All business incentives are not created equal

Kenneth Thomas has a useful blog post pointing out that the New York Times database on business incentives, which accompanies Louise Story’s series, includes sales tax exemptions for business purchases of goods and services.

Thomas’s figures, which are consistent with my own rough preliminary analysis of this database, is that around $52 billion of the approximately $80 billion in identified state and local business incentives are in “sales tax relief”. Much of this appears to be exemptions for business purchases of inputs.

For example, in my own state of Michigan, the New York Times database identifies $6.65 billion in annual state and local business incentives. Of this total, $4.83 billion is in “sales tax refund, exemptions, or other sales tax discounts”.  Of this $4.83 billion, almost all of these refunds come from two provisions of Michigan tax law. First, Michigan does not apply the sales tax to most services, including business services, which saves businesses $3.88 billion annually. Second, for manufacturing, Michigan does not apply the sales tax to goods used as inputs to the manufacturing process, which saves manufacturers about $0.92 billion in sales tax.

Most public finance economists would agree that the sales tax should NOT be applied to business purchase of inputs, whether they are goods or services. Why? If we apply the sales tax to business purchase of inputs, this discriminates in favor of vertically integrated firms, and against firm’s contracting out to have some of their needed inputs be produced by other firms. A firm that purchases inputs from some supplier, which may in turn purchase inputs from other suppliers, will find that the sales tax pyramids with each level of additional purchase. A firm can reduce its sales tax bill by acquiring its supplier, that is by “vertically integrating”. There is no public policy rationale for encouraging such vertical integration. Presumably firms that buy inputs from other firms do so because they find this to be a more efficient way of organizing production. In addition, by encouraging vertical integration, we are discriminating in favor of larger businesses, and against smaller businesses, which will tend to be less vertically integrated.

This illustrates a more general point. Many business incentives are wasteful use of resources, in that they have benefits less than their costs, when compared with other uses of these funds, such as early childhood programs. Other business incentives make sense, and should be part of a well-designed state and local fiscal system.

For example, I have argued that customized business services, such as manufacturing extension programs, and customized job training programs, can be a cost-effective way of increasing the earnings per capita of state residents.

On the other hand, other policies which benefit businesses, but may not be classified as “business incentives”, may not be cost-effective policies for creating jobs. For example, I have argued that estimates suggest that in many states, across-the-board business tax cuts will not be the most cost-effective way of creating jobs. Across-the-board cuts in business tax rates would usually not be classified as business incentives, because they provide uniform tax relief to all businesses. But the lack of targeting, while it may have some political and philosophical merits, may also make such across-the-board tax cuts less effective as a way of creating jobs.

All business incentives are not equally good or bad from a public policy perspective. We need a balanced use of business incentives that are smart and cost-effective, coupled with selective investments in human capital that will also boost the state economy in a cost-effective way.

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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