efficiency and equity issues
of public tax incentives

The use of tax incentives as a policy instrument to encourage economic development is currently being debated for its merits on economic efficiency and equity. Tax incentives include reductions in corporate tax rates, property tax abatements, and the provision of tax-free industrial revenue bonds. New York City, alone, grants $800 million a year in waivers for property, business and excise taxes to induce certain businesses to stay within the city limits. Supporters believe retaining these companies with incentives results in increased local job opportunities and worker training, as well as enhanced private sector profitability and competitiveness. Critics, however, say these tax waivers greatly reduce revenues, forcing cutbacks in public goods like education, transportation and social services. They reason that the costs of tax incentives exceed their possible benefits when measured across society as a whole. The debate, therefore, centers on two major issues - do incentives adversely affect the efficiency of a local market economy, or are they a form of equity redistribution that enhances or decreases social welfare.

Efficiency Issues

One of the key issues in the debate is how government incentives influence the location decisions of a private firm. In a competitive market, firms act to maximize their profits by minimizing their costs. This occurs when a firm chooses a combination of production factors where the marginal product each factor adds to production is proportional to its price. For example, if the marginal product a worker adds to the firm’s output is lower than what the worker expects in wages, the firm will try to substitute labor at a lower wage. Firms may choose to move, taking advantage of lower wage labor in other cities or markets. Firms will sort themselves amongst cities to achieve the best advantage in operating their business. In essence, firms seeking to relocate may be acting in an efficient manner.

Firm Mobility
The effects of free mobility of firms and individuals on a local economy were studied by Tiebout (1956). He developed a market-like model that found free mobility determined the optimal and efficient level of government services a city should provide, and by extension, the level of taxation it would require. In the Tiebout model, communities are homogenous - all citizens of a particular community agree on how much their government provides in services. Companies and individuals are completely free to choose a city that gives them their preferred level of public goods and taxation. If you were dissatisfied with either, you would move to another city that would cater to your preferences. With free mobility, companies seeking to minimize their costs will find cities that will provide their preferences.

Given this model, incentives given to dissuade companies from moving distort the equilibrium allocation of companies among cities. When companies receive an incentive, they do not face the true costs of operating in a particular location, and are not motivated to spend the efficient amount of re- sources on what it produces. The city, in turn, must compensate for its subsidy by increasing taxes on other firms. The additional costs in taxes these firms bear will affect the efficiency of their own produc- tion decisions. Finally, excess burden related to tax increases will exact additional costs on government revenues. The end result severely hampers the market’s ability to operate efficiently, and may ultimately decrease social welfare.

Supporters of incentives maintain the benefits from keeping a factory or business within a city make up for the losses in market efficiency. They believe the firm produces external spillover effects on the rest of the city’s economy that can be greater than the amount of the incentive. In essence, govern- ment may detract from market efficiency, but social welfare is enhanced from economic multiplier effects the retained firms create. The key issue is whether a city can adequately measure the costs and benefits of an incentive strategy to justify its use.

Costs vs. Benefits
Much of the research on tax incentives has been to empirically measure the effects such programs have on a city’s economic development. These studies have tried to determine the effectiveness of the programs by weighing their costs and benefits to society. As a result, much debate has centered on what exactly the costs and benefits of a particular program really are.

A tax incentive program is said to increase social welfare if its benefits are greater than its costs. Cost-benefit analysis for these programs, however, can be very tricky. Trying to quantify a program’s benefits often depend on if you see the program as an incentive or a subsidy. Politicians constantly tout jobs as the chief benefit of these programs. (See Figure 1) Economists forcefully disagree and say jobs are costs to the overall economy. The differences in view extend to intangible factors as well. For example, perceptions of the general business climate can have great effect on how well a development program performs. Yet, it is difficult to attribute dollar values to a perception with any degree of cer- tainty.

In spite of these difficulties, several studies have developed estimates of the costs and benefits of typical incentive programs. In most, benefits tend to focus on those events that indicate growth in the local economy. Gains in real earnings, increases in property values, increased profits, and increased demand for products are measured first for the firm receiving the subsidy, along with possible spillover effects to other firms and industries in the market. What workers spend for lunch in local restaurants is an often cited example.

On the cost side, there will be a loss of tax revenue from the subsidized firm, creating a net budget cost for the program. As discussed earlier, this may cause reductions in public services to compensate for the subsidy. Other costs may result if the program is successful and growth does occur. Higher earnings of workers increases their cost of living. Local businesses will face increased wage costs unless productivity improves. With unemployment falling, more workers and firms may migrate into the locality, increasing the need for government services.

In one recent study, Bartik (1991) tried to model the costs and benefits for an average develop- ment program in an average city based on empirical data. (See Figure 2) Assuming a successful program increasing employment by 1% over the long run, Bartik found a positive, but weak correlation between the incentive and employment. Some variables were strongly correlated. For example, Bartik found the program’s tax cost per job and the unemployment level of the local economy, greatly affects the amount of benefits received by the whole economy. This implies a program should target its incen- tives to high unemployment areas, as well as minimize the cost subsidy per job. Many other factor coefficients, however, showed large ranges in values. This would imply incentives only cause economic growth under certain conditions and may not be applicable in many situations.

The results of Bartik’s study showed where economic development incentives may be useful and cost-effective. It also showed, however, the difficulty in quantifying how incentives affect the entire local economy. Economic growth (or contraction) can happen for many reasons. National trends, the condition of a specific industry, or other economic forces can have as much an effect on local companies as incentives. What most studies have shown is incentives have some effect on economic growth. However, the key issue is that there is no certainty, either from a theoretical or empirical standpoint, that incentives cause economic growth.

Equity Issues

If tax incentives cannot be shown to increase market efficiency, what other reasons are there for their use? Much of the debate over incentives ends up focusing on equity issues. When a particular business is granted a tax incentive, other businesses and citizens in the city feel their own taxes will increase to pay for it. They argue that the statutory incidence of the incentive has an economic incidence on them, far more than what is fair.

Cities and states claim one of the most important reasons for tax incentives is the competitive ad- vantage they provide against another locality’s incentives. If two cities offer an incentive package to a firm to locate in their jurisdiction, the firm will move to the place with the more lucrative deal. As reported in the New York Times, the board of the Coffee, Sugar, and Cocoa Exchange changed its plan to move to Jersey City when New York State and New York City government officials offered an incentive package greater than the one Jersey City originally offered. New York’s package gave the Exchange $91 million dollars in tax abatements to keep the Exchange’s 3,100 jobs from moving across the river. In addition, states and localities must also contend with global competition for firms. Firms are increasingly moving abroad to take advantage of lower wages or taxes. Government officials believe that incentives are necessary because other localities are doing the same thing. The outcome of any escalating war of incentives, however, depends wholly on which locality is willing to give more.

Effect on Public Goods
In decreasing a company’s tax burden with an incentive, the locality assumes this allows the firm to remain competitive and continue to exist, thereby saving jobs. Incentives, however, also reduce budget revenues for the entire city. In a recent speech, Labor Secretary Robert Reich gave two examples where states and cities gave large incentive packages to companies while city services were cut. Tennessee competed against several other states for a General Motors' Saturn plant and won, yet the city the plant was located in was 100 classrooms short of meeting minimum state standards. In Cleveland, eleven schools were closed for lack of funding while the city created a $175 million incentive package to retain its football team in a new stadium.

Tax incentives act as ‘tax expenditures’ - implicit spending that is hidden from view in the budgeting process. Since incentives occur as foregone tax receipts, they are not scrutinized as much as spending programs on public goods. As a result, taxpayers must contend with reduced funding for such things as schools, social programs, and infrastructure projects, without the means of voting booth ap- proval they would have with a bond issue or referendum. Some supporters of incentives, however, say reduced revenues may not be a bad thing. They claim city budgets are bloated already and ‘overcharge’ businesses for public services through waste and bureaucracy. They see incentives, not as subsidies, but as ‘discounts’ on the costs of public goods to entice additional revenue growth. (See Figure 3)

Burden Shifting
The issue of equity is also raised in how firms that receive tax incentives are selected. Many critics claim the process is inherently unfair to smaller businesses. They lack the large number of employees and legal and financial resources firms that receive incentives have. In his recent speech, Reich explained that the capitalist market was being skewed by companies receiving tax incentives: 'These tax abatements can be the most insidious forms of corporate welfare be- cause they are difficult to see at the state and local level, unlike some big federal gov- ernment giveaways, because they do not put competitors at a comparative disadvantage if they do not get the same largess...'

In addition, selection of firms to receive incentives has great potential for political abuse. Incentives given to major Wall Street financial firms came under intense scrutiny recently when it was disclosed that they had given large campaign donations to Mayor Giuliani. It would seem that the added pressure to maintain jobs for voters may influence objective decisions on which companies should receive incentives.

Zero-Sum or Negative-Sum
By expanding the view of the economy beyond the city or state to the nation, incentive competi- tion will mean there will be less revenue available in the overall economy to spend on public goods. The city the firm leaves will lose the tax revenue the firm would have paid, and the city the firm moves to will have to increase taxes or reduce spending to pay for the incentive. Again, Reich speaks about the unfair- ness of the competition in offering tax incentives which have no overall benefit to societal welfare: '...they often (are), in the classic sense of the term, zero-sum games in which jobs are simply moved from one place to another, and there is not a net improvement in job growth or in the quality of jobs. ' As the Federal government continues to devolve more power to the states, it is unlikely that a national perspective on how this competitive process diminishes the entire economy will develop.

Alternatives to Tax Incentives

Because the granting of tax incentives is unlikely to end in the near future, improving the fairness and efficiency of handing out tax incentives must be a top policy priority. One option would be to standardize the rules and formulas that determine which companies will receive an incentive. Analyzing the future costs and benefits of a corporation is extremely difficult and consumes city staff time and money. Changes in future technology, transportation, financial conditions, and the industry's demand for goods may also have unknown effects on estimated benefits. Given these difficulties, standardized formulas and rules create a level of objective fairness in evaluation and can also help remove possible conflicts of interest and charges of blackmail and political influence. In addition, cities should demand “clawback” provisions that force the company to reimburse the city for the costs of the incentive if it should move or fail before the incentive agreement ends.

Increased court challenges against incentives will also become more likely. Citizens who face decreased public services will raise issues of equity, pointing to the millions of dollars given to certain firms as public services suffer. In response, cities may consider requiring complete disclosure of what companies will use the incentive for and what data the city used to calculate its worth. This will force the city and the companies receiving the incentive to justify their need publicly and reduce the excess induced by competitive overbidding.

Another option would be to limit the use of incentives for strategic purposes. It may make sense for a city to target firms based on criteria other than number of jobs saved. High unemployment areas and companies that may need just a minimal subsidy may not achieve the job savings that gets press attention, but may increase social welfare in more advantageous ways.

Finally, it may turn out that tax incentives are a useful tool to encourage economic development. However, they should be considered just one tool out of many. Continued public investment in education facilities and infrastructure needs of a locality creates the impetus for companies to be attracted to the city or state in the first place. Improvements to highways & bridges, as well as making government more ‘customer-oriented,’ benefits all citizens and companies as well. A city cannot depend on tax incentives to create economic growth. It is important to realize that adequate funding of basic government services may do as much, and perhaps more, than any incentive can.

This paper was written by John Fontillas and Colleen Alderson

1. Tiebout, Charles. “A Pure Theory of Local Expenditures.” Journal of Political Economy 64 (1956), p. 416-24.
2. Bartik, Timothy. Who Benefits from State and Local Economic Development Policies. W.E. Upjohn Institute, Kalamazoo MI 1991. p. 183.
3. Pulley, Brett. "New York Makes Staying Put Irresistible to Coffee Exchange." The New York Times October 13, 1995, Sec. B p.1.
4. Reich, Robert. “Bidding Against the Future.” (Keynote address at The Economic War Among the States Conference held at the National Academy of Sciences, Washington DC May 21, 1996.) reprinted in The Region, FRB Minneapolis, Vol. 10, No. 2, June 1996.
5. Ibid.
6. Ibid.

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