The Unsolved Riddle of Tax Incentives

Feb 3, 2020

By Randall Bauer, Director in the Management and Budget Consulting practice for PFM Group Consulting, LLC., and former Budget Director for the State of Iowa

While estimates vary, state and local governments provide billions of dollars each year to spur business activity within their borders.  How effectively is that money spent? Hard to say.  A study just out by economists Cailin Slattery and Owen Zidar found little evidence that state and local business tax incentives increase economic growth. This is not a narrow issue. All fifty states offer some type of incentives to the private sector.

After 35 years in which I’ve grappled with these issues, two past experiences stand out.

In 1994, the State of Iowa was approached by a large steel manufacturing company about situating a manufacturing plant on the Iowa side of the Mississippi River. Not surprisingly, this was welcomed by the State, but the manufacturer wanted multiple tax concessions and other financial inducements. Governor Terry Branstad was supportive, but the requested package would require the House and Senate to make statutory changes.

I helped craft the legislative package. While the manufacturer eventually got its incentives, the resulting legislation sought a reasonable ‘quid pro quo’ – including requiring a capital investment of at least $10 million, creating at least 50 jobs, meeting ‘good job’ wage levels, and paying at least 80 percent of the cost of employee health insurance.

After another decade of observing incentives ‘up close and personal,’ I had become convinced that stronger eligibility requirements alone were not enough to ensure a ‘good deal.’ In 2005, as Governor Tom Vilsack’s state budget director, I worked with the Legislature to upgrade the Iowa Department of Revenue’s professional staff (including hiring PhD economists) to do regular quantitative and qualitative incentive evaluations. That work continues today – the Pew Charitable Trusts identifies Iowa as one of the ‘leading states’ for incentive evaluations.

A growing number of states are now also using regular and rigorous incentive evaluations. The Pew Charitable Trusts now classifies 16 ‘leading’ states and another 16 that are ‘making progress.’ That’s laudable improvement, but there’s a far way to go.  Pew classifies 18 states as ‘trailing’ – including California, Georgia, Illinois, New Jersey, New York and North Carolina.

For the past four years, my consulting firm, PFM, has conducted evaluations for over 50 incentive programs for the State of Oklahoma, and the Legislature and Governor have acted on numerous evaluation recommendations. These were not just minor tweaks – one ended a high-dollar program that could not be justified on a cost-benefit basis. This is not an isolated state example – you can find positive program changes after evaluations in most (if not all) of the states that use this process.

Whether in an evaluation process or during program operation, a major challenge is lack of data. In many cases, incentives are essentially assumed to be effective; there are few requirements that recipients report on the jobs created, wages and benefits paid, capital investment made, etc. Besides back-end reporting, programs often gloss over front-end issues as well, including whether incentives are necessary to attract economic activity in the first place.

This crucial ‘but for’ test has been the subject of many studies. One meta-analysis, by Dr. Tim Bartik, suggested that the vast majority of jobs created by the incentives would have occurred without the incentives.

It occurs to me that the general acquiescence to use of incentives (whether effective or not) at least partly stems from hyper-competitiveness among state and local governments. These ‘job wars’ can create a sort of death spiral ‘race to the bottom’ of tax revenue giveaways. Can governments be saved from themselves and each other?

There are at least some small steps that can help move in a better direction. When a study PFM did for St. Louis, related to incentive policy, suggested greater regional cooperation to forestall disastrous competition, the city and St. Louis County created a regional economic development partnership to pursue common interests. A bit further west, the States of Kansas and Missouri have entered into a sort of truce to their border incentive wars in the Kansas City metro area – in this case both states agreed to end the use of the state incentives to lure businesses to or from Jackson, Platte, Clay or Cass counties in Missouri to or from Johnson, Wyandotte or Miami counties in Kansas. Other states are considering similar measures – and prominent news stories about company threats to move that are never carried out may help tip the scales.

Economic incentives will continue to create controversy, and their benefits will remain an open question. Regardless, policymakers should still seek to make improvements – setting a higher bar for program eligibility, doing rigorous cost benefit analysis on the front end, reporting and evaluation on the back end, and ending competitive death spirals. These will not make these programs perfect, but they should make them better.