Will Issue 3 bring jobs or bankruptcy taxes? Issue 3 proposes to allow local governments to appropriate tax dollars directly to private companies for economic development projects and to pay private organizations for economic development consulting work. Issue 3 would also expand the type of projects for which local debt can be issued as well as increase the number of taxes that can be authorized to retire economic development bonds.

The proposal to loosen the restraints on municipalities stems from a that payments made by the cities of Little Rock and North Little Rock to local chambers of commerce were unconstitutional. Proponents argue that passing Issue 3 will resolve the legal question and enable local governments to offer enough incentives to attract businesses.

, executive director of the Arkansas Economic Development Commission, claims that “when a local community has no defined ability to spend funds for economic development purposes, it is at an immediate disadvantage versus communities that have this ability.” Issue 3 would allow all communities to develop defined spending plans that might help cities and counties develop both direct and indirect employment.

Randy Zook, president and CEO of the Arkansas State Chamber of Commerce/Associated Industries of Arkansas, that “ambiguities in our state Constitution have left our communities with their hands tied when it comes to using local resources to recruit employers.” However, voters should remember that constitutions are put in place to limit government power. Expanding government officials’ ability to use local tax dollars and public debt to finance private economic development projects comes with costs.

For example, Fayetteville city attorney that allowing cities and counties to finance private economic development projects means that “Arkansas cities will likely be invited into bidding wars with each other for new ‘economic development’.” Businesses could threaten to leave for the neighboring town if their current host city did not provide more incentives. This would put Arkansas cities into contests with each other to see who can write the biggest check, which ultimately drives up local tax burdens. Little Rock would compete not just with Oklahoma City and Nashville, but also with Conway and Rogers. Rather than spurring job creation, existing jobs would simply be moved from one Arkansas city to the next.

Furthermore, local governments take on significant financial risk when tax dollars and local debt are used to finance private businesses. , provides a cautionary tale. In March 2015, more than one-third of Port St. Lucie’s debt ($335.5 million) was from “failed or faltering economic-development deals for which the city fronted money with a promise of repayment.” This means that taxpayers in Port St. Lucie are being forced to pay $335.5 million (plus interest) for projects they will see little to no economic benefit from. The city’s struggle with economic development debt led to a If Issue 3 passes, how many Arkansas cities would follow the path of Port St. Lucie?

While many government officials are cautious about such projects, others might not be as diligent – or they might be mistaken. There is always the chance that city and county officials would take risks hoping that they will pay off and, perhaps, also gambling that if their bet fails, the state might step in and pick up the bill. After all, Arkansas taxpayers have seen this before.

In the 1920s, Arkansas’s municipalities to finance road construction projects. Yet, the debt burden quickly became insurmountable for municipalities. In an effort to rescue the failing road districts, the State of Arkansas assumed local road debts. However, Arkansas was hit hard by the 1927 flooding of the Mississippi River system and the Great Depression that followed a few years later. By 1933, Arkansas was drowning in its debts and became the first and only state to declare bankruptcy during the Depression.

Using local tax dollars and public debt to finance economic development projects brings both risks and rewards. Relaxing the constitutional restraints on local governments may enable Arkansas’s communities to attract new economic development, but at what expense? Arkansas voters must ultimately weigh the cost of higher tax burdens and the risk of bankruptcy against the possibility of new employers.

Issue 3 is a complicated ballot measure. The bill runs 9 pages of legal text and it amends at least six sections of the Arkansas Constitution. No wonder voters are confused! In this blog post, we will discuss the benefits and costs of Issue 3’s major change: removing the cap on bonds the state may issue for economic development.

How Issue 3 Impacts Amendment 82 Bonds

Amendment 82 of the Arkansas Constitution allows the state to issue general obligation bonds for the purpose of funding economic development projects. These bonds are generally reserved for large projects such as the . For a company to receive Amendment 82 bonds, the general assembly must approve the bonds’ issuance by a vote.

Currently, the state is only authorized to issue bonds of up to five percent of the state’s general revenues collected during the most recent fiscal year. However, Issue 3 proposes to completely remove this cap, expanding the state’s ability to fund economic development projects.

What are the Pros?

By expanding Amendment 82 bonds, Arkansas could attract huge economic development projects that are not possible under the current Constitutional restrictions. For example, Arkansas may be able to draw an automobile assembly plant that the state hasn’t been able to land because of the five percent cap. Mississippi was able to beat out Arkansas for Toyota in 2007 because worth of incentives for the project. Removing the cap on Amendment 82 bonds would give Arkansas the ability to write a check big enough to attract an auto factory or any other super project that would likely never come to Arkansas without incentives.

An additional benefit is that Arkansas may be able to secure mega projects without incurring fiscal costs. If Arkansas disperses Amendment 82 bond proceeds as a loan rather than a grant, there is no cost to the state’s budget, provided that the company continues to make its payments. The firm pays the state and the state uses those payments to repay the Amendment 82 bonds. Arkansas may even come out on top if the interest rate the firm pays the state is higher than the interest rate the state pays bond holders. Attracting firms that Arkansas would not otherwise draw without using tax dollars means no fiscal cost to the state.

However, history has proven it an unrealistic expectation for Amendment 82 bond proceeds to be delivered solely as loans. The entire (a project which ultimately did not come to fruition) was approved as a grant and just $50 million of the $125 million given to Big River Steel was in the form of a loan.

What are the Cons?

Famed economist that “the good economist takes into account both the effect that can be seen and those effects that must be foreseen.” Arkansas may be able to land large economic development projects with Amendment 82 bonds, but doing so comes with hidden costs.

Arkansas takes on significant risk when it issues economic development bonds. Consider the following hypothetical example:

Arkansas legislators approve a $300 million Amendment 82 bond issue to lure an auto assembly plant. The bonds are sold to the public and the proceeds are provided to the auto company: $180 million as a grant and $120 million as a loan. Arkansas taxpayers are on the hook to repay bond holders for the $180 million grant and the auto company is responsible for the $120 million provided as a loan. Now, imagine that the auto manufacturer files for bankruptcy, which is not hard to do since GM and Chrysler both essentially did so in 2009. Arkansas no longer receives payments from the business and must find another way to repay the Amendment 82 bond holders. Who do officials turn to? That’s right, taxpayers. Taxpayers must now pay for the entire $300 million issue.

Supporters of Issue 3 have argued that the five percent cap on Amendment 82 bonds puts some economic development projects just out of reach. But it’s important to recognize that the proposed amendment does not simply raise the cap to 10 percent or 15 percent of state revenue, it eliminates the cap completely. There will effectively be no limit on how much the Legislature can issue in bonds.

How much debt would Arkansas issue to attract a few companies? 100% of state revenues? $10 billion? While giving $1 billion in incentives seems crazy and hyperbolic, (after Missouri offered them a measly $1.7 billion). Removing the cap on Amendment 82 bonds opens the door for Arkansas to do the same. It provides Arkansas officials an avenue to gamble limitlessly on economic development projects with the backing of the citizens of Arkansas.

Conclusion

Issue 3 is a complex, but important ballot measure. Its major change, removing the cap on economic development bonds, has both pros and cons for the Arkansas economy. On one hand, it may provide the state what it needs to attract major economic development projects. But, in doing so, Arkansas would be taking on significant amounts of debt, risking the solvency of the state.

In a future blog post we will discuss another aspect of Issue 3: its impact on economic development at the local level. A lays out some interesting costs and benefits which we will expand on.

Supporters of financial incentives for businesses argue that incentives are designed to protect the taxpayers who pay for them. Tax incentives generally pay out only after a company makes a business investment. An example is the tax credit for 1 percent of payroll that Elyxor will receive for creating 45 jobs over the next 5 years in North Little Rock. Governments will not award firms a job-creation tax credit if they do not create jobs, just as governments will not give firms a research and development tax credit if they do not engage in research and development.

Subsidies are different: they generally provide payments up front. Because of this, subsidies often come with clawback agreements, which allow governments to take back a portion of the granted money if a firm fails to create the agreed upon number of jobs or make the promised investment.

How Clawbacks Fail to Claw Back Tax Dollars

On the surface, clawbacks seem like a valuable safeguard that limits taxpayers’ risk. However, clawbacks work only as well as they are enforced. If governments don’t enforce them, taxpayers have minimal protection from failed projects.

Consider the case of Hewlett-Packard (HP) in Conway. HP received a $10 million grant from Arkansas’s Quick Action Closing Fund, which provides subsidies to select businesses that locate in Arkansas, in return for its promise to create 1,000 permanent, full-time jobs by the end of 2013. At the deadline, however, the Arkansas Democrat-Gazette reported that . Did Arkansas’s government ask HP to pay back 40 percent of its grant? No. It it received and negotiated an agreement that would “encourage the company to continue hiring people,” according to Arkansas Business. But HP continued to underperform, as evidenced by a in early 2015. But even with both clawbacks, as of the end of fiscal year 2015, HP had been allowed to keep 91.85 percent of the money it received for providing only 60 percent of the jobs it promised, according to the Accounting of the Economic Development Incentive Quick Action Closing Fund as required by Act 510 of 2007.

Another problem with clawbacks is that they do not protect taxpayers when a company receiving a subsidy with a clawback agreement goes bankrupt. If this happens, there is little chance that taxpayers will see any money recouped. German manufacturer is a prime example. After receiving $1.5 million from the Quick Action Closing Fund, the company entered bankruptcy and has been unable to return any grant money to the fund.

Financial Incentives for Businesses and the Moral Hazard Problem

Financial incentives for businesses also create the problem of . Moral hazard arises when people engage in risky activities that they otherwise would not because they share the risk with others. Put more simply, people tend to take more risk when using someone else’s money instead of their own. Politicians are willing to provide incentives to riskier ventures, such as wind turbine manufacturer Nordex in Jonesboro or Beckmann Volmer in Osceola, because they are using taxpayer money. Likewise, firms engage in riskier endeavors when they can use incentives to fund projects instead of making the investment with the company’s own money. The risk of the politician’s handout is spread among the taxpayers; it doesn’t fall on the politician or the benefiting firm. A failed project does not lead to a loss for the government or for the business, but for the taxpayer.

What Else Could Arkansans Get for Their Tax Dollars?

Politicians also largely overlook the of financial incentives. Opportunity costs are the alternatives one forgoes when using resources in a particular manner. In other words, what could a state have done with the money if it did not provide financial incentives?

One alternative use of incentive money would be to leave tax dollars in taxpayers’ hands. Individuals would keep more of the money they earn and use it in a manner that best suits their interests. For example, in 2013 alone, every taxpaying family in Arkansas would have had an extra $179 if the state had left incentive money from business tax incentives, the Quick Action Closing Fund, and Amendment 82 bonds in taxpayers’ hands.

Another alternative use of incentive money would be to work toward increasing the number of Arkansans with a college degree. University of California at Berkeley professor finds that cities with greater growth in their share of college graduates also experience greater growth in manufacturing plant productivity. This finding is important for Arkansas because according to the , only 21.4 percent of the state’s population age 25 and older has attained a bachelor’s degree or higher. Arkansas ranks eighth in this category among the nine neighboring states, which also include Alabama, Kansas, Louisiana, Mississippi, Missouri, Oklahoma, Tennessee, and Texas.

A third alternative use for incentive money would be to hire K–12 teachers. Arkansas had 8 for the 2015–16 school year, and it has 10 critical academic licensure and endorsement . The state also has 54 school districts with a critical shortage of teachers, according to the Arkansas Department of Education and the Arkansas Department of Higher Education. The state is providing corporate welfare to a handful of firms while many of Arkansas’s children are not receiving the education they deserve. Using the 2013 cost of financial incentives ($218,563,864), Arkansas could have hired 4,500 teachers for one year at the average Arkansas teacher salary () instead of providing favors to a handful of firms.

Conclusion

When governments give financial incentives such as tax breaks and subsidies to businesses, the taxpayer often becomes an unwitting victim. Companies don’t always fulfill the promises they make in exchange for the money they receive, and governments don’t always ask for that money back when companies fail to make good on their promises. When states like Arkansas use taxpayer money to fund hit-or-miss economic development projects, they are more than likely bypassing more productive uses of that money.

Proponents of financial incentives for business argue that tax breaks and subsidies don’t create costs to the state’s budget. Advocates reason that if Arkansas forgoes taxing a firm in some way, and that firm truly would not have located in the state without the tax break, there is no cost to the state. Arkansas does not forgo any tax revenue by issuing the tax break because taxing the firm would have led it to locate elsewhere, which means Arkansas would not receive tax revenue, anyway. If, however, the firm or its employees are not completely exempt and do pay at least some taxes, Arkansas would actually see a tax revenue increase despite the tax break—not to mention that the state would also see the other benefits associated with bringing in more business. In short, proponents say tax breaks may make the state better off.

This argument, though, hinges on the assumption that financial incentives are the deciding factor in where a firm chooses to locate. In Arkansas, officials assume that the jobs created in state-involved economic development projects would not have been created without state intervention. State leaders thus assume that these projects lead to net fiscal gains. But are these fair assumptions?

Are Tax Incentives Really the Deciding Factor in Where Firms Locate?

Anecdotal evidence suggests that incentives are frequently not the deciding factor in where firms locate. In a 2016 analysis, Brian Fanney of the revealed that some companies receiving state aid would have expanded regardless of whether they received incentives. Here are two examples:

Bad Boy Mowers of Batesville would have expanded in Arkansas even without the nearly $4 million it received from the state from 2012 through 2014, according to Scott Lancaster, general counsel for the company.

The state provided Peco Foods of Independence County with $485,000 worth of incentives, but chief operating officer Benny Bishop said, “We would have chosen Arkansas for expansion even without state incentives.”

Issuing tax breaks and subsidies to firms that are going to expand or locate in Arkansas regardless of aid means that the state forgoes tax revenue that it would have otherwise received or sacrifices other, potentially more productive uses of its tax dollars. When incentives are not the deciding factor in where a firm chooses to locate or expand, they are nothing more than a giveaway to politically favored firms—a poor use of tax dollars. What’s more, Arkansas officials take false credit for creating jobs that would have been created anyway. Peco Foods and Bad Boy Mowers are just two examples. But how many other firms have we given aid to that didn’t really need it?

Problems with Letting Businesses Buy and Sell Tax Incentives

States also create costs to their budgets when they allow firms that receive incentives to sell their incentives to other companies in the secondary market. The Arkansas Economic Development Commission allows Arkansas companies to sell certain income tax credits, such as the , the , and the . Let me explain why companies would want to sell or buy a tax incentive and how doing so costs states and taxpayers money.

Consider this hypothetical scenario:

Company A receives $100,000 from the In-House Research by Targeted Business Income Tax Credit to aid in oncology research. However, Company A fails to turn a profit because it has yet to have a breakthrough and develop a medicine to sell. Company A cannot use the $100,000 income tax credit because it does not owe any income taxes. But Company A knows it can sell the tax credit.

Company A sells the credit for $80,000 to Business B, which does owe Arkansas income taxes. When filing taxes, Business B uses the tax credit to reduce its income tax liability by $100,000. Company A is $80,000 better off because it was able to sell its useless incentive to Business B for $80,000. By buying Company A’s tax credit for $80,000, Business B lowered its tax burden by $100,000, so it is $20,000 better off.

The state of Arkansas is the big loser. By allowing Company A to sell its income tax credit to Business B, Arkansas lost $100,000 of tax revenue that it otherwise would have received. In other words, the sale of this tax credit cost the state money, making Arkansas residents worse off.

Furthermore, allowing the sale of incentives to third-party businesses means that the state is effectively subsidizing more than just the company it intended to aid. In our hypothetical scenario, Business B benefited from the state trying to aid Company A, even though the state had no intention of aiding Business B. Business B may or may not belong to the industry the incentives were designed to target. In Arkansas, the  (AEDC) decides who can and cannot buy tax credits on the secondary market.

The best solution for Arkansas is to eliminate tax credits altogether. But if abolishing tax credits cannot be accomplished, Arkansas should, at the very least, eliminate the ability to sell tax credits. To achieve this, the state should allow these credits to expire unused if the firm remains unprofitable or, as the least desirable option, turn these transferable credits into refundable credits. Refundable credits mean that if the company cannot use the tax credits, the state will trade the credits for cash. In our hypothetical scenario, this means that Company A would still receive $100,000 even if it had no taxable profits to offset. Company B would no longer be involved in any transactions. Although it is not necessarily desirable for the state to award an unprofitable business cash, refundable credits would at least prevent the government from unintentionally subsidizing companies that it had no intention of subsidizing in the first place.

How Financial Incentives for Businesses Hurt Taxpayers

The costs of financial incentives to Arkansas’s budget also likely lead to other negative outcomes. By nature, subsidies shift public money away from public goods, which creates one of two results:

1. Without increasing tax revenue, the city, county, or state issuing the subsidy must decrease the amount of public goods in its jurisdiction. Likely outcomes include a drop in the quality or quantity of infrastructure, a less developed workforce due to reductions in education, and a decrease in the quality or quantity of public goods like roads, education, parks, and bike paths that improve quality of life.

2. The government, wishing to maintain the current level of public goods, raises taxes. Higher taxes are problematic not only for the taxpayers that must pay them but for the broader economy. shows that states with lower taxes enjoy faster economic and employment growth than high-tax states.

Targeted tax breaks have a similar effect. Tax incentives likely lead to increases in marginal tax rates for business that do not receive tax incentives. When the government provides tax incentives to certain companies, it narrows the tax base and lowers the state’s revenue. To make up for the lost revenue, all other taxpayers must pay more. Otherwise, the government must spend less on public goods.

Either scenario—reduced public goods or increased taxes—discourages firms from locating in the region. Firms become less attracted to a region as infrastructure congestion increases and the quality of both the infrastructure and the workforce diminishes. Higher taxes and costs of doing business discourage firms, too.

Conclusion

If you’ve been following this series of blog posts, you now know how tax breaks and subsidies are supposed to help local economies grow, why these financial incentives don’t help the economy like politicians say they do, and how tax breaks and subsidies for businesses affect government revenue and spending on public goods. In my next post, you’ll learn about how governments use financial incentives to try to steer the economy.