Taxes and agglomeration economies: how are they related to nonprofit firm location?

• Author: Harrison, Teresa D.

1. Introduction

   Nonprofits are an ever increasing component of the U.S. economy. From 1997-2001, employment growth in the nonprofit sector averaged 2.5%, outpacing both the business (1.8%) and the government sectors (1.6%) (Moore 2004). Much of this growth stems from new nonprofits, yet few studies have investigated possible determinants of nonprofit entry and location decisions. Most of these studies focus on demand-side factors (Wolch and Geiger 1983; Downes and Greenstein 1996; Bielefeld, Murdoch, and Waddell 1997). For example, Downes and Greenstein (1996) focus on demographic and religious characteristics of the surrounding community and its relation to private school location. In this paper, I use firm-level data and focus on potentially important supply side variables: tax rates and agglomeration economies.

   Most nonprofits are exempt from corporate, sales, and property taxes. Hansmann (1987) and Gulley and Santerre (1993) find evidence that higher corporate, property, and sales taxes are positively related to nonprofit market share. However, market share measures obfuscate the dynamics of the industry in terms of entry and exit rates. If market share for nonprofits increases in response to higher tax rates, this could be because new nonprofits are entering or because for-profits are leaving the industry. Identifying these two cases is impossible with market share data. Using nonprofit tax return data, I examine the relation between these tax exemptions and state/county location decisions of

   new nonprofits. To my knowledge, this is the first paper to study these interactions at the individual firm level.

   Nonprofits also receive tax-favored status due to the individual tax deduction on charitable contributions (Gentry and Penrod 1998). Employees of and donors to the nonprofits will be affected by the individual tax rates. This in turn alters the costs to the nonprofit of location in a high or low tax area. Unlike previous studies, I therefore investigate the relation between individual marginal tax rates and nonprofit location.

   Another potential supply-side determinant of firm location decisions is the existing firm concentration in the area. The potential economies of scale generated by proximity to other firms have been extensively examined in for-profit industries. (1) Previous studies have generally found a positive relation between agglomeration and location (Carlton 1983; Bartik 1985; Woodward 1992; Gius and Frese 2002; Rosenthal and Strange 2003). To my knowledge, Bielefeld et al. (2004) is the only study that examines nonprofit agglomeration, finding evidence of agglomeration in Dallas, Texas. This warrants additional examination because nonprofit output is generally service-driven and less mobile. Thus, agglomeration implies greater direct competition, making market saturation a larger issue in the nonprofit market. Using a nationwide dataset, I examine how location and existing firm concentration are related and explore the potential presence of market saturation. I also investigate possible differences between inter- and intra-industry agglomeration.

   My results provide new insight into nonprofit firm behavior. In most cases, higher tax rates are associated with new firm location, but the results for corporate and property taxes vary across the sample years. I find that individual tax rates are an important consideration for nonprofits and are positively correlated to location. My analysis also contributes to the literature by examining how the sensitivity to tax rates varies according to the sources of revenues for the institution. Firms that depend highly on individual donations are more likely to locate in high individual tax states while nonprofits with large mission-related revenues are more sensitive to the property tax rate. I find some evidence that nonprofit agglomeration outside an entrant's industry is negatively associated with new firm location. Moreover, the total elasticity for agglomeration within a nonprofit's industry is positive, robust, and appears to be more strongly associated with new firm location than tax rates.

   The next section discusses the theory, specific hypotheses, and empirical model. Section 3 describes the data. Section 4 presents the results and discusses possible implications of the findings. The final section concludes.

2. Theory and Empirical Specification

   Each new firm i chooses to locate in a state/county j from all possible choices in the set J. For clarity, I frame the initial discussion in terms of state choice. I then discuss alterations to the model for county-level location decisions. Each state has (i) an individual income tax rate, [I.sub.j]; (ii) corporate, sales, and property tax rates, [C.sub.j]; and (iii) agglomeration of existing nonprofits in the state, [A.sub.j]. Other characteristics of the state, particularly demand-side factors, that are related to the location decision are also included ([X.sub.j]). Firm i derives utility [U.sub.ij] from locating in a state j and chooses the state that maximizes its utility such that:

   [U.sub.ij]([C.sub.ij], [I.sub.ij], [A.sub.ij], [X.sub.ij]) > [U.sub.ik]([C.sub.ik], [I.sub.ik], [A.sub.ik], [X.sub.ik]) [for all]j, k [member of] J and j [not equal to] k, (1)

   where utility is a function of the tax rates, agglomeration, and other characteristics of each state.

   Although most nonprofits are tax-exempt, previous theory suggests that tax rates still influence their behavior. In industries where nonprofits and for-profits compete, the marginal tax rate paid by the for-profit creates a higher cost of capital relative to the tax-exempt nonprofit firm, suggesting that nonprofits should locate in states with higher corporate tax rates (Rose-Ackerman 1986; Steinberg 1991). However, changes in tax rates are also directly related to other attributes potentially important in the location decision. For example, increased government provisions due to an increase in the tax rate could trigger a decline in entry by nonprofits, particularly if the provisions are substitutes for nonprofit services. In this scenario, the relation between location and [C.sub.ij] would instead be negative.

   Individual taxes are a common regressor in the for-profit literature on location decisions (Bartik 1985; Coughlin, Terza, and Arromdee 1991; Woodward 1992; Devereux and Griffith 1998; and Gius and Frese 2002). Although the nonprofit firms are tax exempt, the workers are not. So, due to the tax burden on their employees, nonprofits may be motivated to locate in states with lower individual income tax rates. A negative relation between individual taxes and location could also occur if higher tax rates decrease individual migration and thus, population growth. Lower population growth would not only affect the size of the potential employee pool but also may decrease the demand for nonprofit services.

   Alternatively, individual tax rates and nonprofit location could be positively related since individual taxes affect the price of the tax deduction on charitable contributions. Many studies have found a negative price elasticity on donations, indicating that higher individual tax rates increase charitable giving. (2) If the nonprofit believes that higher tax rates positively impact their donations, then they will be more likely to locate in higher tax states. (3)

   Thus, it is not clear a priori whether higher individual tax rates increase or decrease the probability of location by a nonprofit firm. As I discuss in the data section, I attempt to remove the indirect effects that taxes have on the location decision through my controls. However, there may be other omitted factors correlated with the tax rates that could bias the estimates. (4) Therefore, I will not be able to identify the direct cause of my observed relations.

   A firm's response to changes in tax rates will also vary by industry due to variation in the extent of for-profit competition and the degree of financial dependence on donations. Nonprofits that do not compete with for-profit institutions should not be directly influenced by the corporate tax rate; an increased cost of capital to a for-profit competitor is a moot point. Nonprofits with more mission-related revenues are more likely to have for-profit competitors since for-profits in such an industry could also receive service-related revenues. Similarly, nonprofits with donations as the primary source of revenue should be more influenced by the individual tax effect on donations. Thus, I include measures of the percentage of revenues obtained through mission-related revenues and donations to examine the relation between revenue sources and nonprofit location decisions.

   Labor market pooling, knowledge spillovers, and input sharing are generally the three primary theories used to explain the (generally for-profit) firm benefits of agglomeration. (5) However, agglomeration economies can equally exist for nonprofit firms. Nonprofits clearly employ workers, so they could benefit from higher quality job matches due to labor market pooling. A larger workforce can also produce internal economies of scale in production. Similarly, knowledge spillovers could take the form of learning from other nonprofits about popular fundraising events or successful methods to connect with the target population.

   In my paper, I distinguish between within- and outside-industry agglomeration. The first measure is generally thought to capture localization economies in which it is the shared knowledge and inputs within an industry that spur growth. Increased diversity or improvement in employer/employee matching due to labor pooling is generally captured by the outside-industry agglomeration and are referred to as urbanization economies (Rosenthal and Strange 2003; Henderson 2003). Rosenthal and Strange (2003) find a positive relation for within-industry agglomeration but a negative relation for higher firm concentration outside the industry...