Saying Goodbye To Targeted Tax Incentives?

The value of interstate tax competition, that is, the use of tax incentives, has always been a point of contention among economists and government officials.

Economist Milton Friedman, a free-market advocate who propounded that the government’s appetite for revenue was insatiable and will unproductively consume whatever revenue it can grab, believed that any means — like tax incentives — that force a government to take in less revenue is beneficial.

Other economists, such as Clayton P. Gillette, take a slightly less radical view, supporting tax incentives, or “locational subsidies,” because “they may be viewed as signals [to a business] of comparative advantage.” 

Then there are economists like Peter D. Enrich, who assert that any kind of interstate competition is harmful because “the economic benefits that they purport to generate are highly questionable, and the costs they entail, with respect to both state revenues and the national economy, are quite substantial.”

Finally, there are those who fall in the middle of the spectrum like Edward A. Zelinsky, who find “compelling the argument that tax competition among states and localities is healthy because such competition disciplines political officials and allows taxpayers to sort themselves among jurisdictions by taxpayers’ tax and public spending preferences.” However, he continues, “targeted tax incentives are generally inefficient and unfair.”

There is little question that over the last several decades, the states’ use of targeted tax incentives has at times gotten out of hand. The competition between states has been characterized as an all-out war or a race to the bottom, using policies intended to “beggar thy neighbor.” The benefits of these outlandish incentives generally accrue to large corporations at the expense of in-state businesses, residents, and the provision of government services.

A few examples from recent years include Amazon’s search for a second headquarters. Virginia ultimately won the competition in 2019 and paid $750 million for the privilege. Although the award is astronomical, it should be noted that Virginia is the 10th wealthiest state in the nation. Tax inequities will be inevitable, but the in-state businesses and residents may be able to better absorb the costs than other states.

Alabama is a case in point. In 1993 Alabama awarded Mercedes-Benz $238 million to locate its automobile manufacturing facility in the state. While it brought prestige to the state and was a plum for then-Gov. Jim Folsom Jr., the state was at the time grappling with “a failing educational system, a crisis in education funding, and statewide poverty.” 

Those tax breaks and subsidies reduced the amount of revenue available to Alabama, which could have been used to combat its endemic problems with education, poverty, and more. It was a political coup for Folsom, but at the expense of his constituency.

The Problem of Poaching

A tactic states and localities use to boost the number of jobs in their jurisdictions at the expense of another location is job poaching.

A jurisdiction entices a company to relocate by dangling generous tax incentives, whether the company was considering such a move or not. In past years the poster children for job poaching were Kansas City, Kansas, and Kansas City, Missouri.

The two cities lured businesses between Kansas and Missouri, and in many cases back again. Between 2009 and 2019, the year Kansas Gov. Laura Kelly (D) and Missouri Gov. Mike Parson (R) declared a truce, Kansas spent $184 million and Missouri $151 million to entice companies to shuttle between the two states, most companies moving just a few miles. 

The problem is that the tactic wasn’t creating new jobs, but simply shifting existing ones. At the time the cease-fire took effect, Kansas emerged as the “winner” — with a net gain of 1,200 jobs. Yet that is not the end of this story. The truce applied only to the two states, and not cities and counties in either state.

With Kansas City, Missouri, offering to waive local property taxes up to 25 years as compared with the 10 years offered by Kansas City, Kansas, the truce was in danger of falling apart, with Kelly declaring that if Kansas City, Missouri, tried to lure a company from Kansas with its generous property tax breaks, the deal was off.

Luckily for all involved, Kansas City, Missouri, reduced its tax break from 25 to 10 years, bringing it in line with Kansas.

Two Possible Solutions

Interestingly, the simplest solution to curb the use of targeted tax incentives lies in the states’ constitutions.

In the first half of the 19th century various frauds perpetrated on the states, usually involving railroads, prompted many to amend their constitutions prohibiting the state from raising revenue through taxes, bonds, and other securities that inured to the benefit of private parties.

In other words, such revenue could be raised and spent only for a public purpose. Today, 45 state constitutions have such clauses. Targeted incentives, then, are a classic example of public funds spent for a private benefit.

Although these clauses were watered down by the courts in the latter half of the 19th century by expanding the breadth of the term “public purpose,” it doesn’t appear to be a stretch for states to restore the clauses to full strength.

Barring constitutional clauses, perhaps an obvious solution would be an interstate compact. Before the Kansas and Missouri resolution, some states tried to create such compacts, notably states in the Midwest.

However, in the end it proved impossible to get all the states involved to sign on. Yet the idea of an interstate compact is still alive and well.

A bipartisan state legislative campaign, the Coalition to Phase Out Corporate Tax Giveaways, began the first phase of its mission in 2019 by introducing legislation to end poaching of businesses by member states. The movement is growing. Six states’ legislatures introduced bills in 2019, which grew to 15 states in 2021.

As one would expect, all bills are substantially similar, such as creating a board to develop best practices in approaches to economic development and to create a shared resource. Not surprisingly, the bills designate the state’s attorney general as the chief enforcement officer. 

One very curious provision appearing in many of the bills is that targeted incentives offered by cities and counties are not prohibited. This was precisely the sticking point between Kansas and Missouri, and it seems that permitting local governments to offer targeted incentives defeats the purpose.

Kansas and Missouri are not the only states with cities that either share a border or cities located within a few miles of the border of two states. It might be a different story if the localities, like Kansas City, Kansas, and Kansas City, Missouri, offered incentives that are on par with one another. Yet the bills do not specify whether this is required of localities.

Another curiosity regarding local government incentives is transparency. Florida and Massachusetts are the only states that allow targeted incentives to be offered by localities, but the specifics of such incentives are subject to the states’ public records laws.

Indeed, the Massachusetts bill goes even further. Not only are local government incentives subject to its own public records law, but also to the public records laws of every member state.

As for the rest of the states that have introduced legislation, excepting localities from the prohibition of offering company-specific tax incentives but not requiring the transparency of the incentives offered seems odd.

There are other oddities contained in the bills, too. Michigan’s bill, for example, limits participation in the compact to other Midwestern states. Does that mean if both Michigan and Rhode Island enact the compact, Michigan is not prohibited from poaching companies from Rhode Island? Of course, neither Michigan’s nor Rhode Island’s bill has advanced in its respective legislature, so if Michigan’s bill does so, the limiting provision should be deleted.

At least, one would hope so, because if it isn’t, of all the bills that have been filed, the only state that would be safe from Michigan’s depredations is Illinois.

Conclusion

There is a wide gulf between economists on whether tax incentives are beneficial to states. On one hand, there are those who advocate letting the free market dictate tax incentive awards, because any action that forces governments to reap less revenue is a positive. On the other hand, there are those who vehemently decry tax incentives in any form.

Finally, there is the view that not all tax incentives are bad, but targeted incentives are egregious. It has been suggested that the problem of tax incentives in the states is solvable through an interstate compact. A nationwide, bipartisan coalition of legislators in 15 states is working to bring such a compact to fruition.

At present, the draft legislation prohibits member states from poaching businesses from other member states. Although substantially similar, the bills are not alike in terms of excluding local jurisdictions from coverage or requiring transparency in the records of local governments’ targeted incentive awards.

Given the politics involved, it is doubtful if any of these bills will be enacted anytime soon but they are steps in the right direction.