Tax Incentives for Economic Development

1. Tax Incentives for Economic Development MGMT 932 Local Public Economics and Business Strategy Session 6: April 13, 2006 Professor Therese McGuire These slides are for exclusive use in MGMT 932 at the Kellogg School of Management, Northwestern University. No other use is allowed without permission of Professor Therese McGuire.

2. Road Map • “Smokestack chasing”: Firm-specific or industry-specific tax incentives. • Location-specific inducements.

3. Firm- and industry-specific tax incentives • High-profile efforts to try to lure or retain firms. • Fairly or not, state and local politicians are judged, in part, by how well the local economy performs. • Examples: • Efforts in the early 2000s (during and after the recession) by dot-com and entertainment industries in California to secure tax breaks and subsidies. • Automobile plants over the years (Saturn and Tennessee, BMW and South Carolina, etc.). • Closer to home: Sears corporate headquarters from Chicago to suburban Hoffman Estates; a Motorola plant to Harvard, IL; Boeing corporate headquarters from Seattle to Chicago. • Issues with “smokestack chasing.” • Is it a waste of taxpayers’ money? • Is it a zero sum game? • If we are simply shuffling economic activity from one state to another, then it is a zero-sum game for the nation. • Why might it be positive sum? • Picking winners: Do we think the government is better at it than the market? • Claw-back provisions. • Signal to other firms that the government is weak or treats firms unfairly. Strategy can backfire.

4. Case study: GM’s choice of TennesseeBased on case packet reading by Bartik et al. • Why did GM choose Tennessee for its Saturn plant? • Low freight costs, low wages, low overall taxes. • Bartik et al. emphasize the low wages. Why? Why was this a political issue? • Saturn (GM) was given subsidies of $70-80 million in training and infrastructure improvements. • What was the benefit to Tennessee? • Not many jobs for local workers as laid-off northern workers got first dibs. • The county of location is not a particularly high unemployment county relative to others in Tennessee. • “The most important economic benefit of Saturn is not the change in land values or in the number of jobs, but the change in the types of jobs in Tennessee…The Saturn plant will increase the proportion of higher wage, higher-skilled jobs, in contrast to Tennessee’s traditional reliance on low-wage manufacturing.” (page 35) • Was it a zero-sum game?

5. Case study: Boeing’s choice of Chicago • Basic facts of the case. • Press conference in Washington, D.C. in March 2001 to announce that the headquarters was leaving Seattle and to limit the competition to three cities: Chicago, Dallas and Denver. • The three cities offered different incentive/subsidy packages. • Decision in May 2001 to move to Chicago. • What was Boeing offering? • Jobs? Not really. Executives and staff would relocate en masse from Seattle. • Prestige (signal to the world) for the city? Maybe. • Benefits to other firms in the city? This is the story I want to tell. • Is the competition for plants of flagship firms, for headquarters plants in particular, a zero-sum or a positive-sum game? Can it be welfare improving to offer tax incentives to attract firms?

6. Case study: Boeing’s choice of Chicago(continued) • Quote from the Corporate Headquarters Relocation Act passed in Illinois in May 2001: • “The General Assembly has determined that the relocation of the international headquarters of large, multinational corporations from outside of Illinois to a location within Illinois creates a substantial public benefit and will foster economic growth and development within the State.” • What could this “substantial public benefit” be? Clearly, the firm benefits, otherwise it would not make the move. Can society benefit as well from moving a plant or headquarters from one state to another? • A question posed in the economics literature: Does tax competition among jurisdictions for mobile capital yield efficiency? • One strand of the literature says NO. Such competition results in a “race to the bottom” as jurisdictions lower taxes below the efficient (benefit) level in an attempt to attract firms. This leads to under-provision of public services. • Another strand says YES. Jurisdictions impose benefit taxes (tax = value of services provided), which firms readily pay. This leads to efficient provision of public services. • Neither strand calls for firm-specific tax breaks. They would take the economy away from (in the second case) or further away from (in the first case) the efficient allocation.

7. Case study: Boeing’s choice of Chicago(continued) • In a paper I wrote with Teresa Garcia-Mila, we depart from the literature in the following way. • Suppose a firm would generate positive spillovers, in the sense of reducing costs, for other firms in the city. Would it then make sense (from society’s perspective) to offer the firm tax incentives (or subsidies) that result in a tax rate on the firm lower than the marginal benefit of the public goods and services provided to the firm? • If the firm’s entrance into the region improves the business environment for existing (and future) firms, are tax breaks justified? • The answer is YES. Societal welfare is boosted by facilitation of such locations. • Question: what do we have in mind by way of “positive spillovers” to other firms in the city? • How can the entrance of a firm (such as the corporate headquarters of a large, high-tech manufacturing concern) reduce production costs for other firms or make the other firms more productive?

8. Case study: Boeing’s choice of Chicago(continued) • Answer: Concentration externalities: Knowledge spillovers from one firm to another – a form of public good that is privately provided. • Since it is a public good and it is privately provided, a public subsidy is needed to induce the firm to invest in the efficient amount of capital (to make the right location decision). • We have in mind the following. • The executives who work in headquarters are highly skilled, highly knowledgeable individuals who must make complex decisions. • These executives rely on the services provided by law firms, advertising firms, management consulting firms, accounting firms, etc. • By virtue of their interactions with the executives, in working on contracts and deals with them, the lawyers, consultants, marketers, and accountants will become better at their jobs. The positive externality is the productivity boost for the city’s business services industry. • It can be welfare-improving – a positive-sum game – to offer tax breaks to and to attract firms to your city/state.

9. Case study: Boeing’s choice of Chicago(continued) • Interpreting the Boeing situation in light of this model. • Suppose you have two cities that differ only in their capacity to benefit from concentration externalities. • One city has a high concentration of relevant business services firms. • The other city has a high concentration of traditional manufacturing firms. • Which city should offer the greater tax incentive to Boeing? • Suppose you have two firms that differ in their ability to generate concentration externalities. • One firm is a corporate headquarters of a high-tech, multinational firm that presents challenging and innovative problems and has highly educated employees. • The other firm is a traditional manufacturing plant. • If our city has a large concentration of business services firms, which firm should it offer a greater tax incentive to? • The model is consistent with the Boeing story. • Dallas and Chicago offered different packages. The city with a larger business services sector offered a greater tax break (because their gain would be greater). • Chicago offered Boeing headquarters a different deal than it offered a manufacturing plant of Brach’s Candies. The firm that presented the greater capacity to generate knowledge spillovers was offered the sweeter deal.

10. Bidding for Industrial Plants: Does Winning a ‘Million Dollar Plant’ Increase Welfare?Michael Greenstone and Enrico Moretti, 2004 • Gathered data on 82 new plant locations from an article entitled “Million Dollar Plants” published monthly in the corporate real estate journal Site Selection. • The identities of the winning county and the losing county (counties) are known. • The amounts of the “bids” are not known. • Methodology: examine relevant economic data for the counties before and after the location of the new plant to ask the question, what are the consequences of successfully bidding? • The authors compare the fortunes of the winning county to the losing county (counties) along a number of dimensions: • Earnings (wage bill). • Announcement of a “Million Dollar” plant opening is associated with a 1.5% increase in the trend in earnings in the new plant’s industry in the winning county relative to the losing ones. Also, positive trend breaks in total wages in other industries in the same county and neighboring counties. • Property values. • Idea is that that costs and benefits (net impact on social welfare) of attracting a plant should be capitalized into the price of land. Find a positive, relative trend break of about 1% in property values. • Local government finances. • Suspicion that local public services are hurt by the tax breaks. Evidence refutes this. If anything, the authors find a positive trend break in both revenues and expenditures, and, notably, a substantial increase in education spending.

11. Case study: Denso’s choice of Osceola, ARBased on case packet reading from the WSJ • In 2003, Denso Corp., an affiliate of Toyota Motor Corp., chose Osceola, AR as the location of a new automobile parts plant. • What were the factors that went into the decision? • Quality of the labor force? • Cost of labor? • Proximity to suppliers and customers? • Low taxes? • Financial incentives? • Most important factor? Commitment to improving education. • One reason why empirical studies may find little or no effect of taxes on economic activity and business location decisions is that high taxes may support high quality education.

12. Location-specific inducements • The practice of giving tax breaks or subsidies to firms that locate, increase investment, or increase employment in a designated geographic area. • Typically the area is a “distressed” or “blighted” small neighborhood (certainly on a smaller geographical scale than the jurisdiction). • Issues – similar to issues with firm-specific tax breaks. • Is it new economic activity or is it just a reshuffling of activity from one area to another? • Does the practice encourage inefficient firms and uneconomic decisions? • Even if the policy results in a reshuffling of relatively inefficient firms, the policy may still be worthwhile. • Providing long-term unemployed individuals with employment may enhance their long-run employability. • Reductions in unemployment and increases in investment may have side benefits, including less crime and less social unrest.

13. Enterprise zones • Offer tax breaks, subsidies and regulatory inducements to firms locating and hiring in the designated zone. • 37 states, D.C. and the federal government have EZ initiatives. • Chicago has a federal empowerment zone; Illinois does not have a state EZ program. • Evaluations of the effectiveness of EZs. • Papke on the EZ program in Indiana, which targets incentives toward investment in inventories. • EZ designation increased the value of inventories by 8%, but reduced the value of machinery and equipment by 13%, implying a shift in the type of capital investment. • She also found a decline in unemployment claims in the EZs, but no increase in the well-being (income) of zone residents. (How could this be?) • Boarnet and Bogart on the EZ program in New Jersey. • No evidence that the program had a positive effect on municipal employment or on municipal property values. • Mixed evidence. Why might EZs not be effective? • Intervention may be too small or poorly targeted.

14. Tax increment finance districts • TIF operates like an EZ in that it targets a small distressed (“blighted”) area. • Unlike an EZ, firms do not receive tax breaks for locating in the TIF district. Rather, incremental property tax revenues are directed toward expenditures and programs that benefit the firm or make the area more attractive for business locations. • Infrastructure improvements are the most typical use of TIF revenues. • Tax increment refers to the increase in property tax base and therefore the increase in property taxes occurring after the designation of the TIF district and the infrastructure improvements. • The tax increment is used to finance the infrastructure improvements either on a pay-as-you-go basis or through paying off bonds. • TIF designation often has a long life; the TIF district is a single-purpose entity overseen by the municipality; other taxing jurisdictions do not have access to the increments in tax base (property value) during the life of the TIF. • 48 states have TIF enabling legislation; Chicago has well over 100 TIFs.

15. Tax increment finance districtsAn example • Suppose we have a city with a coterminous school district. Each has authority to impose property taxes. • City tax rate is .01; school tax rate is .02. • Suppose the city designates a 4x4 block area as a TIF district. • Before the TIF begins, the 4x4 block area has $500,000 in taxable property valuation. • The city raises $5,000 in property taxes from this area. • The school district raises $10,000 in property taxes from this area. • Year 10, the TIF area now has $1,500,000 in taxable property valuation. • The city raises __________ in property taxes. • The school district raises ___________ in property taxes. • The TIF authority (run by the city) raises ___________ in property taxes.

16. Tax increment finance districtsIssues • Not all increases in property value in a TIF are caused by the TIF. Should these property taxes be directed toward the TIF authority? • If the TIF draws economic activity and people into the TIF area, it can cause an increase in expenditures for overlapping districts, schools in particular, without a concomitant increase in revenues. • Note that, outside the TIF, both expenditures and revenues track population fairly closely. • There can be overuse and abuse of TIF. • If virtually all of the city is a TIF, what happens to the financing of normal operations of the overlapping jurisdictions, including the municipality? • If virtually all of the city is a TIF, how can the TIF be an effective, targeted economic development tool? • If TIF monies go into developers pockets, is this an abuse of the public trust? • Evidence on the effectiveness of TIF as an economic development tool is mixed. • Man and Rosentraub found TIF had a positive effect on median house values in Indiana. • Dye and Merriman found that TIF had a negative effect on property values in suburban municipalities in the Chicago area. Evidence of a negative-sum game?

17. Taxes and Economic DevelopmentKey Lessons • Evidence of the effect of taxes (and spending) on economic development is: • Inconclusive for inter-regional studies, • Fairly convincing for intra-regional studies. • Despite the evidence, the practice of granting firm-specific tax breaks and location-specific inducements (TIF, in particular) is alive and well. • Tax incentives can be justified from society’s perspective (they can be positive sum), if: • The firm brings positive externalities (knowledge spillovers, for example) to the local business community, • The firm moves from a high-employment location to a low-employment location, • Employment in related industries (“spillover jobs”) increases.

18. Preview of Topics for Week 4 • Fiscally-empowered local governments. • The Tiebout Hypothesis: the benefits of competition among governments. • Fiscal federalism. • Why different levels of government for different functions. • Centralization versus decentralization. • Efficiency considerations. • The equity-efficiency tradeoff.