The Region

Taxes, incentives and competition for investment

Peter S. Fisher - Associate Professor
Alan H. Peters - Assistant Professor, Graduate Program in Urban and Regional Planning, University of Iowa

Published June 1, 1996  |  June 1996 issue

This report is based on a study conducted by the authors and funded by the W.E. Upjohn Institute for Employment Research, Kalamazoo, Mich.

Over the past several years, there has been a great deal of "revisionist" research on the effects of economic development programs at the state and local level. There is now substantial evidence that programs to attract jobs by lowering business costs are more effective than previously thought and are likely to provide some long-term benefits to the locality in the form of lower unemployment and higher annual earnings. Some, such as Bartik (in his book Who Benefits from State and Local Industrial Policies?), have gone beyond this to argue that such local policies are beneficial for the nation as a whole to the extent that the incentives are concentrated in relatively low-growth or high-unemployment regions, since the benefits of jobs created there will exceed the benefits lost by not creating jobs in low-unemployment areas.

Whether competitive state and local economic development policy enhances the welfare of the nation as a whole depends crucially on whether incentives do affect location and where such incentives are offered. Previous research has provided only limited, and somewhat contradictory, evidence on the latter issue. This paper reports the results of a two-year study sponsored by the W.E. Upjohn Institute for Employment Research on the question: Are the economic development incentives offered by states and cities significantly higher in high-unemployment places? In other words, is there evidence that the end result of competition for jobs could be a redistribution of jobs to regions that would benefit the most?

It is reasonable to assume that the states and municipalities with the highest unemployment face the greatest political pressure to create jobs; thus one might expect that they offer the largest incentives. On the other hand, high unemployment and slow job growth are likely to coincide with fiscal distress, a declining tax base and reduced capacity to support new expenditure initiatives. Furthermore, many of these programs are tax expenditures and thus escape scrutiny during the annual budget process; once enacted, perhaps during a recession, they may persist long after their political, no less economic, rationale has disappeared.

In our research, we measure competition among places based on the dollar value of the locality's standing incentive offer to industrial firms expanding or locating in that locality. The standing offer includes the whole range of competitive incentives over which state or local governments have some direct control: income tax investment and jobs credits, property tax abatements, sales tax exemptions, grants, loans, loan guarantees, and firm-specific job-training and infrastructure subsidies. Since incentives may be embedded in tax codes, and since the value of incentives to a firm must be measured net of income tax effects, we also model the federal corporate income tax, each state's and city's corporate income and net worth taxes, the major state and local sales taxes paid by business, and local property taxes.

The present study uses the hypothetical firm method to measure the value of competitive incentives. We constructed financial statements for 16 hypothetical firms, representing the characteristics of a typical large and small firm in each of eight fast-growing manufacturing industries. The model then measures the net returns on a new plant investment, after state, local and federal taxes, and after state and local competitive incentives. The new plant is located in one of 24 states, the 24 that account for the most manufacturing employment in the United States, and in one of 112 cities, randomly selected from within these 24 states. (Together, these 24 states account for about 87 percent of U.S. manufacturing employment.) The effect of multistate taxation is modeled because our firms can be given multistate locations. The difference between returns on investment with incentives and returns with only basic taxes modeled measures the value to the firm of the incentives offered. Calculations are done over a 20-year period to capture the full effects of incentives. Project returns are the incremental value of cash flow over the 20-year period.

Is there significant variation in returns across locations?

Is there sufficient variation in returns on investment across states and cities so that tax and incentive differences could plausibly affect location decisions? If incentives have little effect on the profitability of plant location at different sites, there is little reason to worry about their potential effects in terms of redistributing employment.

Table-Project Returns Alfter All Taxes  ans Incentives for 16 Firms, 24 States, 112 Cities

Table 1 provides summary information on project returns for each of the 16 firms at the 112 city locations. The coefficient of variation and range both suggest that there are substantial differences in returns among sites. For instance, there is a $1.1 million 20-year cash flow difference between a small furniture and fixtures firm investing a new plant in the least profitable city and the most profitable city. For the large drugs firm, the difference is $58.7 million, for the large motor vehicles firm, a huge $76.7 million. Clearly, these differences are substantively significant—but are they significant enough to influence location decisions?

The last two columns of Table 1 translate the range between the best and worst cities into wage equivalent figures. Given the level of employment modeled for each plant, and assuming that all employees work a 40-hour week over a 50-week year, what is the present value wage equivalent of the range? For some firms, the results are startling. For the small industrial machinery firm, the differences between the best and worst site translate into an average hourly wage decrease, for the full 20-year period, of $1.09, or an annual per employee decrease in wages of $2,184. For large drugs firms the numbers are even greater ($1.84 an hour, $3,679 a year). For most firms modeled, the range is equivalent to around $1 in hourly wages. Thus it seems reasonable to conclude that, at least at the extremes, taxes and incentives are potentially large enough to influence location decisions. The worst cities are substantially worse than the best cities.

Nevertheless, for most states and cities, small changes to their tax and incentives systems are unlikely to make much of a competitive difference. Figure 1 plots net returns across the 112 cities for a single firm type: a small industrial machinery firm making a $10 million new investment. It is immediately clear that focusing on city rank positions, as is commonly done in the business climate literature, distorts the true impact of taxes and incentives on project returns. In hourly wage terms, most cities are separated from the city just above them in rank by less than a penny. We doubt such separation is substantively significant. In fact, a rank position change of as many as 20 places often represents less than a 25 cent difference in hourly wages.

To what extent does the provision of tax incentives and other incentives such as grants, loans, loan guarantees, tax increment financing instruments and so on, alter the relative competitiveness of a city's position? Figure 2 presents the data for the 29 cities offering the best returns to the small industrial machinery firm. Tax incentives and other incentives often play an important role in ameliorating the burden of a state and city's basic tax structure. Thus, merely looking at the basic tax structure misrepresents the true competitiveness of a city and state. It should be noted here that we found that other incentives seem to play a bigger role for small firms than for big firms. Other incentives seldom significantly improve the returns offered by a city and state to a big firm. Finally, tax incentives and other incentives do not level the playing field: We found no evidence to suggest that states and cities with less competitive tax structures tend to offer more incentives. On the contrary, many states and cities with low basic taxes also have high tax incentives and other incentives.

Three tentative conclusions emerge: (1) The differences in investment returns across states and cities due to tax and incentive differences are quite substantial, and it is certainly plausible that these differences are large enough to influence location choices; (2) the magnitude of incentives, relative to returns after taxes but without incentives, is substantial; and (3) incentive competition per se is not producing convergence across sites, but if anything is increasing inter-site differences.

Are returns higher in high-unemployment cities?

Our sample of cities was stratified into four city population size classes: (1) 500,000 or more, (2) 100,000 to 499,999, (3) 25,000 to 99,999 and (4) 10,000 to 24,999. Since the sampling percentages and response rates varied by size class, some results are shown separately for each of the four classes.

Table-Correlation Between City 1992 Unemployment Rate and Firms' Net Returns from New Plant Investment

The relation between project returns and city unemployment rate is shown in Table 2 in two different ways: (1) separately for five of the 16 firms (to illustrate the range of differences across firms), using the average correlation for cities of all sizes; and (2) separately for each of the four city size classes, showing the average correlation across the 16 firms. Almost all of the correlations are weak. There is a consistently negative relation between unemployment and returns after basic taxes (without any incentives); the highest-unemployment places have the highest tax burdens. There is a consistently positive relation between unemployment and tax incentives: The highest-unemployment places offer the largest state and local tax incentives. This result is dominated by local property tax abatements and by enterprise zone incentives; we deliberately allowed the largest incentives available in a city (which would be enterprise zone incentives in the 40 percent of our cities with such zones) to represent the city as a whole. Considering discretionary incentives, there is no clear pattern of providing inducements to shift jobs either toward or away from high-unemployment places.

The correlations do vary substantially by city size class. For the largest and smallest cities, the basic tax system results in higher returns in low-unemployment places, and the results are similar (but weaker) even after all incentives are included. For the two middle size classes, however, the relation is ambiguous, with incentives more clearly producing a pattern of returns more favorable to high-unemployment places.

The combined effects of statewide, citywide and enterprise-zone incentives are, in a sense, sufficient (on average) to overcome the perversity of the state-local tax system. But the end result is a pattern of returns on investment that is essentially random: There is no discernible tendency for returns to be more attractive in high-unemployment or in low-unemployment places.

Conclusions: The national benefits of competitive economic development policy

While the results for incentives lend some rather weak support to the hypothesis that incentive competition produces a spatial pattern of returns that favors places with more severe unemployment, this conclusion is tempered, if not negated, by considering the overall pattern of after-tax returns. State tax systems exhibit a strong tendency to skew returns on new industrial investment in a perverse direction, producing higher after-tax returns in states with lower unemployment rates, other things equal. This perverse pattern is offset to a degree by local taxes, which tend to be more favorable in states and cities with higher unemployment. The addition of tax incentives at the state and local level clearly helps tilt returns more in favor of distressed areas, and the inclusion of discretionary incentives also helps to a degree, but not consistently across city sizes and firms. However, the incentives taken in the aggregate are still not enough to clearly offset the effects of state taxes.

The end result is a spatial pattern of returns on new investment that bears little or no relation to the spatial pattern of unemployment. It appears that, after at least a decade and a half of intense competition for investment and jobs, and the widespread adoption of pro-development tax policies and development programs, states and cities have produced a system of taxes and incentives that provides no clear inducement for firms to invest in higher-unemployment places.

These results are consistent with the following two arguments (though they certainly cannot be taken as proof of either one): (1) State and local economic development incentives are adopted for a variety of reasons, high unemployment being one, but slow growth and simple imitation of other states being more important reasons; and (2) even where economic distress, as measured by high unemployment, provided the original political impetus to incentive adoption, incentives are likely to persist even if state economic performance improves.

What about the arguments that competition enhances efficiency? While our research does not address this issue explicitly, it has made one thing very clear: The characteristics of the firm can make a large difference. A state that appears very high in the rankings for a large, multistate automobile manufacturer may be near the bottom for a small, high-profit electronics firm. The sectoral patterns that emerge are surely not deliberate on the part of state policy-makers. It is unlikely that the implications of particular tax policies or programs for different industrial sectors are even considered, even less that the end result can be taken as the expression of some well-thought-out state industrial policy. But the fact of the matter is, there is probably as little rhyme or reason to the spatial preferences for different industries embodied in the pattern of returns after taxes and incentives in 1992 than there was in the pattern of after-tax returns in 1972. It is difficult to argue that two decades of competition has produced a more efficient pattern of location inducements.

To the extent that tax and incentive competition results in a redistribution of jobs, our research lends little or no support to the argument that this redistribution has beneficial effects for the nation as a whole, shifting jobs from places with low unemployment to places with high unemployment. Neither can we say that it is clearly harmful, providing inducements to redistribute jobs in the opposite direction. Of course, one can only speculate as to the counterfactual: what the spatial pattern of returns on investment in 1992 would have looked like had states and cities never undertaken to influence their economic fortunes by offering inducements to industry in competition with one another. If this pattern would have been distinctly counterproductive, with higher returns in lower-unemployment places, then one could conclude that competition has at least nullified such effects.

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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