The Upjohn Institute has posted a recent working paper of mine, co-authored with my colleague George Erickcek, that looks at how different types of business tax cuts affect economic development goals such as job creation. The Institute’s website also right now has a highlight that summarizes some of the content of the working paper.

One main point of the paper is that among business tax reductions, an across-the-board reduction in state business taxes is not the most cost-effective way to increase state job growth.  The same boost to job growth could be achieved at a far lower revenue cost by well-designed business tax incentives.

Well-designed business tax incentives would be targeted in two ways. First, they would be targeted at “export-base” businesses with high multiplier effects. Second, these business tax incentives would be targeted at businesses that actually are creating jobs.

“Export-base businesses” is regional economics jargon for businesses that sell their goods and services outside of the state’s economy, to non-state residents and businesses. Examples would be most manufacturing industries. The problem with business tax cuts for locally-oriented, non-export-base businesses – fast food restaurants, for example – is that their sales and hence employment are largely determined by the size of the state’s economy, not by business taxes.

In contrast, when export-base businesses expand their sales to non-state residents, they bring new dollars into the state’s economy. These dollars are used to directly hire state residents for new jobs. In addition, some of these new revenues for a state’s export-base businesses are used to buy goods and services from suppliers located in the state, further boosting state employment. The boost in employment at export-base businesses and their state suppliers in turn boosts spending by these businesses’ workers, which will boost demand for retailers in the state, thereby boosting state retail employment.

These indirect boosts in suppliers’ employment and retailers’ employment are the “multiplier” effects of boosting export-base businesses.  These multiplier effects will be larger for export-base businesses with stronger local supplier links. These multiplier effects will also be larger for better-paying export-base businesses, as a boost to their employment will have stronger effect on demand for local retailers.

Therefore, targeting business tax incentives at high-wage export-base businesses will have stronger employment effects than cutting business taxes for all businesses.  But even more cost-effective job-creation effects can be achieved by further targeting business tax incentives only on export-base businesses that are creating jobs. This is more cost-effective for two reasons. First, conditioning business tax incentives ion job creation provides a greater reward for job creation. Second, businesses that are creating jobs are likely to be more responsive to job creation incentives than many businesses that are in no position to add employment.

In our working paper, we estimate that well-designed business tax incentives, by being more narrowly targeted on businesses most likely to respond to business tax cuts and create more jobs, can achieve the same state job creation goals as across-the-board business tax cuts at about one-sixth the costs per job created.  This is an important finding for state policymakers seeking to cut business taxes without excessively cutting state public services.

Does this mean that well-designed business tax incentives should be made as large as possible? No, because we also need to account for the opportunity cost of the funds used for these incentives.  If such incentives are excessive, they may result in cuts in public services that also are important to state job creation.

A balanced state economic development strategy would combine some strategic use of well-designed business tax incentives with productive business services, and support for human capital investments such as early childhood education.