How we can improve the local productivity of business incentives

Although this blog (and my book, Investing in Kids) is mainly concerned with how early childhood programs can provide economic development benefits, I also consider the role of business incentives in economic development. Business incentives are tax breaks or services that are to some degree customized to individual businesses.

To fully appreciate the role of early childhood programs in economic development, both economic developers and early childhood program advocates need to understand the role of business incentives. Well-designed business incentives and well-designed early childhood programs complement each other. Early childhood programs can increase the quantity and quality of labor supply, while business incentives can increase the quantity and quality of labor demand. In addition, from a political perspective, it makes more sense to advocate for early childhood programs as part of an economic development strategy that includes reformed business incentives.

I’ve already argued that subsidies for sports stadiums and film production are often problematic incentives that may not be worth the costs. Are there business incentives that are more likely to make sense?

Business incentives only make sense if they increase local per capita earnings by more than they cost. How can business incentives best be designed to do so? This issue is addressed in the first half of chapter 5 of Investing in Kids.

Incentives are more effective if they follow the following guidelines:

(1)    Providing small and medium sized businesses with well-designed services, such as customized job training and manufacturing extension advice, has been shown by several research studies to be more effective in encouraging business expansion per dollar spent than business tax breaks or other financial assistance..

(2)    Helping export-based businesses (businesses that sell their goods and services to those from outside the state) will have beneficial multiplier effects on local jobs. In contrast, helping businesses that sell to people and businesses within the state will have some detrimental displacement effects by reducing sales and employment at other in-state businesses.

(3)    Helping businesses that pay higher wages relative to the skills provided will have greater benefits for local workers in higher wages and greater multiplier effects.

(4)    If assisted businesses hire more of the local unemployed, the employment benefits of the incentives will be greater. Fiscal benefits will also be greater because there will be less fiscal strain from in-migration. Assisted businesses may hire more local unemployed workers if these workers’ skills better match the skills needs of the assisted businesses. More hires of the unemployed can also be encouraged by combining incentives with help from local labor market intermediaries who will match job openings to the local unemployed.

(5)    Providing upfront incentives may affect location decisions more, because many businesses have short time horizons, but upfront incentives raise the issue of recovering the incentives via “clawbacks” if the business leaves. Customized job training and infrastructure services have built in clawbacks because the infrastructure and many of the trained workers will remain if the assisted business leaves.

(6)    Incentives are more effective in local areas with high unemployment, which need jobs more. If unemployment is already low, more of the jobs created will go to in migrants.

Many real world incentives do not follow these guidelines.  This blog has already mentioned the examples of sports stadium subsidies and film production subsidies. In addition, many business incentives are long-term tax breaks going to large businesses with few strings attached on local hiring. Finally, the political process often supports continuing hefty local incentives even if the local economy is doing quite well, and incentives are no longer as needed and effective.

Reforms to incentives would help free up resources for more effective business incentives, as well as for high-quality early childhood programs. Early childhood programs complement incentives by providing skilled workers to match the increases in labor demand encouraged by well-designed incentives.

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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