Across-the-board business tax cuts vs. business incentives

In Investing in Kids, I calculate that high-quality business incentives can pay off for state economic development. For each dollar a state invests in high-quality business incentives, the present value of the earnings per capita of state residents increases by $3.14. This analysis can apply to well-designed business tax incentives.

However, such a high benefit/cost ratio does not apply to general reductions in state business tax rates.  (This follows up on my reply to a comment in a previous blog post.) For a permanent across-the-board reduction in state business tax rates, I calculate that benefits for state residents in higher earnings per capita are much less than costs. For each dollar in present value of tax revenue lost due to lower business tax rates, earnings per capita of state residents is estimated to increase by only $0.51. If the business tax rate cut was financed by higher personal taxes,  these higher personal taxes would be almost twice as great as the increase in residents’ earnings.

Why the difference? First, business tax incentives are targeted on “export-base” businesses, whereas across-the-board business tax rate cuts go to all businesses.  “Export-base” businesses are defined by regional economists as businesses that sell their goods and services to non-state residents. If export-base businesses can be induced to expand, their expansion will have multiplier effects on other state businesses, as the new dollars brought into the state economy recirculate. In contrast, the economic activity of non-export base businesses is largely set by the personal income of state residents. The portion of across-the-board business tax cuts that go to non-export base businesses will be relatively ineffective in inducing additional business activity.

(This discussion also implies that if the general state corporate tax largely already exempts export-base businesses, the impact of state corporate tax rate reductions will be even lower. Many states exempt most of the economic activity of export-base businesses from taxes by “apportionment” formulas that only impose taxes on the portion of the businesses’ activity that is attributable to sales within the state.)

Second, business tax incentives tend to be front-loaded, whereas general business tax cuts are evenly spread over the future. Businesses heavily discount the future. Business tax reductions beyond 10 years or so have little effect upon current business location and growth decisions.

Third, business tax incentives are targeted at businesses considering new investment decisions, whereas general business tax cuts go to all businesses. Eventually all businesses will consider new investment, but this means that much of the effects of general business tax cuts will be delayed.

(This argument implies that business tax reductions that are targeted at new investment will be more effective than general business tax reductions. This post is considering general business tax rate reductions. All business tax reductions are not created equal, or equal in their effects either.)

These calculations all assume that the lower business tax rates are financed by higher personal taxes. If business tax cuts are financed by lower public services, then these lower public services would tend to discourage business growth. The net effect of the package on business growth may still be positive, but the benefit to cost ratio for state residents would be lowered below 0.51.

For general business tax cuts to pass a benefit-cost test, other benefits and costs would have to enter the picture.  General business tax cuts may make sense as part of a comprehensive tax reform.  Perhaps in some cases one could argue that business tax cuts may have a symbolic importance that increases their benefits. If the costs of financing the business tax cuts result in higher personal taxes paid by upper-income state residents, then the distributional effects of the business tax cut package will be more progressive. The additional jobs brought about by the business tax cut will tend to have greater percentage effects on the income of lower-income households. (The progressivity of local jobs growth is discussed in a previous blog post.  This post is based upon chapter 8 of Investing in Kids. )

However, in most cases, general business tax cuts cannot be justified by their benefits for state residents’ per capita earnings.  Positive results for business tax incentives do not imply the same positive results for general business tax cuts. All business tax reductions are not the same.

Compared to general business tax cuts, state economic development benefits per dollar would be much greater for high-quality business incentives or for high-quality early childhood programs.

For those interested in more discussion of across-the-board business tax reductions versus business incentives, or versus business tax credits for expanded employment or investment, I have written about this topic numerous times. My recent paper with my colleague George Erickcek compared Michigan’s MEGA business tax incentive program with general corporate tax reductions of the same magnitude. We found that the tax credit had greater effects on the state economy than general corporate tax reductions of the same dollar magnitude.

About timbartik

Tim Bartik is a senior economist at the Upjohn Institute for Employment Research, a non-profit and non-partisan research organization in Kalamazoo, Michigan. His research specializes in state and local economic development policies and local labor markets.
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One Response to Across-the-board business tax cuts vs. business incentives

  1. Pingback: Reforming business incentives: possibilities for state and local reforms | investinginkids

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