Across-the-board business tax cuts vs. business incentives

Posted on February 23, 2011 by timbartik

In Investing in Kids, I calculate that high-quality business incentives can pay off for state economic development. For each dollar a state invests in high-quality business incentives, the present value of the earnings per capita of state residents increases by $3.14. This analysis can apply to well-designed business tax incentives.

However, such a high benefit/cost ratio does not apply to general reductions in state business tax rates.  (This follows up on my reply to a comment in a previous blog post.) For a permanent across-the-board reduction in state business tax rates, I calculate that benefits for state residents in higher earnings per capita are much less than costs. For each dollar in present value of tax revenue lost due to lower business tax rates, earnings per capita of state residents is estimated to increase by only $0.51. If the business tax rate cut was financed by higher personal taxes,  these higher personal taxes would be almost twice as great as the increase in residents’ earnings.

Why the difference? First, business tax incentives are targeted on “export-base” businesses, whereas across-the-board business tax rate cuts go to all businesses.  “Export-base” businesses are defined by regional economists as businesses that sell their goods and services to non-state residents. If export-base businesses can be induced to expand, their expansion will have multiplier effects on other state businesses, as the new dollars brought into the state economy recirculate. In contrast, the economic activity of non-export base businesses is largely set by the personal income of state residents. The portion of across-the-board business tax cuts that go to non-export base businesses will be relatively ineffective in inducing additional business activity.

(This discussion also implies that if the general state corporate tax largely already exempts export-base businesses, the impact of state corporate tax rate reductions will be even lower. Many states exempt most of the economic activity of export-base businesses from taxes by “apportionment” formulas that only impose taxes on the portion of the businesses’ activity that is attributable to sales within the state.)

Second, business tax incentives tend to be front-loaded, whereas general business tax cuts are evenly spread over the future. Businesses heavily discount the future. Business tax reductions beyond 10 years or so have little effect upon current business location and growth decisions.

Third, business tax incentives are targeted at businesses considering new investment decisions, whereas general business tax cuts go to all businesses. Eventually all businesses will consider new investment, but this means that much of the effects of general business tax cuts will be delayed.

(This argument implies that business tax reductions that are targeted at new investment will be more effective than general business tax reductions. This post is considering general business tax rate reductions. All business tax reductions are not created equal, or equal in their effects either.)

These calculations all assume that the lower business tax rates are financed by higher personal taxes. If business tax cuts are financed by lower public services, then these lower public services would tend to discourage business growth. The net effect of the package on business growth may still be positive, but the benefit to cost ratio for state residents would be lowered below 0.51.

For general business tax cuts to pass a benefit-cost test, other benefits and costs would have to enter the picture.  General business tax cuts may make sense as part of a comprehensive tax reform.  Perhaps in some cases one could argue that business tax cuts may have a symbolic importance that increases their benefits. If the costs of financing the business tax cuts result in higher personal taxes paid by upper-income state residents, then the distributional effects of the business tax cut package will be more progressive. The additional jobs brought about by the business tax cut will tend to have greater percentage effects on the income of lower-income households. (The progressivity of local jobs growth is discussed in a previous blog post.  This post is based upon chapter 8 of Investing in Kids. )

However, in most cases, general business tax cuts cannot be justified by their benefits for state residents’ per capita earnings.  Positive results for business tax incentives do not imply the same positive results for general business tax cuts. All business tax reductions are not the same.

Compared to general business tax cuts, state economic development benefits per dollar would be much greater for high-quality business incentives or for high-quality early childhood programs.

For those interested in more discussion of across-the-board business tax reductions versus business incentives, or versus business tax credits for expanded employment or investment, I have written about this topic numerous times. My recent paper with my colleague George Erickcek compared Michigan’s MEGA business tax incentive program with general corporate tax reductions of the same magnitude. We found that the tax credit had greater effects on the state economy than general corporate tax reductions of the same dollar magnitude.

Posted in Business incentives, Incentive design issues | 1 Comment

Are business tax incentives a zero sum game regardless of which local areas offer such incentives?

Posted on February 22, 2011 by timbartik

I argued in a previous post that the national benefits of business tax incentives were less than 20% of the state benefits of business tax incentives. But is this true regardless of which local area is offering these tax incentives? The answer is No. Business tax incentives have greater national benefits if offered in areas that are economically distressed, and smaller national benefits if offered in economically booming areas.

Even if business incentives do not boost the number of national jobs, they may provide significant national social and economic benefits if jobs are redistributed towards economically distressed local areas. Business incentives can do so if such incentives are provided for business location and expansion in economically distressed areas, but not provided in economically booming areas.  I present the evidence for this argument as part of chapter 10 of Investing in Kids.

Redistributing jobs to economically distressed areas can offer net national benefits for several reasons. First, in more distressed areas, the local unemployed are more in need of jobs on average than is true for booming areas. Therefore, job growth is more highly valued in distressed areas than in booming areas.

Second, in more distressed areas, compared to booming areas, there will tend to be greater excess capacity in local infrastructure and public services. Therefore, there will be some fiscal benefits of redistributing jobs to distressed areas. Another way of putting this is that redistributing jobs to distressed areas better preserves existing infrastructure and minimizes the need for building expensive new infrastructure.

Third, there is some evidence that redistributing jobs to distressed areas, compared to redistributing jobs to booming areas, will reduce national inflationary pressures. If booming areas aggressively offer business incentives, the resulting job growth in these booming areas is more likely to bid up local wages and prices, which will eventually affect national inflation trends.

Fourth, as outlined in a previous post, the labor market benefits of creating jobs in already booming areas may be modest, as more of the jobs will go to in-migrants.  The unemployed are less likely to be helped.

These differences in the national benefits of business tax incentives, according to which area offers such incentives, is relevant to setting federal policy towards business incentives. I consider this issue in a future blog post.

How does this contrast with early childhood programs? Early childhood programs contribute to national economic productivity and provide net social benefits regardless of which local area provides these programs. They do so because early childhood programs directly target the productivity of labor, by intervening early.  Business tax incentives only provide net national benefits if provided in economically distressed areas.  Only if the jobs are redistributed to distressed areas, where such jobs can lead to better use of excess labor ,and better use of excess capacity in infrastructure, do business tax incentives increase national productivity.

Posted in Business incentives, National vs. state vs. local | 2 Comments

Can states afford now to invest in early childhood programs?

Posted on February 21, 2011 by timbartik

In a previous post, I argued that even with states facing short-term and long-term budget issues, states could choose to invest more in early childhood programs. What is the evidence for this argument?

Even in state budget crises, states are able to make strategic budget choices to free up expanded resources for whatever the state deems to be its highest priorities. For example, here in Michigan, Governor Rick Snyder recently proposed his fiscal year 2012 and 2013 budget. Even though the state already faced a projected $1.4 billion deficit for its general fund for FY 2012, Governor Snyder chose, as he had promised during his campaign, to adopt reforms to the state’s main corporate tax that would cost about $1.8 billion in revenue.

As explained in the Governor’s Executive Budget, the belief is that this new business tax system will be “simple, fair and efficient” and will therefore “enable all businesses and industries, large and small, to grow and create jobs” (p. A-5, Executive Budget, State of Michigan, Fiscal Years 2012 and 2013). Based on this belief, the budget makes some very tough choices to free up the $1.8 billion needed to reform the state’s corporate tax structure. For example, the budget eliminates various individual income tax credits and deductions, which increases revenues by $1.7 billion. This includes eliminating Michigan’s unusual exemption of most pension income from income taxation.

The budget also maintains the state’s current $110 million in spending devoted to state-funded pre-k education. For advocates of early childhood education, this maintenance of current spending levels is clearly welcome, instead of facing budget cuts.

On the other hand, I estimate that it would cost about $300 million annually for the state of Michigan to have universal access to pre-k education for 4-year olds. If Michigan can find $1.8 billion to lower business taxes, it clearly would be fiscally feasible to find $300 million to move to universal pre-k.  The issue is simply one of budget priorities.

Similar calculations can be done for other states. Governors and state legislatures frequently propose  large changes in tax policy that reduce tax revenues by far more than the cost of even far-reaching expansions of early childhood programs.  These proposals for tax reductions are made even during times of budget crisis.  States can afford to invest in early childhood programs if they choose to make such investment a priority.

Posted in Early childhood programs | 4 Comments

Early childhood programs and state budget cuts: now is a good time to invest

Posted on February 18, 2011 by timbartik

As detailed in a previous post, states are facing significant additional budget problems this year. These budget problems may lead to pressure to cut early childhood programs.

I don’t think there’s any need for states to cut high-quality early childhood programs. Now is as good a time as any to consider how to make room for needed investments in early childhood programs.

Sensible federal policy would provide additional counter-cyclical assistance to states and local governments. During a recession, the resulting cutbacks in state/local spending, or increases in state/local taxes, exacerbate the problem of low demand for goods and services. Federal assistance to state and local governments that is explicitly temporary, ideally tied by formula to the unemployment rate or other macroeconomic variables, can help reduce short-run unemployment without creating long-run budget deficit problems.

President Obama has proposed some modest assistance to states. This takes the form of some provisions to help states deal with their debts for their unemployment insurance systems.  However, this assistance is modest, and its prospects are politically uncertain.

So, states are probably on their own. Why, in a time of budget shortfall, should states avoid cutting early childhood programs? Why should they consider maintaining or even increasing their investments in early childhood education?

In the short-run, states will do less damage to their state economies by increasing taxes rather than cutting spending.  This is a well-known result in economics, sometimes explained in intro economics courses under the label of the “balanced budget multiplier”.

The intuitive idea is that only a portion of increased state taxes would have been spent on goods and services produced in the state. In contrast, reducing state spending has direct effects on reducing demand for public sector goods and services in the state. To put it another way, if state X increases taxes, a large percentage of the resulting reduction in demand will lead to layoffs of private employees outside of state X, in other states.  In contrast, if state X reduces public spending on early childhood programs, this will directly reduce jobs in state X of the early childhood workers who are funded by that program.

For example, consider some analysis from 2003 that I did with my colleague George Erickcek. We considered the economic impact on Michigan’s economy of closing a budget gap by tax increases vs. spending cuts. Both alternatives had negative effects on Michigan’s economy.  The negative effects of spending cuts were much greater. Compared to tax increases, spending cuts had a 42% greater effect in reducing Gross State Product. Compared to tax increases, spending cuts has a 47% greater increase in reducing total employment of all workers in the state.

This is of course a short-run analysis. Whether tax increases or spending cuts are preferable long-term depends on the specific tax increases and spending cuts. The devil is in the details.

In the long-run, states need to undertake significant budget reforms. These reforms need to address significant problems that are escalating spending faster than state personal income, and causing tax revenues to rise slower than the long-run growth of state personal income. These problems on the spending side include rising health care costs for Medicaid and for public workers and retirees, increased pension costs, and rising correction costs. These problems on the tax side include sales taxes that exempt too many services, escalating tax deductions and credits, and in some states, problems in property tax systems or in income tax systems that are insufficiently graduated in rates.

In the process of making these large and painful budget changes, states should also act to reallocate state funds to more efficient uses. This includes but is not limited to increasing investments in early childhood programs.

Such investments can be affordable because their dollar magnitude is modest compared to the needed long-run structural budget reforms. Strategic investments are in areas that do have a high “bang for a buck”, and that therefore do not have huge drains of resources relative to the state economy.

Consider early childhood programs. According to chapter 4 of Investing in Kids, moving to universal preschool would have an annual cost of less than $50 per capita. Expanding the Nurse Family Partnership to all eligible households costs a little more than $10 per capita. In contrast, the short-run budget problems facing the states for FY 2012 is around $400 per capita. The long-run budget problems facing states are much greater than that in per capita terms.

In other words, if we are going to have to make large-scale and difficult budget reforms, why not tweak these reforms so they are a bit more ambitious, and free up some resources for long-term investments?

Of course, every program claims that it provides long-term benefits. But early childhood programs have more rigorous evidence for long-term benefits than most, as outlined in my book and in numerous blog entries.

Part of these benefits includes long-run benefits for state and local budgets. I have already outlined that many early childhood programs will provide significant savings in special education costs.  For example, for universal pre-k, the eventual special education cost savings are about half of the budgetary costs.  In addition, there are numerous analyses showing that after we add in other budget savings, such as reduced costs of crime, that early childhood programs in the long-run pay for themselves.

In sum, cutting early childhood programs is the wrong choice if the goal is to minimize short-run economic pain and move to long-run budget reforms. Investing in early childhood programs is helpful economically in the short-run and in the long-run.

Posted in Early childhood programs, Economic development | 1 Comment

Do all business incentives have the same national benefits?

Posted on February 17, 2011 by timbartik

I argued in a previous post that business tax incentives did not have large national benefits because such incentives did nothing directly to raise the economy’s productivity. But some business incentives do seek to directly raise business productivity. Can such business incentives have greater national benefits than costs? The answer is yes.

For example, one common business incentive is customized job training. This seeks to encourage additional business activity by helping provide training for the business’s current or new employees.

Another possible business incentive is manufacturing extension. Manufacturing extension offices provide small and medium-sized manufacturers with free or low-cost technical assistance to improve their productivity.

Services to help business improve their productivity can provide net national benefits. The key issue is whether the benefits of these services, in improved productivity, exceed their costs.

For both customized job training and manufacturing extension, there is good evidence that these programs can have productivity benefits greater than costs. This evidence is reviewed in chapter 5 of Investing in Kids.  The evidence is also discussed in a recent policy brief I wrote for the Hamilton Project of the Brookings Institution.

One point this illustrates is that early childhood programs are not the only way to enhance the economy’s human capital. Increasing skills is perhaps the most important way to improve economic productivity.

Such a skills increase can be brought about by early childhood programs. Because early childhood programs intervene so early, they can better increase more general skills, and can often help a wide variety of persons.

But later intervention to improve human capital is also feasible. For such later intervention to be successful, these human capital improvements must be more targeted on particular types of individuals and more attuned to business needs.

Early childhood programs are part of a continuum of services that can efficiently improve the economy’s productivity, and thereby raise per capita earnings. Early childhood advocates should keep in mind this broader human capital agenda for the nation.

One way to help finance a portion of this human capital agenda is by scaling back business tax incentives for economic development. Some of the funds saved by this scaling back could be devoted to business services that enhance productivity, such as customized job training and manufacturing extension.  Other funds could be devoted to expanded early childhood programs.

However, this reallocation of resources may be difficult at the state and local level. There is a mismatch between the benefits of different policy options from a state and local perspective, versus a national perspective. Future blog posts will discuss implications for federal and state policy.

Posted in Business incentives, Incentive design issues, National vs. state vs. local | 2 Comments

Ed Glaeser’s Triumph of the City book

Posted on February 16, 2011 by timbartik

I have been reading Ed Glaeser’s new book, Triumph of the City, and enjoying it tremendously. Ed Glaeser is a Harvard professor, and is arguably the leading American urban economist.

One issue on which most urban economists agree is the importance of skilled human capital to the future development of any city. This is an important theme of Triumph of the City. It is also a main theme of my book Investing in Kids. We attack the same theme, but from  different angles.

This issue of education and the cities comes up in Ed Glaeser’s February 15 interview with David Leonhardt of the New York Times. Mr. Leonhardt asks Professor Glaeser  the following question:

“You suggest that education is the single best strategy for making a city prosperous… But producing an educated population obviously takes a long time. So let’s stipulate that a struggling city today, like Detroit, begins immediately taking steps to improve its schools. What else should it do to improve its prospects of success — especially over the next few years rather than only the next few decades?”

Ed Glaeser responds by mentioning ways in which cities can attract entrepreneurs and skilled workers through in-migration. This includes making city amenities more attractive, for example by encouraging more vibrant downtowns and more livable neighborhoods. But Professor Glaeser than goes on to say the following:

“[F]inally, don’t forget that better schools can reward a city more quickly than they can graduate students, by attracting skilled parents. They are America’s most important investment in the 21st century, and the linchpin of urban success.”

The short-term benefit for local economies from attracting parents is one theme of Investing in Kids. One way to attract parents is through a better K-12 system. Another way is through a better early childhood learning system.

As pointed out in an earlier blog post, Iowa business leaders have argued publicly that the state’s universal pre-k system helps attract skilled employees from other states. And several other blog posts argue that better preschool programs, by attracting parents, will drive up property values in the short-run.

Migration and property values are two of the key ways in which the long-run benefits from state and local investment in education are translated into short-run gains.  These short-run gains provide good reasons for even the most myopic local political leader to invest in high-quality early childhood programs, as well as in improving the K-12 educational system.

Posted in Early childhood programs, Economic development, Timing of benefits | Comments Off on Ed Glaeser’s Triumph of the City book

State fiscal problems and early childhood programs

Posted on February 16, 2011 by timbartik

Many states face significant fiscal problems over the next several years. These fiscal problems will lead to attempts to cut back on early childhood programs.  How should advocates for early childhood programs respond to these threatened cutbacks? I will address this in several blog posts. This post begins by describing the size of the state fiscal problem.

The state fiscal crisis is serious.  According to the Center for Budget and Policy Priorities (CBPP), 44 states are facing budget shortfalls for fiscal year 2012, which in most states runs from July 1, 2011 until June 30, 2012. The combined budget shortfall for these 44 states is estimated at $125 billion.

Why are these shortfalls so serious? First, the U.S. “Great Recession” is proving to be quite prolonged. For example, the Congressional Budget Office is projecting that the U.S. unemployment rate will only drop to 8.2% by the last quarter of calendar year 2012. This contrasts with the 4.6% unemployment rate that the U.S. economy had in 2007, prior to the recession.

Second, states are facing economic tough times in FY 2012 with less federal stimulus assistance. According to CBPP, absent federal policy changes, federal stimulus aid to the states will drop from $59 billion in FY 2011 to $6 billion in FY 2012. This drop in fiscal stimulus aid of $53 billion explains over 40% of the states’ FY 2012 problem.

In addition to the short-run fiscal problems, many states face long-run fiscal problems. Common long-run fiscal problems include: sales taxes that grow slower than state personal income because they exempt many services; increasing magnitude of tax deduction and exemptions over time; property taxes that are increasingly limited by state constitutions and laws; in some states, either no income taxes, or flat-rate income taxes that are insufficiently responsive to state income growth;  increasing public worker pension costs; increasing health care costs for the state share of Medicaid, as well as public workers and public worker retirees; increasing  correctional system costs.

Early childhood programs have done OK in recent years despite state budget crises. For example, for fiscal year 2011 (July 1 2010 to June 30 2011 in most states), states had to deal with a budget shortfall of $130 billion. Despite this budget shortfall, Pre-K Now reports that overall state pre-k funding increased by a little bit over 1%, to $5.4 billion.  Fifteen states and the District of Columbia increased their pre-k spending; 11 states flat funded pre-k; and 10 states reduced pre-k funding. (Four other states did not have final figures for pre-k funding, and 10 states do not have state-funded pre-k.)

However, this past political success may not predict future success for efforts to maintain or expand pre-k and other early childhood programs. Each additional budget shortfall forces state officials to look for new sources of budget savings, as what has been cut once cannot be cut again. In addition, the political makeup of most state legislatures and many governors has shifted in a more politically conservative direction.  Finally, there is some increased awareness of the long-term budget problems facing state and local governments.

Subsequent posts will consider how early childhood advocates can respond to these budget issues. To anticipate my conclusions, I will argue that budget reforms can and should make room for needed investments in high-quality early childhood programs.

Posted in Early childhood programs | 4 Comments

Is the federal budget for early childhood programs half-full or half-empty?

Posted on February 15, 2011 by timbartik

Lisa Guernsey of Early Ed Watch has an informative post outlining President Obama’s fiscal year 2012 budget request for early childhood programs.

Even though the President did not mention early childhood programs in his State of the Union address, the fiscal year 2012 budget is relatively generous towards early childhood programs. In the context of a budget that freezes non-defense discretionary spending, early childhood programs are treated very well. I agree with Lisa Guernsey’s analysis that the budget proposes increases for early childhood programs that amount to at least $2 billion. The percentage increase in federal funding is probably well over 10%. (I calculate this by assuming various proportions for different programs of how much goes to early childhood programs.)

From an early childhood program perspective, the most important initiatives are significant increases in funding for Head Start and child care subsidies, a renewed call for an Early Learning Challenge Fund, and the Home Visiting funding already enacted as part of health care reform.  The Early Learning Challenge Fund would provide competitive grants to states to encourage them to set up better systems for early learning from birth to age 5.

If this budget request was enacted as proposed, it would significantly increase federal early childhood funding. These increases would help support and supplement state efforts to maintain and expand early childhood programs.

On the other hand, the political prospects for Obama’s budget request are questionable. Republicans in Congress have proposed much larger cuts in spending.  For example, the House Appropriations Committee recently proposed cutting Head Start by more than $1 billion for the rest of this fiscal year.

Furthermore, compared to the size of the need for early childhood investments, an increase of $2 billion is not large. For example, in Investing in Kids, I estimate that moving to universal pre-k would cost an additional $14.3 billion. As another example, the proposed annual funding in the President’s budget for home visiting programs is $350 million. Yet according to my estimates in Investing in Kids, operating the Nurse Family Partnership at full scale for all disadvantaged first-time mothers would have an annual cost of $3.7 billion.

If early childhood programs are to be significantly expanded, such expansions will probably depend on the actions of state and local governments.

Posted in Early childhood programs | Comments Off on Is the federal budget for early childhood programs half-full or half-empty?

The national perspective towards early childhood programs

Posted on February 15, 2011 by timbartik

In this series of posts, I am exploring how the economic development benefits of business incentives and early childhood programs vary when considered from a national perspective, compared to a state or local perspective. This topic is explored in depth in chapter 10 of Investing in Kids.

Why do we care about the differences between the state perspective and the national perspective?  We care mainly because of what this difference implies for federal policy. If national benefits of some program exceed state benefits, there is a risk that states may underinvest in the program. If national benefits are less than state benefits, states may overinvest in the program. In either case, there may be a rationale for some federal policy intervention.

A previous post found that the benefits of typical high-quality business tax incentives were much lower from a national perspective, compared to a state perspective. This post will look at the national benefits of early childhood programs.

In chapter 10 of Investing in Kids, I find that the national benefits of early childhood programs are significantly greater than benefits from a state or local area perspective. In shifting from a state perspective to a national perspective, the percentage increase in benefits is similar for the three programs I consider: preschool; the Nurse Family Partnership; full-time child care and preschool.  For each program, the percentage increase in benefits is slightly over one-third.

For early childhood programs, national economic development benefits exceed state economic development benefits because of out-migration. Some participants in a state’s early childhood programs will end up spending some or all of their adult worklife in some other state. These increased earnings in other states will be counted from a national perspective, but not from a state perspective.

Why do national benefits exceed state benefits for early childhood programs, while national benefits are less than state benefits for business tax incentives? Early childhood programs provide services that raise economic productivity. Business tax incentives do not directly raise business productivity. Business tax incentives only induce certain changes in business behavior. Some of those changes in business behavior, such as increased national investment, may increase national output. Other changes in business behavior due to business tax incentives, such as business’s making different business location decisions, do not in general improve business productivity.

The excess of national benefits over state benefits for early childhood programs are the benefits that accrue to other states. These “other state” benefits are sufficient to potentially justify a considerable federal subsidy for such programs.

For example, I calculate that for each dollar a typical state invests in universal pre-k, the state’s own economic development benefits are $2.78, and the national benefits are $3.79, which implies that other states receive economic development benefits of $1.01. In other words, if state X on its own decided to not invest in universal pre-k, it would be in the self-interest of other states to subsidize state X to provide universal pre-k.

However, there are other issues involved in deciding on federal policy towards early childhood programs. I will consider these issues in a future blog post.

Posted in Early childhood programs, National vs. state vs. local | Comments Off on The national perspective towards early childhood programs

Interview on website of Michigan’s Early Childhood Investment Corporation

Posted on February 14, 2011 by timbartik

A recent interview with me, by Teri Banas of the Michigan Early Childhood Investment Corporation, is now up at their website.  I appreciate the opportunity to bring my work to their audience.

Posted in Uncategorized | Comments Off on Interview on website of Michigan’s Early Childhood Investment Corporation