Economic Development Policy Supply side policies ECON 4480 State and Local Economies 1.

Economic Development PolicySupply side policies

ECON 4480 State and Local Economies

1

Policy: Introduction• First wave: Smoke-stack chasing

– Emanating out of the Great Depression– Policies based on the notion of export-based growth: attract

capital from other areas, and build up the export base industries.

– Led to competition among states based mostly on cost criteria.

– States offered direct payments and subsidies, including cheap land, subsidized loans, tax breaks, and training subsidies.

– Growing states (south and west) attracted footloose firms from old industrial areas (northeast and midwest).

– Tended to focus on recruiting manufacturing firms.2

Policy: Introduction• First wave: Smoke-stack chasing

– Outcomes: a community tended to grow according to the ability of a single firm or single industry to grow.

– Focus was on jobs, just about any jobs.– “Shoot anything that flies, claim anything that falls’ was

the mantra of industrial recruiters.

3

Supply-side Policies (First wave)• Supply side policies are all about offering

incentives to employers that help lower costs.• These policies are viewed as part of the

overall business climate of a state; the better the business climate, the more attractive to external investment.

4

Supply-side Policies (First wave)• Supply-side incentives include:

– 1) Favorable tax policy,– 2) Availability of debt financing,– 3) Labor force incentives, and a– 4) Favorable regulatory framework.– These policies will be discussed in turn.

5

Favorable tax policies• Tax policy is comprised of the general tax structure and

specific tax incentives.• The general tax structure is the set of taxes imposed on all

businesses and households.• Tax incentives are limits or abatements of general taxes for

employers that engage in new investments.• Comparisons of the tax burden should start with the general

tax structure, after taking into consideration the set of tax incentives available for an employer.

• Thus, high tax states may not necessarily create the highest tax burdens for employers.

6

Favorable tax policies• Property tax abatements: one of the oldest tax incentives; partial

reduction of property tax liability for a given property for a fixed number of years.

• Can include abatements for the following:– Exemption of land from property tax,– Exemption of improvements (new construction or rehabilitation),– Manufacturer’s inventories,– Raw materials used in manufacturing,– Abatements tied to the level of investment or job creation, with

certain minimum levels required to qualify for the tax abatement.– In many states, employers are required to make tax payments instead

of paying property taxes.– These are called Payments In Lieu Of Taxes, or PILOT.

7

Tennessee Taxes

8

• Tennessee tax structure (relevant items):• No tax on household earned income,• No statewide property tax.

• The primary taxes on business are the Excise Tax and the Franchise Tax.• Excise Tax – is 6.5% of Tennessee taxable income for a

corporation, LLC, or limited partnership,• Franchise Tax – is 0.25% of Tennessee net worth, with a

minimum of $100 annually.• Excise and Franchise Taxes average about 14% of total state

government revenue; typically one of the most volatile components of revenue.

Tennessee Taxes

9

• Tennessee Job Tax Credit• Works as a credit against franchise and excise taxes based

on the amount of capital investment and jobs created.• A company investing $500,000 and creating 25 new jobs

in a 12 month period can take a tax credit of $4,500 per job.

• Can offset up to half of combined Franchise and Excise Tax for a given year; unused tax credit can be carried forward.

• This company could save $112,000 in tax for the year.• More generous terms are available for Tier 2 and Tier 3

counties: employers are expected to generate the 25 jobs within three years and five years, respectively.

Tennessee Taxes

10

• Tennessee Job Tax Credit• Businesses than can qualify for the Jobs Tax Credit:

• Manufacturers,• Warehousing and distribution,• Research and development,• Computer services,• Call centers and data centers,• Headquarters, and• Convention facilities.

Tennessee Taxes

11

• Other Tennessee tax incentive programs (http://www.tn.gov/ecd/BD_business_tax_credit.html :

• Headquarters tax credit – companies satisfying minimum investment, jobs, and average pay requirements can receive: credit against franchise and excise tax liabilities, sales tax reductions for purchases of new property, and credit for relocation expenses.

• Data center tax credit – similar tax breaks for investment in new data centers in Tennessee.

• Emerging industry tax credit – tax breaks for investment in high-skill, high-wage jobs in high-technology areas, emerging occupations, or clean energy technology.

Whither tax incentives?• Do tax incentives work? Are they worth the cost? These are

very controversial issues.• According to corporate relocation expert Daniel Levine:

“Despite overwhelming evidence that state and local tax incentives are having little to no positive effect on promoting real economic growth anywhere in the country, states continue to up the ante with richer and richer incentive programs. This is occurring despite the extreme fiscal stress confronting almost all state governments. Moreover, as federal tax dollars continue to prop up state government expenditures, there are real questions as to whether the interstate competition for jobs is a wise use of anyone’s tax dollars and, if not, then what can be done to at least slow down this zero sum game?” – Site Selection Magazine, November 2010 (www.siteselection.com)

12

Whither tax incentives?• Levine continues: • “The issue is how to slow down the hugely expensive interstate

competition for jobs so that scarce state fiscal resources can instead be focused on strategies that promote real economic development and growth as opposed to simply chasing scarce projects or fending off challenges from neighboring states. In discussions with senior state policymakers from around the country, it is clear that most would prefer to end many of the incentive programs offered by their state but equate such action with unilateral disarmament: a fear that their companies will be lured across state lines by aggressive neighbors that will continue to offer seductive awards, or that they will be unable to compete for projects because other states offer lucrative incentive packages that their state will no longer be able to match. This is not an irrational fear. States need some mechanism for leveling the playing field.”

13

Whither tax incentives?• Levine recommends rewriting IRS regulations, in effect in

including some state tax incentives as taxable income to the industrial prospect.

• This would have the effect of rendering ineffective some of the most expensive incentives, and would apply to all states at the same time.

• The point is that sates are caught in a strategic game, with no state willing to blink first.

14

What matters?• Interestingly, the November issue of

Site Selection contains another article that presents the results of an annual survey of corporate site selection experts.

• Asked to rank what matters most, the experts ranked ‘workforce skills’ highest, followed by the ‘state and local tax scheme’, which means the general structure of taxes.

• Availability of incentives are in the top five most important for site selectors.

15

What matters?• How can we reconcile Levine’s view with that of the site

selection experts?• Levine is viewing the problem from the state’s point of

view: additional tax incentives simply cause competitor states to offer the same incentives; the tax base for all states suffers, and state and local government services have difficulty growing services to meet demand.

• The site selection experts view the issue from the business point of view: after the workforce skills issue, the state’s structure of taxes is important.

16

What matters?• One could argue that even though tax structure matters,

its importance is vastly inferior to that of the availability of a workforce with sufficient skills.

• Just in terms of dollars, businesses pay vastly more in labor costs than for state and local business taxes:– One study showed that business paid $20 in labor

compensation (payroll plus benefits) for each dollar paid in state and local business taxes.

– Thus, a 2 percent difference in wages could offset a 40 percent difference in state and local taxes.

• Firms also pay much more for transportation, materials, and supplies than they do for state and local taxes.

17

Favorable tax policies• Although economic developers (mostly) recognize that state

and local taxes are much less important for a firm’s cost than labor, they argue for keeping taxes low anyway for two major reasons:– 1) if regional competitors have low taxes, so must our

state in order to remain competitive. The actions of our state depends on what we believe other states will do.

– 2) keeping taxes low creates a signal that our state has a favorable business climate. In this view, low taxes have a symbolic role even if lowering taxes has little effect on overall employers’ costs.

18

State’s Dilemma• The decision for states is whether to offer

additional tax breaks for new industrial prospects.

• Making this decision, the states must consider not only what the prospect will do, but also what the competitor state will do.

• Suppose both states agree to not offer any additional tax breaks. The payoff to both is $50 million each.

19

State’s Dilemma

20

•The table shows payoff amounts for the two states depending on whether they cut taxes or don’t cut taxes.•If both states agree to not cut taxes, the size of the pie is $10.•If KY cheats on the agreement, it receives $8 if TN does nothing.•But TN will respond with its own tax cut to stay competitive.•The total payout is now just $6, split evenly between the states.•The result of the competition is to reduce the total size of the pie.

State’s Dilemma

21

•The result will be the same if TN ‘cheats’ on the agreement first instead of Kentucky. •If TN cuts its tax, the payout for TN is $8 if KY does not respond.•But KY will soon respond, reducing the total payout for both states to $6.•The ability of industrial prospects to play one state against the other is an example of the ‘race to the bottom’.

Favorable tax policies• States must find a balance in tax policy between offering the

most favorable business climate and generating revenue sufficient to provide critical public services, including education, law enforcement, and infrastructure.

• Ideally, a state will structure a set of taxes that grows tax revenue in proportion to the increasing demand for public services.

• A state will be in difficulty if its tax structure effectively exempts growing portions of the state economy.

22

Availability of Debt financing• Subsidized capital for employers has been around as long as

tax incentives.• Two types of capital could be provided:

– Debt financing, and– Equity capital.

• Debt financing consists of direct loans, loan guarantees, and revenue bond financing.

• Direct loans are used heavily by some states; firms are usually required to first seek reasonable financing in the private lending market.

• Many states target their loans to specific sectors or to growth firms.

23

Availability of Debt Financing• Loan guarantees are less common than direct loans. • The idea is that the state provides a guarantee to a provide

lender that some portion of a loan to a business prospect will be paid back in the event of default.

• For example, a state could guarantee up to 80% of a loan for equipment and machinery, with a cap of $5 million.

24

Availability of Debt Financing• By far, the most important type of capital financing for

economic development is tax-exempt bond financing.• Interest received on bonds issued by state and local

governments typically is exempt from Federal income tax.• Benefits:

– Lenders pay no Federal income tax on interest payments from the bonds,

– Borrowers get a lower interest rate, lower than with commercial bank loans, and

– Local governments borrow at low cost, because the bond market offers a higher price for these bonds compared with taxable bonds.

25

Availability of Debt Financing• These bonds, usually called industrial revenue bonds (IRBs),

are typically issued by a local authority: an organization such as an industrial development board that is sanctioned by a local government but otherwise has no formal ties or obligations.

• Thus, the IRBs are to be paid by the revenue-generating ability of the borrower; the local government is not legally bound to make good on the bonds in case the borrower defaults.

• IRBs are only available for companies with good credit history, else there would not be a market for the bonds.

• This means that IRBs are usually not used to foster new business development.

26

Availability of Debt Financing• The usage of IRBs took off in the late 1970s and early 1980s.• The rapid growth of IRBs caused Congress to examine the

potential loss in income tax revenue due to their tax-exempt status. This loss in tax revenue is an example of a tax expenditure.

• By 1988, Congress estimated the loss of revenue at $4.8 billion annually.

• In the 1984 Deficit Reduction Act, Congress instituted a state volume cap on IRBs, with per capita dollar limits and a statewide limit of $200 million in new bonds annually.

• IRBs remain a very popular form of financing.

27

Labor force policies• The third supply-side policy has to do with the state and local

labor force.• Labor force policy has three major aspects:

– Right to work laws,– Job training programs, and– Worker compensation and unemployment insurance policies.

• Right to work (RTW) policies prohibit the union shop requirement that a worker be compelled to join a union as a condition of employment.

• RTW originated in Florida and Arkansas in 1944, spread to all the South by the 1980s. Plains and Mountain states also are RTW.

28

Right to work states

29

•23 states have right to work laws.•No state in the industrial north has a right to work law.

Right to work• Proponents of right to work rely on arguments concerning the

liberty of workers choice of where to work, without being compelled to join a union.

• Opponents of right to work point out the free rider problem that non-union workers would enjoy in a union shop: the union negotiates a favorable pay package that applies to non-members as well as union members.

• Right to work does not prohibit unions; for example, workers in the GM plant in Spring Hill belong to the United Auto Workers. Tennessee is a right-to-work state.

• RTW will matter for some firms.• RTW is not as important as other differences between

locations.30

Comparing state outcomes

31

•RTW states experience substantially higher job growth in the long run (1969-2009).•Most jobs still are in the non RTW states.

Comparing state outcomes

32

•Per capita income lower in RTW states, but growing a little faster (+0.5%) than in non RTW states.•RTW states comprise just 38% of total U.S. personal income for 2009.•Clearly, more than RTW matters.

Comparing state outcomes

33

Comparing state outcomes

• Some generalizations about right-to-work:– Right to work states experience higher job growth

and somewhat lower unemployment rates, – Most workers still work in non right-to-work

states,– Average pay is higher in non right-to-work states,

but the gap is very slowly closing.– Some firms may view right-to-work as a signal of a

business-friendly environment.

34

Job training programs

• Training programs are of two general types:– Workforce Investment Act (WIA) programs, and– Customized training for individual employers.

• WIA was initiated in 1998; replaced the old Job Training Partnership Act program.

• Administered through local workforce boards, comprised of employers and local officials.

35

WIA Job training programs

• WIA has several important features:– One-stop centers: one location for both workers

and employers to obtain information about jobs and available workers, and training programs.

– Local WIA boards: determine local training priorities.

– Evaluation: training outcomes are tracked in terms of number of trainees obtaining jobs and the average pay of those jobs.

36

Customized training programs

• Tennessee and most other states offer customized worker training for new and expanding businesses.

• This typically consists of a mix of on-site and off-site training in skills that will be required to operate specific machinery. May also include management skills.

37

Regulatory environment and business climate

• Smoothing the process of business formation and relocation can be an effective competitive tool.

• The best practice is to establish a one-stop center where an employer can learn about all the state’s requirements and benefits.

38

Regulatory environment and business climate

• Streamlining the process does little good if the staff is not helpful to businesses.

• Therefore, the best states also offer a customer-oriented, problem-solving culture within the staff that deals one-on-one with businesses.

• First contact with prospective businesses can be very important for a state’s business climate.

39

Business Climate Survey 2010

40

• According to Site Selection, Tennessee ranks second to North Carolina in terms of overall business climate.

• The top six states are all located in the South.

• Interestingly, some RTW states are out-ranked by non RTW states (Indiana, Ohio, Pennsylvania).

• Strong union state Michigan ranks in the top 15.

Summary and conclusions: supply-side policies

• Six conclusions regarding supply-side polices:– 1) supply-side considerations can matter, but

other factors such as workforce quality and access to markets (transportation networks) typically matter more.

– 2) supply-side incentives are offered in order to remain competitive with other states,

– 3) new supply-side incentives will work for a time, but soon, other states will offer the same incentives,

41

Summary and conclusions: supply-side policies

– 4) states must balance the benefits of tax cuts with the costs,

– 5) right to work is associated with higher job growth but lower average pay; the advantage of RTW may exist mostly as a signal of a favorable business climate,

– 6) simplifying and streamlining the incentive and permitting process and establishing a simplified tax structure may be the most effective means to demonstrate a positive business climate.

42