rolnick propose that Congress impose sanctions against states that engage in bidding wars; others have proposed restricting the use of incentives to those areas with high unemployment or slow job growth.
  • Educating their constituencies about: (1) the dangers posed by an unregulated incentives arms race and the fact that most new jobs come from expansions and new business start-ups - not from relocations, and (2) the fact that creating the conditions for profitable companies (i.e. delivering quality public services in an efficient manner) has a much greater impact on job growth than the combined effects of a state or local community's entire economic development arsenal.

This paper, published by the Minneapolis Fed for "The Economic War Among the States," a conference held in Washington, D.C., on May 21-22, 1996, is reprinted in this issue of The Region.

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