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Cascade: No. 54, Spring 2004

Spotlight on Research: Are Economic Development Incentives a Failure?

This column is the first of a regular series that will highlight research of interest to Cascade's readers. Since research sometimes influences policy in both the public and the private sectors, knowledge of current thinking on key issues allows interested parties to keep pace with the debate. This column will report on studies that provide a window through which current topics might be viewed, with an eye toward stimulating further discussion.1 On occasion, the column might include the positions of individuals who have opposing views on a subject. Their points of view will be presented without independent comments by the author of this column. Readers can expect uncensored access to information that will increase their knowledge about pressing issues of the day.

Although economic development policy continues to play a key role in local planning decisions, business incentives, the most expensive aspect of this policy, have generated a great deal of criticism.2 The question at the center of the controversy is whether the incentives are a cost- effective means of achieving economic growth. According to Alan Peters and Peter Fisher, of the University of Iowa, total state and local expenditures on economic development incentives in the U.S. are around $50 billion annually and are likely to increase. Given this magnitude, concerns about business incentives warrant attention. Peters and Fisher addressed the central question about incentives in a recent article.3 A summary of that article follows.

The rationale for employing economic development incentives is two-fold. First, supporters say incentives lead to business investment and thus new jobs, which produce an increase in the demand for goods and services and give rise to further economic growth. Second, the resulting economic growth increases public revenues, which allow governments to improve public services or lower tax rates.

In their work, Peters and Fisher focused on three related aspects. Do business incentives cause states or localities to grow more rapidly than they would have otherwise? If so, is the growth targeted to provide net gains to poorer communities or poorer people, or is it merely a zero-sum game? How costly to government is the provision of these incentives compared with alternative policies?

Peters and Fisher answered these questions after taking into account decades of policy experimentation and reviewing hundreds of scholarly studies, including some of their own.

"Does Economic Development Induce Jobs or Investment?"

This question is the most important of all. Although much research has focused on the question, the authors found that the insight the studies offer varies over time. Until the late 1980s, the prevailing wisdom among most academics and many practitioners was that economic development (tax) incentives had only a marginal impact on firms' location decisions and net job generation in local areas. The primary reason was that taxes make up a small percentage of a firm's operating costs. Thus, even a small variation in resource prices or transportation costs between localities could offset a large variation in taxes and other incentives. Moreover, firms pay taxes on incentives, which further neutralize the incentives' effects.

However, in the late 1990s, a new consensus emerged: Lower taxes or more incentives are likely to result in greater growth. To reconcile such differences in positions, the authors point to improvements in econometric or statistical methods that have helped researchers better model the relationship between taxes and growth.

Another possible contributing factor is an increase in the tax and incentive differentials across states and cities and their increased competition with one another using incentives. Nonetheless, some researchers have questioned the new consensus by pointing to the seriously flawed data used in some of the studies and the inability to replicate the results over time and across geographic regions.

Another sticking point is that even if studies find a statistically significant relationship between incentives and economic growth, does it translate into practical significance? Peters and Fisher are not convinced. Thus, on the basis of the research to date, they concluded that while there are reasons to believe that incentives are not very effective, there is no definitive answer at this time.

"Who Takes the Jobs Created by Economic Development?"

Peters and Fisher broke this question down into three corollary questions: Do poorer states or localities pursue economic development more vigorously than others? Do states target incentives at more needy places or populations? Do poor people living in targeted areas benefit from targeted policies? Unfortunately, there is a dearth of empirical studies that deal with these questions. On the first question, the evidence seems mixed, and more recent studies find little or no relationship. This might be due to poorer places having less money to finance incentives, believing they will be outbid by wealthier places for new investment, or the tendency for incentives to increase long after growth has been achieved.

Many states make every effort to target state and local incentives to poorer localities or poorer populations by offering state incentives only to firms in targeted areas (or to firms that hire targeted populations) or local tax incentives within distressed areas. Enterprise zones in most states reflect this targeting philosophy. However, the evidence suggests that while incentives may well be targeted to designated areas, they are not effectively aimed at depressed populations.

When enterprise zones and analogous programs are successful in making use of incentives to generate job growth, who gets the jobs? Ideally, the firms attracted to the area will employ workers from the local labor market, particularly inner-city residents and those unemployed. This would underscore the rationale for a policy of targeted incentives, namely, to rectify the mismatch between the supply and demand for jobs and earning differentials between areas. But Peters and Fisher found that firms in enterprise zones tend to draw workers from metropolitan labor markets, not local ones. This has resulted in the majority of job gains in targeted areas going to residents outside the zone, essentially subsidizing mobility.

"Are Business Incentives Fiscally Beneficial?"

Even if state incentives induce new jobs but fail to target them to the poor, they might still provide fiscal benefits to local communities, provided the revenues from the new jobs exceed the cost of the incentive program. However, while incentives are likely to yield net revenues at the local level, they generally fail to produce the same for the state, possibly because the fiscal benefits that accrue to cities from firms' relocation result from beggar thy neighbor, with the state paying the costs. Moreover, states might incur fiscal losses if they give tax incentives to firms that were planning to relocate within their borders anyway or if firms leave the state after the incentives expire. The literature on the fiscal benefits of incentives is very sparse; nonetheless, what research there is suggests that incentives might be a costly proposition.

Recommended Alternative

Peters and Fisher proposed an alternative to traditional economic development policy that relies heavily on incentives. Their approach is for policymakers to avoid micro-managing economic growth and instead provide a nurturing economic environment through sound fiscal practices, quality public infrastructure, and good education systems-and let market forces operate. Within this context, a place would still exist for programs designed to improve the employability of workers as well as their occupational and geographic mobility.

  • 1 However, the views expressed here are those of the author(s) whose work is being summarized and not those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
  • 2 Business incentives may include various tax instruments-property tax abatements, tax increment financing, sales tax exemptions, and credits for investment or jobs-and some nontax incentives such as business grants, loans, and loan guarantees.
  • 3 "The Failures of Economic Development Incentives," Journal of the American Planning Association 70, 1 (Winter 2004). Alan Peters is an associate professor and Peter Fisher is a professor in the graduate program in urban and regional planning, University of Iowa.