As a series of posts have outlined, many state and local business tax incentives have national benefits less than their costs. A federal policy to restrain such business tax incentives would be in the national interest. However, such a federal policy seems unlikely, at least in today’s political climate.

If federal action is unlikely, are there policies for state and local reforms to improve business incentive policy? This issue is discussed in chapter 10 of Investing in Kids.

In all state and local areas, it makes sense to urge that business tax incentives be incorporated into the regular business tax system. This does not mean substituting across-the-board business tax rate cuts for business tax incentives. Such across-the-board business tax cuts usually would be less cost-effective than business tax incentives. What it means is making a business tax incentive for a job-creating investment into something a business receives under normal tax law rather than as a discretionary award.

By incorporating business tax incentives into the regular tax code, the political system will have to take greater account of their overall cost. In contrast, discretionary business tax incentives are often sold as being restricted to a few extraordinary cases. However, once business tax incentives are given to a few businesses, it becomes politically impossible to avoid granting such incentives to other businesses in similar circumstances. It is far better to recognize this reality from the outset, and realistically budget for the true cost of business tax incentives.

All state and local areas should consider replacing some of their business tax incentives with customized services to business. Such customized services include customized job training and manufacturing extension services.  The empirical evidence suggests such customized services have benefit/cost ratios that can be over ten times as great as the benefit/cost ratios for even well-designed business tax incentives. State and local areas can provide a greater boost to their state or local economy at lower cost through greater reliance on such customized business services.

For state and local areas that already have healthy growth, the evidence suggests that business tax incentives’ local benefits are less than costs. Fast-growing local areas should be thinking about ways to develop their local labor force to fill the new jobs, not about how to further accelerate job growth. If a state has some slow-growth areas within a generally fast-growing state, business tax incentives should be restricted to these lagging areas.

Many advocates of reforms to state and local business incentives believe that such reforms will be promoted if business tax incentives are more “transparent”. Greater transparency means that more information is available to the public on what incentives are offered to what businesses, and on the outcomes of incentive deals.  This greater transparency will yield public pressure to help restrain the magnitude of incentives.  According to LeRoy (2004, 2007), twelve states have already enacted reforms to increase the transparency of economic development incentives.

More and better evaluation of business incentives is also politically helpful. For business tax incentives, it is often difficult to tell whether a given business tax incentive was decisive in inducing a particular business location decisions. However, it is possible to evaluate the consequences of business location decisions in terms of greater state or local earnings per capita and fiscal benefits (or costs) for state and local budgets.  Good evaluations are likely to find many cases where for the business tax incentive program to pay off, an unrealistic proportion of business location decisions would have to be tipped by the incentive program.

For business incentives that are services to individual businesses, it is feasible to evaluate such programs by comparing the performance of assisted businesses with similar unassisted businesses. Past studies suggest such customized services are more cost-effective than many business tax incentives. Therefore, better evaluation is likely to strengthen the political fortunes of customized services.

An overall reform of business incentives towards greater reliance on customized services rather than tax incentives is likely to be advantageous for several reasons. First, as mentioned before, such customized services are more cost-effective. Second, because customized services are financed through the appropriations process, rather than through the tax system, they are likely to be subject to more regular close scrutiny by legislative bodies.  Third, customized services will only be demanded by businesses to the extent to which such services are useful and productive. In contrast, there is an unlimited demand by businesses for business tax incentives.

It is common to urge advocates of investment in human capital, such as advocates for investment in early childhood programs, K-12, or higher education, to recognize the importance of reforms to make sure that such investment dollars are used wisely. An analogous argument can be used for business incentives. Our business incentive dollars should be used wisely.  Such wise use requires: transparency in business incentive practices; rigorous evaluation; full accounting of all costs as part of the tax system and appropriations process; shifting towards a greater reliance on customized services rather than less-efficient business tax incentives.  Rather than pushing for abolishing business incentives, we should be pushing for reforms to make incentives more effective in achieving economic development benefits.  Higher-quality business incentives, along with high-quality early childhood programs and other well-designed human capital investments, should be part of a comprehensive local economic development strategy.