The use of tax incentives as an economic development tool is so common that many politicians don’t give it a second thought. It’s just standard practice. But these incentives do not always have the hoped-for effect. States and cities should examine what (if any) effects these incentives have and consider whether the practice should continue.

Why do governments offer tax incentives?

Tax incentives for businesses are fairly common practice. Meant to attract, retain, or sometimes grow businesses, cities and states will offer companies various tax breaks. These can take any number of forms, from reduced levels of property tax to lower corporate tax levels, and can last for a few years or a few decades.

Attracts new businesses – One of the justifications for using these incentives is that it makes your jurisdiction (city, county, state) more attractive. If a company is looking to open or relocate, they will pick the place offering the best (lowest) level of taxes, or so the argument goes. This same line of reasoning is used to justify giving incentives to businesses already in a state or city: if we don’t offer them tax incentives, they might leave for greener pastures.

Expands current businesses – A different, more supply-side argument for tax incentives focuses on business expansion. In this line of thinking, lowering taxes on existing businesses can give them more money to expand or hire new employees. This in theory grows the tax base enough to offset any losses.

And this isn’t an occasionally used policy. We offer a lot of tax breaks to a lot of companies. It’s not just another tool for economic development. Unfortunately, it has become the go-to policy, whether the situation calls for it or not.

The level of tax incentives varies greatly by state, regardless of actual economic conditions. As Richard Florida writes, “Incentives are not the result of economic or fiscal conditions but reflect state politics and past practices. In other words, some states like to give away more money to business than others – for no obvious economic reasons.”

Other reasons for tax incentives – In some cases, the politicians offering incentives legitimately feel they are the right move. In others cases, incentives give them talking points for an election (“My action helped create this many new jobs”). Politicians may also give out incentives for fear of losing jobs. And others may simply do it because that’s just the way things are done, without thinking critically about them at all.

Do tax incentives work?

With all the money given out in incentives, it is important to examine the actual effects. In general, incentives don’t alter the “locational calculus” of a business. Firms choose to locate where they do for many reasons, and factors such as an educated and skilled workforce, access to markets, infrastructure, and agglomeration have more of an impact on that decision than tax incentives.

For example, Amazon held a “contest” to see which local or state government would give it the greatest incentives package. In the end, the company chose New York and Washington DC, the two cities they were leaning toward anyway, even without incentives.

And in fact, incentives may not make a difference in a company’s decision-making, no matter how large they are. General Motors received $60 million in incentives over ten years to keep its Lordstown plant open. Even with that incentive (and a $157 million tax bonus from the Republicans’ tax cut), GM announced that it was shutting down the plant.

Incentives may have an even lower impact because so many states and cities offer them. If a business can get an incentive anywhere, it becomes much less likely that the incentive itself will be what attracts them to a location.

This means that in many situations, tax incentives are rewarding companies for doing something they would do anyway. This depletes an area’s tax base without promoting any economic development or helping distressed areas. One study found that, while tax incentives more than tripled from 1990-2015, governments would have received the same results without incentives 94% of the time.

This depletion of the tax base is likely to make a region’s economic situation worse, as there is less money going to education and infrastructure. Cutting back on incentives would give governments more money to spend on the policies that actually promote economic development and create jobs.

When looking at job creation for individual businesses, firms which receive tax incentives do not create more jobs than those that do not receive them. According to one study, incentives may even have a negative effect. Gains in employment were found to be around 20% less with incentives than without.

There is no noticeable association between tax incentives and economic performance, wages, or unemployment. The only association found with incentives was an area’s poverty rate (though this only shows correlation). It may be that, through decreased funding for education and infrastructure, tax incentives cause the poverty rate to rise. It could also be that states with higher poverty rates are in a worse economic position to negotiate with businesses, making incentives the result rather than the cause.

Incentives in Kentucky – not evaluated

Kentucky gives out a large amount of tax incentives to businesses, just as all states do. Where we lag behind, however, is in evaluating the effectiveness of these tax incentives.

A recent Pew study found that, nationwide, 10 states were “leading” in evaluating the effectiveness of their incentives, including our northern neighbor, Indiana. Seventeen more were listed as making progress, including Tennessee, Ohio, Virginia, and Missouri. Kentucky is in the last group, listed as “trailing,” with no process for reviewing tax incentives.

Tax incentives in Kentucky are a bipartisan endeavor. The most notable example in the state currently is the Ark Encounter in Williamstown. The incentives here were originally approved by Governor Beshear, but they were cancelled due to discriminatory hiring practices. The incentives would later be approved by Governor Bevin. As a candidate, it should be noted, Bevin spoke strongly against such incentives, saying he was “insulted” by the idea.

The project was originally estimated to create 20,000 jobs, which is nearly as many jobs as there are people in Grant County. Despite the optimism, however, the Ark is not exactly bringing in a lot of money for the area.

Reviewing and evaluating how incentives affect the economy of the state is important for the sheer amount of money involved. Currently, incentives offset over half of the corporate tax burden in Kentucky – money which is desperately needed elsewhere.

An extensive review process would not be hard to establish. Kentucky has a thorough database of tax incentives from the Cabinet for Economic Development. Evaluating the results and effectiveness of these incentives at standard times would help legislators decide whether to continue with existing incentives and gain information for when future initiatives are proposed.

Review of incentives by states is growing

For the most part, states and cities don’t really know what happens with incentives after they are approved. States give out too much money up front rather than waiting to see how a business performs. Fewer than half of localities in one study even report the names of the companies receiving subsidies. And it can obviously be hard to track a program’s performance if lawmakers don’t clearly state what is expected.

Recently, some states have begun not just to monitor incentives, but actually take action if expectations are not met. Perhaps no state has done more in this area than Washington. Washington’s state tax auditing program helps to show how much the state is giving up, not just with initial reporting but also with tracking. A citizen commission reviews many of the incentive programs. Over the past decade, either the commission or the audit office have recommended that 12 tax incentive programs be ended, and the legislature has agreed in 9 of those instances. It is not surprising then that Washington has the lowest level of incentives of any state in the country.

And Washington is not alone. Other states are beginning to examine the effectiveness of incentives, and take action if they are not providing the expected results. In Oregon, tax incentives expire after six years unless renewed, giving the legislature time to review the results. Florida has allowed programs to expire as well.

This style of review and reporting may soon spread across the country. The Governmental Accounting Standards Board (GASB) is set to require governments to change how they establish, report, and monitor tax incentives. State and local governments will be expected to report the total amount of tax incentives, the criteria businesses must meet, and perhaps most importantly, how governments will get their money back if those criteria aren’t met (commonly known as clawback provisions). These features, along with many others in GASB 77, will make the tax incentive process much more open, and allow legislators and citizens to see the true cost of the programs.

Other programs are more effective than incentives

If legislators come to understand that tax incentives are not the only solution to every economic development situation, what sort of programs should be undertaken in their place?

One answer is job training programs. Training workers either for new skills or simply to improve their skills is a much more effective and efficient use of money. In fact, creating a job through training costs less than 10% of what it costs to create one through tax incentives ($2,510 for job training, $26,775 for incentives). Maryland is even combining job training with tax incentives, with business incentives being tied to workforce development programs.

More investment in education and research would also help. Kentucky has two universities (UK and UL) which are classified as “Highest Research Activity” universities, but employment in research-intensive industries is just ¼ that of peer states. The impact of these schools is enormous, and the two have created dozens of startups over the last few years. Investing in education not only improves our workforce, making us more attractive to businesses, but is also more likely to create new businesses. If we want businesses not just to move here but to start here, investing in education is an incredibly effective way to do that.

We should also focus more on businesses and institutions already in the state. Relocation accounts for a very small percentage of job growth compared to homegrown economic development. If we fear mobile capital, we should invest in anchor institutions (universities, hospitals, many non-profits) which tend to stay in a specific location, making them reliable and interested in helping the community.

Going forward

As we go forward, what should we expect? Following the guidelines set out in GASB 77 should help. We should have clearly-defined criteria for what is expected of businesses which receive tax incentives, and be willing and able to get our money back if those criteria are not met. We should also be open with the public about the process.

It may also be helpful to agree to a truce of sorts regarding the use of tax incentives to poach jobs from other jurisdictions. Cities and counties in Kentucky could agree not to offer incentives for a business looking to relocate from another part of the state. When jobs move from one city to another in the same state (or even the same county), there is no net job growth – just a reshuffling of jobs with a smaller tax base.

We could even work with neighboring states to reach a similar agreement. The Missouri Senate passed such a truce with Kansas (the Kansas City region being notorious for poaching). The agreement would only take effect if Kansas passes similar legislation, but it shows there is a willingness on the part of legislators to end the race to the bottom type competition.

Incentives may be beneficial in some cases (ones focused on job training or local business). However, they are used in nearly every situation, meaning that most are costly and ineffective. We should be focusing instead on programs that result in real economic growth. Careful examination of the results of tax incentives (and any other program) is vital for making good economic development policy in the future.

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Neal Turpin
Dr. Neal Turpin is a recent PhD graduate of the University of Louisville’s School of Urban and Public Affairs, where he focused on public policy and participation, democratic structures, and efficiency. He enjoys spending time with his wife, Sara, working out at the Southeast YMCA, where the two of them met, and teaching Sunday school at Buechel Park Baptist Church. Neal also has an appreciation for trivia, movie scores, and the Muppets.