The development of the economy is almost always a top focus for state government. A better economy means more jobs and more wealth, which results in happy constituents. Two examples of possible ways to improve the economy are tax breaks and subsidies. Unfortunately, these often have unintended consequences or hidden incentives that leave the state worse off than if they hadn’t been implemented. In the policy brief Tax Breaks and Subsidies, ACRE Policy Analyst Jacob Bundrick explores two of the most common targeted incentives used by state government.
Tax breaks, or tax incentives, are a way for a government to reduce the tax burden of a specific firm or company. There are many different forms of tax incentives, such as tax exemptions, tax reductions, tax rebates and refunds, and tax credits. These tax incentives almost always have qualifications that the firm must meet, and these qualifications are often aimed at incentivizing specific behavior. One example in Arkansas of a tax incentive is Advantage Arkansas, which is an income tax credit given to firms based on the payroll of new, full-time employees to the firm.
Subsidies are much different than tax incentives; rather than reducing how much a firm owes, subsidies directly give money to the firm. Much like tax incentives, subsidies are a way for the government to reduce the cost of doing business. Arkansas often gives subsidies like this through the Governor’s Quick Action Closing Fund (QACF).
These two ways to spur economic activity sound good in theory, as they promise increased employment and economic growth, but in practice they often fail or certain consequences are overlooked.
One such consequence is the negative spillovers from the increased number of firms in an area. These can include increased costs for labor and real estate, infrastructure congestion, and increased probability of tax hikes as a result of increased firms and increased population in an area.
These financial incentives also create the incentive for firms to engage in rent-seeking, or the use of resources to gain a competitive advantage without creating any value for the economy. For example, one type of rent-seeking is lobbying, where businesses attempt to gain an advantage through political means rather than innovating. This results in firms winning in the marketplace not because of innovation but because of special breaks given by the government.
Proponents of tax incentives often argue that they have a net cost of 0 because without the incentive the firm wouldn’t have located in Arkansas anyway; however, evidence shows that tax incentives are often not the deciding factor in where a firm locates.
The selling of tax incentives also creates problems. Often a company can sell another company a tax credit, and it could be possible that the buying company was not even in the industry targeted by the tax credit.
Tax incentives also have negative fiscal impacts, as they do one of two things: either take money away from public goods, or public goods do not see a reduction in quality but taxes increase.
Tax incentives also do not protect taxpayers very well. If a subsidy is paid up front, often times the company is allowed to still keep much of that money. The company also has the incentive to be riskier in its actions because the money it is risking is not its own – it is the taxpayers. Furthermore, the opportunity costs of tax incentives are often ignored, such as spending more on higher education.
There are two examples of tax incentives that are often touted as successes, but the evidence says they do little to boost economic growth. These are sports stadiums and film incentives. Each do not bring in much, if any, economic growth, and in the case of films, most of the benefits go out of state.
Arkansas could do better by eliminating tax incentives and subsidies, lowering marginal tax rates, and simplifying the tax code.
You can find more of our research related to this topic here.