By Mr. Jacob Bundrick
Proponents of financial incentives for business argue that tax breaks and subsidies don’t create costs to the state’s budget. Advocates reason that if Arkansas forgoes taxing a firm in some way, and that firm truly would not have located in the state without the tax break, there is no cost to the state. Arkansas does not forgo any tax revenue by issuing the tax break because taxing the firm would have led it to locate elsewhere, which means Arkansas would not receive tax revenue, anyway. If, however, the firm or its employees are not completely exempt and do pay at least some taxes, Arkansas would actually see a tax revenue increase despite the tax break—not to mention that the state would also see the other benefits associated with bringing in more business. In short, proponents say tax breaks may make the state better off.
This argument, though, hinges on the assumption that financial incentives are the deciding factor in where a firm chooses to locate. In Arkansas, officials assume that the jobs created in state-involved economic development projects would not have been created without state intervention. State leaders thus assume that these projects lead to net fiscal gains. But are these fair assumptions?
Are Tax Incentives Really the Deciding Factor in Where Firms Locate?
Anecdotal evidence suggests that incentives are frequently not the deciding factor in where firms locate. In a 2016 analysis, Brian Fanney of the Arkansas Democrat-Gazette revealed that some companies receiving state aid would have expanded regardless of whether they received incentives. Here are two examples:
Bad Boy Mowers of Batesville would have expanded in Arkansas even without the nearly $4 million it received from the state from 2012 through 2014, according to Scott Lancaster, general counsel for the company.
The state provided Peco Foods of Independence County with $485,000 worth of incentives, but chief operating officer Benny Bishop said, “We would have chosen Arkansas for expansion even without state incentives.”
Issuing tax breaks and subsidies to firms that are going to expand or locate in Arkansas regardless of aid means that the state forgoes tax revenue that it would have otherwise received or sacrifices other, potentially more productive uses of its tax dollars. When incentives are not the deciding factor in where a firm chooses to locate or expand, they are nothing more than a giveaway to politically favored firms—a poor use of tax dollars. What’s more, Arkansas officials take false credit for creating jobs that would have been created anyway. Peco Foods and Bad Boy Mowers are just two examples. But how many other firms have we given aid to that didn’t really need it?
Problems with Letting Businesses Buy and Sell Tax Incentives
States also create costs to their budgets when they allow firms that receive incentives to sell their incentives to other companies in the secondary market. The Arkansas Economic Development Commission allows Arkansas companies to sell certain income tax credits, such as the Delta Geotourism Incentive, the In-House Research by Targeted Business Income Tax Credit, and the Targeted Business Payroll Income Tax Credit. Let me explain why companies would want to sell or buy a tax incentive and how doing so costs states and taxpayers money.
Consider this hypothetical scenario:
Company A receives $100,000 from the In-House Research by Targeted Business Income Tax Credit to aid in oncology research. However, Company A fails to turn a profit because it has yet to have a breakthrough and develop a medicine to sell. Company A cannot use the $100,000 income tax credit because it does not owe any income taxes. But Company A knows it can sell the tax credit.
Company A sells the credit for $80,000 to Business B, which does owe Arkansas income taxes. When filing taxes, Business B uses the tax credit to reduce its income tax liability by $100,000. Company A is $80,000 better off because it was able to sell its useless incentive to Business B for $80,000. By buying Company A’s tax credit for $80,000, Business B lowered its tax burden by $100,000, so it is $20,000 better off.
The state of Arkansas is the big loser. By allowing Company A to sell its income tax credit to Business B, Arkansas lost $100,000 of tax revenue that it otherwise would have received. In other words, the sale of this tax credit cost the state money, making Arkansas residents worse off.
Furthermore, allowing the sale of incentives to third-party businesses means that the state is effectively subsidizing more than just the company it intended to aid. In our hypothetical scenario, Business B benefited from the state trying to aid Company A, even though the state had no intention of aiding Business B. Business B may or may not belong to the industry the incentives were designed to target. In Arkansas, the Arkansas Economic Development Commission (AEDC) decides who can and cannot buy tax credits on the secondary market.
The best solution for Arkansas is to eliminate tax credits altogether. But if abolishing tax credits cannot be accomplished, Arkansas should, at the very least, eliminate the ability to sell tax credits. To achieve this, the state should allow these credits to expire unused if the firm remains unprofitable or, as the least desirable option, turn these transferable credits into refundable credits. Refundable credits mean that if the company cannot use the tax credits, the state will trade the credits for cash. In our hypothetical scenario, this means that Company A would still receive $100,000 even if it had no taxable profits to offset. Company B would no longer be involved in any transactions. Although it is not necessarily desirable for the state to award an unprofitable business cash, refundable credits would at least prevent the government from unintentionally subsidizing companies that it had no intention of subsidizing in the first place.
How Financial Incentives for Businesses Hurt Taxpayers
The costs of financial incentives to Arkansas’s budget also likely lead to other negative outcomes. By nature, subsidies shift public money away from public goods, which creates one of two results:
1. Without increasing tax revenue, the city, county, or state issuing the subsidy must decrease the amount of public goods in its jurisdiction. Likely outcomes include a drop in the quality or quantity of infrastructure, a less developed workforce due to reductions in education, and a decrease in the quality or quantity of public goods like roads, education, parks, and bike paths that improve quality of life.
2. The government, wishing to maintain the current level of public goods, raises taxes. Higher taxes are problematic not only for the taxpayers that must pay them but for the broader economy. Federal Reserve Bank of San Francisco research shows that states with lower taxes enjoy faster economic and employment growth than high-tax states.
Targeted tax breaks have a similar effect. Tax incentives likely lead to increases in marginal tax rates for business that do not receive tax incentives. When the government provides tax incentives to certain companies, it narrows the tax base and lowers the state’s revenue. To make up for the lost revenue, all other taxpayers must pay more. Otherwise, the government must spend less on public goods.
Either scenario—reduced public goods or increased taxes—discourages firms from locating in the region. Firms become less attracted to a region as infrastructure congestion increases and the quality of both the infrastructure and the workforce diminishes. Higher taxes and costs of doing business discourage firms, too.
Conclusion
If you’ve been following this series of blog posts, you now know how tax breaks and subsidies are supposed to help local economies grow, why these financial incentives don’t help the economy like politicians say they do, and how tax breaks and subsidies for businesses affect government revenue and spending on public goods. In my next post, you’ll learn about how governments use financial incentives to try to steer the economy.