Do economic effects justify the use of fiscal incentives?

• Author: Fox, William F.
• Position: Tax incentives

1. Introduction

   Recruitment of large industrial and commercial facilities is a key aspect of most local development strategies. Policy makers presumably act on the assumption that new sitings will create positive shocks and significant net benefits for the local community. It is this premise that justifies the significant inducements and incentives that appear very large relative to the magnitude of the locating firm. (1) Economists have dabbled around the margin of this debate. Oates and Schwab (1991), for example, argue that interjurisdictional fiscal competition is efficiency enhancing by bringing business tax payments in closer alignment with services received from the public sector. Inman and Rubinfeld (1996), on the other hand, argue that competition for mobile capital may lead to a local public sector that is too small. This paper explores the question of whether large, mobile companies, the typical targets of aggressive industrial recruitment activities and recipients of lucrative incentives, have positive net impacts on regional economics. In the spirit of Jacobson, LaLonde, and Sullivan (1993), we apply the tools of the program evaluation literature to address this question.

   There are several reasons why the net economic effect of a new location could in fact be well short of the direct (or gross) employment and investment effects that are the basis for granting concessions. First, concessions erode the fiscal gains of location. Tax incentives limit revenue gains, and other concessions (such as site acquisition and development) require expenditure of public funds. Foregone tax revenues and higher public expenditures mean that state and local governments must either provide fewer public services or impose higher taxes on existing industry and residents to maintain balanced budgets.

   Second, a significant new location can easily crowd out other economic activity. For example, Porter (1999) found that megasports events, specifically Super Bowls, have no real effects on spending in host communities, a result he attributes in part to the crowding-out phenomenon. The 1996 Atlanta Olympics provides another example. Spending by Olympic patrons created significant short-term jobs and income. At the same time, the Olympics crowded out other economic activity, as fewer other special events were held during the summer of 1996 and many local businesses not tied to the Olympics lost sales. In fact, anecdotal evidence suggests more than complete crowding out since the total number of visitors to Atlanta during 1996 was down 8.8% from 1995. (2) Also, wages were driven up by labor shortages during both the construction and operational phases. (3)

   More generally, the location of a large company can crowd out other economic activity by shifting sales from existing firms, congesting local infrastructure, and raising prices in factor markets; Porter (1999) noted the possibility of diminishing returns in production. The factor market effects can be pronounced, especially for existing firms that produce in highly competitive national or international markets. Further, large companies (like Mercedes Benz and BMW) may prefer locations without other significant, visible firms sited in the same jurisdiction so that they can dominate the business and civic community. (4) Thus, the incentive for other firms to locate may be diminished by the preexisting presence of large firms in an area.

   The business location literature has focused on the ways in which market forces and public policies influence firm location, investment, and job creation. (5) This paper reverses the focus of previous research by modeling the discrete location behavior of large firms with an eye on estimating the net impact of location on traditional measures of regional economic growth. Although our reduced form model does not explicitly take into account the concessions that are granted to firms nor the specific channels through which firm location positively or negatively influences regional economic performance, we are nonetheless able to identify the net effect of large firm location on regional income and employment. Panel data techniques and extensive statistical tests are applied to a primary database of large companies that made location decisions in the 1980s. We control for nonrandom site selection on the part of firms and nonrandom company selection on the part of communities in order to estimate the time path and magnitude of net economic effects on host communities. The primary finding is that the location of a large firm has no measurable net economic effect on local economies when the entire dynamic of location effects is taken into account. Thus, the siting of large firms that are the target of aggressive recruitment efforts fails to create positive private sector gains and likely does not generate significant public revenue gains either.

   The next section of the paper details the model of firm and community selection leading to an empirical model of regional economic growth. An important aspect of this model is the discrete and noncompetitive process that typifies the siting of large firms. This is followed by discussion of the data used in the empirical model. Empirical findings are then reported and discussed.

2. Conceptual Framework

   Economic growth and decline occur as firms locate, expand, contract, and exit the economy in response to market forces and public policies. The focus of this analysis is on the role that large, newly locating firms play in the regional growth process and the extent to which the large firms influence the propensity of other firms to locate, expand, contract, or exit. The large firms can be viewed as demanders of sites, and the communities can be seen as suppliers, either directly (through industrial parks) or indirectly (through accommodating land use controls). (6) The negotiations that characterize the siting process of large new companies suggest the presence of market power on both the demand and supply sides of the market. Other firms are modeled separately (below) as competitive agents in the regional economy.

   Large firms determine their demand for sites by examining the expected profitability associated with each site based on a region's demand, cost, policy structure, and amenities. Note that firms may not choose locations with the best profit potential, possibly accepting lower market returns in exchange for amenities (see Fox and Murray 1990). During the negotiating process with communities, firms reveal their general intentions including planned production, capital investment, employment, and nonpayroll spending. Communities, as discussed below, may choose to induce location through provision of incentives that improve site-specific profits or may seek to limit access to sites through zoning or other restrictions. Together, market forces and information on incentives enable firms to formulate expectations on intersite profitability. Generally this information is not available to a researcher.

   Just as firms evaluate site-specific profits, states and localities determine their willingness to supply sites based on evaluations of potential returns from the location of large companies within their jurisdiction. (7) In practice states and substate jurisdictions have separate indices of expected returns from large company locations. The state would have greater interest in state-wide benefits and costs, whereas localities would be expected to hold a more parochial view of benefits and costs. It is difficult to know exactly how specific states and communities will evaluate the returns to location since the weights applied to benefit and cost factors will vary dramatically. Narrowly, the calculus might reflect the perceived surplus (deficit) of revenues over public sector costs. Other factors that might be included are economic effects such as jobs, income, and changes in industry structure as well as the prestige effects that accrue to political leaders when a large location occurs.

   In cases where net economic, fiscal, and/or political surpluses are anticipated, states and communities may seek to increase the probability of a large firm locating through grants, abated taxes, provision of training services, site development assistance, and other concessions. There is presumably some maximum amount that a community would be willing to give away to attract a large new company, some or all of which may be provided to a locating firm through concessions and other forms of support. A stick, such as zoning or other regulatory controls, might be used instead of a carrot in cases where policy makers perceive net costs instead of net benefits from a specific location. Information on pieces of incentive packages actually accepted by firms is often available, whereas unaccepted incentive offers are generally unobserved.

   The noncompetitive location process begins as firms reveal their production and investment plans and scrutinize alternative sites. Communities then make their best offer based on expected returns. Firms respond by accepting or rejecting community bids or by making a counter offer. (8) A new round of negotiations could begin if the offer is not accepted. Generally, it is impossible to observe the sites examined by a large firm and the firm's assessment of intersite profitability as well as incentives offered and incentives accepted. But actual company locations are observed to take place in specific regions, in which case it can be assumed that the location satisfies both the company's required minimum or reservation level of profit and the community's required return on available sites.

   An important question is the ex post effect of location on regional economic performance. One approach to estimating the economic effect of a large company's intervention is to specify a detailed structural model capturing the optimization behavior of firms, factors of production, and policy makers...