Are subsidies worth it?: How to calculate costs and benefits of business incentives.

• Author: Wiewel, Wim
• Position: Chicago, Illinois - Includes related articles

A cost-benefit spreadsheet based on an econometric model of the local economy is being used by analysts in Chicago's Department of Planning and Development to improve the economic and fiscal information available for making decisions about business subsidies. By substituting local data, the spreadsheet can be used in other cities and states.

Governments rarely have good information about the actual costs or benefits of a business incentive package. When negotiating incentives for a firm expansion or new location, it is difficult to assess the long-term effects on the local economy as a whole or to the government's own fiscal condition, and government officials admittedly often do not know the real cost of what they are putting on the table or the value of what the firm is offering. This may result in offering firms more than the ultimate benefits are worth or offering too little. In the summer of 1992, the catalog clothing company Spiegel rejected the City of Chicago's final offer of incentives to keep the national warehousing and distribution center in Chicago and decided to leave for Columbus, Ohio, taking more than one thousand jobs with it. Public criticism was swift and strong - why did the city not offer more? Was its package too little, too late? This reaction was quite a contrast with the public outcry a few years earlier, when the State of Illinois managed to retain the headquarters of Sears' merchandising group through several hundred million dollars worth of free land, infrastructure improvements, and job-training dollars - generally characterized as a "corporate giveaway."

Spurred on by the criticism, the Chicago Department of Planning and Development (DPD) asked the Center for Urban Economic Development at the University of Illinois at Chicago (UICUED) to develop a methodology that would allow the department to assess in advance the costs and benefits of any particular subsidy package. This article presents the methodology, which is now being used by the department in a computerized spreadsheet format. It first discusses the experience of other cities and then focuses on how the key theoretical issues in assessing costs and benefits are resolved. Finally, it describes how the spreadsheet works and what would be required to make it applicable in other cities.

Chicago is not alone in how it negotiates subsidy packages. A survey conducted by the UICUED turned up no cities that used a comprehensive cost-benefit analysis to determine the level of business subsidies to be given. Of course, all cities require companies to provide estimates of jobs created and retained or produce their own estimates. Several cities, such as Phoenix, Milwaukee, and Columbus, also require targeted hiring to increase the economic benefits to low- and moderate-income persons or city residents. Most cities do not analyze secondary benefits. San Jose and Philadelphia sometimes examine increased tax revenues, as does Jacksonville, which also looks at other categories of benefits, such as the increase in services to poverty areas. Columbus tries to estimate jobs created indirectly by a project but does not use this in determining the amount of subsidy to be given. Thus, the state of the art in evaluating possible costs and benefits of subsidies, especially in advance of the investment, is quite limited.

Cost-benefit Analysis

At its most basic level, cost-benefit analysis compares two situations: the city with the project and the city without the project. Economic models, whether formal ones or consisting of educated hunches of program administrators, must be used to forecast the most important economic variables both with and without the project. For Chicago, the authors decided to build cost-benefit analyses around simulations from the model developed by Regional Economic Modeling, Inc. (REMI). This is an econometric model, available for many counties and states, of the regional economy, based on an input-output model and a larger set of equations about the local economy. Other cities could use their own local versions of the REMI model or a different model. Even starting with a sophisticated regional model, there was a series of technical and conceptual hurdles.

The first question to be answered in developing a methodology is to define the population for whom costs and benefits are to be calculated. To a certain extent, this is a policy question rather than a theoretical one, and DPD decided to count benefits to any current resident or potential residents who migrate to the city to take a job created by a subsidy. This also implies that benefits to suburban residents are excluded. It also means that subsidies that merely improve firm efficiency, without thereby increasing payroll or without saving jobs that otherwise would be lost, do not create relevant benefits.

In addition to general economic costs and benefits, DPD also wanted to know the distribution of the benefits over different income categories and a separate analysis of the fiscal effects on city government.

Finally, many economic development projects produce important benefits other than jobs or taxes. These benefits - and possible costs - often relate directly to the location of the project. Putting these neighborhood spillover effects, such as increased neighborhood confidence, improved appearance, or increased congestion, in dollar terms is often misleading and limits the analysis to easily quantifiable effects. Therefore, a separate index of neighborhood spillover effects was designed. Because of its experimental nature and space constraints, the authors do not discuss this index in this article; the technical references contain a complete discussion of...