The impact of state government subsidies and tax credits in an emerging industry: ethanol production 1980-2007.

• Author: Cotti, Chad

1. Introduction

   In 1980, ethanol production in the United States was virtually nonexistent, but by 2007, production had expanded to 6500 million gallons. Federal subsidies and mandates requiring ethanol to be mixed with gasoline are notable driving factors in the emergence of the biofuel industry in the United States. (1) Currently, the federal government subsidizes ethanol blended with gasoline at a rate of 51 cents per gallon. (2) Federal subsidies have received much attention from supporters as well as critics. Much less focus, however, has been on the subsidies and tax credits provided at subnational levels of government. Many states offer subsidies and/or tax breaks for the production and/or consumption of ethanol, and in a number of cases, these are substantial: Some states offer 20 cents per gallon, and in a few cases, as much as 40 cents per gallon are offered to ethanol producers. To illustrate, consider Wisconsin, which offers an annual subsidy at the rate of 20 cents per gallon up to 15 million gallons. According to the National Corn Growers Association, a 40 million gallon plant employs 32 full-time workers.

   On a per worker basis for the average-size plant in Wisconsin (53 million gallons), this subsidy is equivalent to about $71,400 per worker. This is a sizable and costly subsidy if the goal is to generate jobs, but clearly the goals of such subsidies are much broader than job creation.

   Beginning in the 1980s, state and local governments increasingly began to rely on subsidies and tax breaks to stimulate growth in employment and business activity. Between 1984 and 1993, the number of states offering various incentives increased from 27 to 44 (Chi 1994). A significant focus of within-state incentive packages is generating economic activity in economically distressed rural areas (Greenberg and Reeder 1998). More recently, it has been argued that one of the benefits of ethanol production and consumption is job creation in rural areas. (3) What is less clear is whether such incentives actually stimulate economic development. Much of the academic research evaluating the impacts of economic development incentives suggests that such incentives are costly in terms of direct payments or forgone taxes, and the ultimate gains in development are limited (Bartik 1991). Nearly all of this work has sought to evaluate the impacts of incentives on general business activity or activity in well-established markets.

   The present study makes several contributions to the body of work on the emerging biofuel industry and the research that has sought to evaluate the effectiveness of development incentives. First, while we have detailed and accurate national data on ethanol production dating back to 1980, state-level data on ethanol production are not systematically collected. Using information from multiple sources, we constructed annual data on ethanol production capacity dating back to 1980 for each state. These data may be of interest to researchers seeking to understand the evolution and emergence of the ethanol industry in the United States. Second, we compiled a detailed list of all state-level tax credits and subsidies with imposition dates over the 1980-2007 period. We use these data to evaluate the role of incentives offered by subnational governments on the location of ethanol production plants. To date, little is known about the role of state subsidies in the emerging biofuel industry, particularly in terms of influencing location decisions. This research also contributes more generally to the literature evaluating the importance of incentives in fostering the development of an emerging industry.

   As a prelude to our results, we find that incentives directed at ethanol production (particularly per gallon credits) have a significant influence on plant location/production. However, we also show that the magnitudes of our estimates are sensitive to estimation technique. Next, we provide a brief review of the most relevant research on the emerging biofuel industry and the research on effectiveness of development incentives. In section 3, we present our data and empirical analysis, and section 4 concludes.

2. Literature Review and Theoretical Discussion

   In this section, we present a review of the recent research in the emerging biofuel industry, as well as the extensive body of work that has sought to evaluate the effectiveness of state and local government economic development incentive programs.

   Ethanol Production

   Much of the research on ethanol production is only peripherally related to state government incentives. For example, Gardner (2007, p. 19) employs a cost-benefit analysis to evaluate the net societal benefits of relying more heavily on ethanol as a renewable fuel source. His analysis evaluates the market impacts and deadweight loss resulting from the 51 cents per gallon federal ethanol subsidy. He concludes that "ethanol subsidies and mandates are unlikely to generate social gains." While such subsidies clearly have an appeal for certain farm interests (for example, corn producers), the net societal gains of such policies are questionable. Similarly, Hahn and Cecot (2007) also employ a cost-benefit method to evaluate current federal biofuel policies. Consistent with Gardner (2007), they conclude that under current policies, the costs of increased production are likely to exceed the benefits.

   Hahn and Cecot (2007) regard federal as well as state and local government subsidies and regulations as the driving force of the ethanol industry. The following are some of the incentives that "corn states" (4) are using: Illinois grants up to $5.5 million for the production of new plants; Indiana offers a 0.125 cents per gallon production tax credit; Iowa offers 0% interest loans up to half the cost of the production project; and Missouri offers tax incentives of 20 cents per gallon of ethanol produced. Even many states that are not typically thought of as corn states are using such measures in an attempt to attract the industry. Some of these states and the provisions they offer include: Hawaii, which has a tax credit equal to 30% of nameplate capacity; Maine, which has a tax credit of 0.05 cents per gallon; and Vermont, which provides loans to assist research and planning for the production of biofuels. To our knowledge, no studies have evaluated the importance of state government subsidies and tax credits in ethanol plant location decisions. While it is clear that state officials are using incentives as tools to compete for ethanol plants, the effectiveness of such policies remains open to debate. There is, however, a substantial literature evaluating the effectiveness of general economic development incentives, and we turn to this research next.

   Subnational Incentives and Economic Development

   Given that this literature is now very extensive, it is not within the scope of this article to review this entire body of work. Rather, our goal is to summarize some of the key findings of the existing research in the context of the objectives of the present study.

   Perhaps it is appropriate to begin with the text by Fisher (2007), who provides an excellent summary of the existing research. Generally, state and local governments use three basic types of fiscal incentives to attract business: (i) financial incentives, including loans below market-level interest rates, direct grants, and loan guarantees; (ii) tax reductions, including the use of credits, deductions, abatements, and specialized rates; and (iii) direct grants of goods or services, including land, labor training, and infrastructure. According to Fisher, "Most states offer all these incentives in one way or another, developing a package of specific incentives from the general list for each potential investment project" (Fisher, 2007, p. 647). The primary goal behind these provisions is to offset real or perceived business cost differences among states.

   Regarding the implementation of subsidies and other fiscal provisions, the evidence as to whether such policies are effective is mixed. Citing many references, Edwards (2007) argues that policy instruments and financial assistance payments are largely ineffective. Rather, the more important driving forces in firm location decisions are as follows: (i) proximity to the product market, (ii) the quality of labor, and (iii) the quality of transportation networks. Edward concludes that government incentives distort markets and lead to inefficient outcomes.

   There is, however, some work showing that incentives may influence some firm location decisions. For example, Bartik (1991) shows that in the long run, the elasticity of business activity with respect to state and local taxes lies in the range of -0.1 to -0.6 for business location decisions. Wasylenko (1997) furthers the argument by noting that significant differences among states' incentives must exist in order for an impact to be felt as a result of the incentives. He argues that an impact substantial enough to be measured will occur only when a state's policies are significantly different from those offered by other states. Bartik reviewed 30 studies, of which 60% find statistically significant positive effects on business activity. The work of Bartik (1989), Garcia-Mila and McGuire (1992), and Tannenwald (1996) suggests that the success of the incentives may depend on the type of business the region is trying to attract. Finally, Gabe and Kraybill (2002) show that establishments receiving incentives tend to overstate announced employment targets.

   Our work adds to both these lines of research. In terms of biofuel research, little is known about the ways in which state incentives influence location decisions of ethanol plants. With regard to the general research evaluating the effectiveness of economic development incentives, our work makes two contributions. First, we evaluate the role of incentives in an emerging industry as opposed to already...