In my last post, I went over the basics of why tax incentives and subsidies are considered staples of economic development. In this post, I’ll explain why they don’t work as politicians might hope.

A common argument in favor of financial incentives is that tax breaks and subsidies motivate firms to create new jobs and invest in new projects, which sparks demand for more products and services within the local economy.

For example, if Hewlett-Packard builds a plant, then construction workers get hired, computers get bought, employees eat at local restaurants, and so on. As demand rises, more firms are attracted to the area and either establish new operations or expand existing operations, leading to further job creation, project investment, and an overall uptick in economic activity.

This uptick increases public revenue as new businesses and employees pay taxes on their earnings and purchases. With increased public revenue, governments may be able to afford to decrease marginal tax rates on businesses or individuals or increase the number or quality of public goods and services. And who doesn’t want lower taxes or better schools, roads, and parks?

While these arguments seem sound, the reality is that financial incentives often fail to spur economic activity for several reasons.

Positive and Negative Spillover Effects from Tax Breaks and Subsidies

Traditionally, incentive programs are evaluated only by the jobs, local investment, and tax revenue directly created by the firm that receives the incentive package. For example, the only reports the direct number of jobs created or retained and the direct investments made by the companies receiving subsidies.

But new and expanding firms create spillover effects that both help and hurt surrounding businesses. Some of these effects support economic growth.

-Labor pooling encourages economic growth by increasing the concentration of workers in the area with specialized skills and knowledge.

-Technology spillovers, or the exchange of technology among people and firms, increase efficiency and innovation. -Knowledge sharing, or the exchange of thoughts, concepts, and ideas among people and firms, also leads to increased innovation.

But there are also several negative spillovers. Increasing the number of firms in a location

-increases the demand for a variety of inputs, such as labor and real estate, which increases the cost of labor and rents and raises the cost of doing business.

-means that, unless infrastructure is expanded, more firms are competing to use the same level of roads, railways, utilities, and communication systems.. The resulting congestion can slow the movement of people and products, which hurts a company’s profits.

-makes tax hikes more likely. An influx of businesses and people means that demand for public goods such as roads, schools, and police will increase. Public money (taxpayer dollars) pays for these goods, which means that the government must collect more revenue. While more businesses and people mean that the tax base will expand and the government will collect more revenue even if it doesn’t raise tax rates, increasing the demand for public goods also increases the likelihood that taxes will rise to keep up with demand for public goods. (Related: Taxes Take Their Toll on Arkansas Manufacturing)

-leads to the cannibalization of existing firms. Tax breaks and subsidies provide a cost advantage to firms that receive them over firms that don’t. When a particular market is saturated (isn’t big enough for more firms), providing a cost advantage to select new firms through incentives allows them to “steal” employees and customers away from existing firms, often to the point that some existing firms must close.

Because of these spillover effects, both positive and negative, tax incentive projects should be evaluated based on their total impact on an economy—not just based on the direct effects from the incentivized firm.

When Looking at the Whole Economy, Tax Incentives for Businesses Don’t Help As Much As Politicians Think They Do

Much research on the net effects of tax incentives for businesses has found that large, new firm locations have a much smaller benefit on the local economy than advertised. In other words, the negative spillover effects outweigh the positive ones. Research by economist Kelly Edmiston examining the found that “after five years, each 100 new employees hired by a new or expanding firm results in a net gain of only 29 workers to the resident county.”

In addition, found that using tax incentives to attract large firms to an area doesn’t have any positive overall effect on the private sector, and likely doesn’t increase tax revenue, either. These findings contradict the common argument that financial incentives increase economic activity. If new firms take employees and customers from existing firms, there are no positive spillovers.

Rent-Seeking

Because incentives reduce the cost of doing business, firms that receive incentives have an artificial competitive advantage over similar firms that do not receive them. The government-granted competitive advantage gives incentivized firms a better chance of survival than those that do not receive aid. By providing advantages to select firms, the government is picking winners and losers rather than letting the market decide. Who do you think should decide whether, say, Target or Walmart is more successful in your hometown: the government or the customers who shop there?

Another problem is that when governments pick and choose who receives financial incentives, they create an environment of rent-seeking: the use of resources to gain financial advantages without creating value in the overall economy. Firms use their resources to lobby for political favors that provide competitive advantages rather than creating a better product or service. Are you, as a consumer, better off when for (that your tax dollars pay for) or spends money on better quality clothes and a more unique shopping experience? Is the economy better off when Dillard’s spends money courting governments for handouts instead of courting customers, whose purchases lead to jobs and economic growth? By issuing financial incentives, governments are encouraging firms to waste resources courting politicians instead of focusing on value-adding activities.

When politicians increase the rewards, or financial incentives, for unproductive behavior, more entrepreneurs engage in , which leads to a misallocation of talent and hurts the economy in the long run.

Seen and Unseen Effects

Policy makers need to consider both the because policies do not have a single outcome, but a series of outcomes. Only the initial outcome is immediately apparent; subsequent effects take time to develop. However, failing to consider the unanticipated outcomes of policy is dangerous. Policies that have short-run benefits often have negative long-run outcomes, and vice versa. Sound economic policy requires foresight to anticipate the future consequences of today’s decisions.

In the case of policies that provide financial incentives to select firms, the immediate, seen effect is that the firm receiving corporate welfare creates new jobs. This effect is often well documented in photo opportunities with politicians. What we don’t see are the other Arkansas jobs destroyed or the jobs that would have come to Arkansas but don’t because of the unintended consequences of financial incentives. While a handful of firms and the workers they hire may initially benefit from subsidies and tax breaks, the economy at large suffers in the long run.

If you’ve ever wondered why corporate welfare gets such a bad rap, you’ll want to read this post and the five follow-up posts I’ll be publishing over the next few weeks. My goal is to help you understand why governments give tax breaks and subsidies to local businesses and why, even with the best of intentions, these efforts tend to fail and cause new problems. These posts are based on a paper I just published, “Tax Breaks and Subsidies: Challenging the Arkansas Status Quo.”

Economic development is a constant focus of state and local governments. Government officials work to attract businesses, jobs, and investment to the area. They often do this by offering financial incentives, such as tax breaks and subsidies, to select firms. However, financial incentives used to entice businesses come at the taxpayers’ expense. Politicians may enjoy bragging about the remarkable progress they’ve made when they trade tax dollars for a handful of jobs, but they ignore the resulting economic costs. Tax incentives create market distortions that make residents worse off and leave them with less money in their pockets.

Here at ACRE, we want Arkansans to be as well off as possible. To ensure that they are, we want to help you understand the problems with financial incentives, why you should care, and what government officials should do instead to create the best outcomes for each individual Arkansan, their families, and the state as a whole.

What Are Tax Incentives and Subsidies?

When trying to improve economic development, politicians and government officials frequently use two carrots to entice firms: tax incentives and subsidies. Tax incentives aim to attract more business to the state by making it less expensive for businesses to operate in Arkansas relative to other states. Subsidies are grants, or sums of money, that governments give firms in an effort to boost business. Let’s take a look at how each one works.

Tax incentives are always designed to increase a firm’s profitability by decreasing its overall tax burden. They come in several forms:

–Tax exemptions fully excuse firms from paying certain liabilities.

–Tax reductions partially offset the amount a firm is obligated to pay in taxes.

–Tax refunds and rebates repay a portion of the taxes a firm has already paid.

–Tax credits are more flexible: they allow a firm to offset a portion of its tax obligation, and they can often be carried forward to subsequent tax years or be sold in the secondary market.

To see how tax credits can impact a company’s profitability, take a look at this sample profit and loss statement. The yellow highlights show how a business income tax credit, in this case for labor, increases a firm’s bottom line.

How Do Businesses Get Tax Incentives?

To receive tax incentives, firms must meet certain requirements from the government. These vary depending on the tax incentive, but common ones include:

-belonging to certain industries

-investing so much in a particular project

-creating a particular number of jobs

-reaching a minimum payroll threshold

The qualifications often depend on the tax incentive’s purpose, which might be creating new jobs, spurring private investment, or increasing research and development. After all, government officials use incentives to promote their particular agendas. Politicians can attempt to steer business practices with incentives because incentives encourage firms to engage in a specific activity by lowering the firm’s cost of that activity, making the return on investment more attractive.

For example, the Arkansas job creation tax incentive known as is an income tax credit given to qualifying firms based on the payroll of new, full-time, permanent employees. Because the tax credit lowers the firm’s labor costs, the return on investment of hiring a new employee is greater and thus a more attractive option relative to other investments the firm could make. Most recently, , a software engineering, development, and deployment firm, is poised to benefit from Advantage Arkansas. Elyxor will receive an income tax credit for 1 percent of its total payroll. In return, the company plans to hire 45 employees within 5 years.

Using Tax Incentives to Target Preferred Businesses and Industries

Politicians commonly use tax incentives to target certain preferred businesses or industries in which they want to encourage the creation, expansion, or relocation of firms. This targeting is an attempt to steer the economy by lowering the cost of doing business in a desired industry. For example, to six emerging technology sectors:

-advanced materials and manufacturing systems

-agriculture, food, and environmental sciences

-bio-based products (adhesives, biodiesel, ethanol, etc.)

-biotechnology, bioengineering, and life sciences (genetics, geriatrics, oncology)

-information technology

-transportation logistics

Tax incentives aren’t the only tool governments and politicians can use to attract business: they can also use subsidies.

How Governments Use Subsidies to Attract Business

Often, governments issue subsidies under the premise that firms will create jobs or increase investment in the local economy. Subsidies, much like tax incentives, lower the cost of doing business and increase returns on investment. The potential for new jobs and investments to improve economic development makes subsidies an attractive tool for politicians.

Arkansas frequently provides subsidies through the . Both the governor and the legislative council must approve the Arkansas Economic Development Commission’s use of the QACF. The QACF is funded with general revenues, which are funds that come primarily from individual income taxes and sales and use taxes. The legislature allocates these funds across the state’s agencies and programs, including to the QACF. [Related: Making Cents of $18 Million: Voters Decide Whether to Increase Sales Taxes in Pulaski County.]

From its creation in 2007 through end of fiscal year 2015, the QACF has subsidized 73 entities. Some of the largest beneficiaries include Hewlett-Packard in Conway ($10 million), LM Windpower in Little Rock ($6.8 million), and Nordex in Jonesboro ($3.8 million).

Arkansas’s government also provides subsidies through . Amendment 82 of the Arkansas Constitution allows the Arkansas General Assembly to authorize the issuance of general obligation bonds of up to 5 percent of the state’s general revenues collected during the most recent fiscal year (in Arkansas, the fiscal year runs from July 1 to June 30; fiscal year 2016 started on July 1, 2015, and ended June 30, 2016). Amendment 82 bonds are generally reserved for “major economic development projects,” such as the . For a company to receive Amendment 82 bonds, the general assembly must approve the bonds’ issuance by a vote. Because these bonds are general obligations of the state, they become a liability of the taxpayers. In other words, it’s your tax dollars that must pay off the debt the state legislature voted to place on you. Legislators have to find the money for these bonds somewhere, which means they could cut spending elsewhere or, more likely, raise taxes.

Conclusion

Rather than focusing on developing the next special tax break or subsidy, government officials should focus on creating a better business environment to attract and retain businesses. Specifically, Arkansas should implement comprehensive tax reform that not only lowers taxes for all businesses, but creates a more simple, fair, and transparent system.

Stay tuned for my next post, where I’ll discuss why financial incentives don’t have the positive effect on economic activity that their supporters think they do.