Federal policy towards business incentives

Several posts have identified some problems with business incentives’ national benefits.  Business tax incentives in average- growth or fast-growth local areas are likely to have national benefits that are less than costs.

On the other hand, business tax incentives in slow-growth areas may have net national social and economic benefits, by better utilizing unemployed labor and existing infrastructure. Business incentives that efficiently improve productivity through customized business services (such as customized job training or manufacturing extension services) may also have net national benefits.

This analysis suggests a natural federal policy: a federal prohibition on large business tax incentives except in distressed areas.  I suggest that the prohibition apply to business tax incentives that are awarded with some discretion to individual businesses. The prohibition would also include state business tax laws that discriminate in favor of “export-base” businesses, which are businesses that sell their goods or services outside the state.

Federal policy should permit business tax incentives in economically distressed areas. Federal policy should also permit customized services that help small and medium sized businesses to improve their productivity.

As discussed in chapter 10 of Investing in Kids, such federal policy would have a precedent in the European Union. It is interesting that the European Union puts more constraints on what member countries can do in economic development incentives than the U.S. federal government does for U.S. states. The EU considers business tax incentives or service incentives to individual business to be a type of subsidy to exports.  In the EU view, such export subsidies must be limited to be consistent with free trade among the member countries.

In the EU, in general subsidies by member counties to individual businesses are outlawed. The exceptions are subsidies that promote EU objectives. These EU objectives include helping distressed areas designated by the EU. Other EU objectives include assisting small business, increasing R&D, and promoting job training.

If a subsidy is found to be illegal, the assisted business is required to repay the subsidy. Complaints to the EU can be levied by other member countries or by other businesses.  More information on EU handling of business subsidies can be found in an informative 2004 article by Adinda Sinnaeve, later published in the 2007 book Reining in the Competition for Capital, edited by Ann Markusen.

As argued by Art Rolnick and Melvin Burstein of the Minneapolis Fed, federal regulation of state business incentives can be seen as part of the federal government’s authority to regulate interstate commerce. Our federal constitution was originally set up in part to address problems due to the Articles of Confederation, under which some states were imposing import duties on goods imported from other states. Import duties distort the pattern of interstate trade by making imports from other states more costly, whereas business incentives distort trade by making exports to other states artificially cheaper.

Federal regulation of business incentives might free up considerable state and local government resources. Total resources devoted to state and local business incentives are probably at least $30 billion per year. Most of these dollars go to tax incentives that do not target economically distressed areas.

If business incentives were better regulated by the federal government, the resulting additional state and local resources would be sufficient to accomplish a wide variety of goals, including significantly expanding early childhood programs. For example, the estimated costs of universal pre-k are about $14 billion, slightly less than half the cost of current business incentives.  We could keep more efficient business incentives while diverting the less efficient incentives towards other programs that would better help accomplish economic development objectives, such as early childhood programs.

Whether the federal government is willing to regulate such business incentives is questionable, at least in the current political climate. For example, in 2004, a federal appeals court decision temporarily raised doubts about the constitutionality of some state business tax incentives.  This federal appeals court decision was later overturned by the Supreme Court on the grounds that the plaintiffs lacked standing. But before the decision was overturned, legislation to negate the federal appeals court decision was endorsed by the National Association of Manufacturers, the National Governors Association, and the U.S. Conference of Mayors.

If the federal government refuses to regulate business incentives, are there any alternatives to reduce inefficient business incentives? A subsequent post will consider that issue.

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

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