Independent Analysis and Information on Iowa Tax and Budget Issues

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Business Tax Credits and Expenditures 101

A Primer on the Economics of State Tax Subsidies to Promote Iowa Development
Policy Brief (5-pg PDF) February 2010

What is a:

  • Tax expenditure?

            Tax expenditure means spending through the tax code by providing special exemptions, deductions or credits. It has the same fiscal impact as a direct outlay of funds. Revenues not received due to exceptions in the tax code affect the budget balance just like spending.
            Some tax expenditures are made intentionally but are rarely reviewed, such as credits for taxes owed, or result from deductions from taxable income. Others are unintended, such as loopholes that allow corporate filers to avoid tax.

  • Tax credit?

            A tax credit is one form of tax expenditure. The amount of a credit counts against taxes owed. If the taxpayer owes less in tax than the amount of the credit, in some cases the taxpayer may receive a check for the balance. This is called “refundability” It does not reflect taxes paid in excess of taxes owed, as the term “refund” is most commonly used and understood. It is a direct subsidy discounted by taxes owed. Not all credits are refundable. Because they involve taxes, most are secret.

By Charles Bruner and Peter S. Fisher

Iowa lawmakers are concerned about economic development and eager to attract private-sector investments and jobs into their states. Iowa actions to promote economic development have included direct state appropriations and subsidies to businesses, investments in new infrastructure needed by business, loan and grant programs, and tax credits and expenditures.

The stated goals for these actions are to be produce net new business activity that would not have occurred without the economic development expenditure. Businesses, meanwhile, make decisions regarding their activities in terms of their ability to be profitable. Without any government support, through the free-market system, businesses expand their workforces, make capital investments in new facilities, and invest in research and development — when those are determined to be profitable and they can secure the financing for them.

The question is: Where can government assistance be a determining factor in those business decisions in ways that provide an overall benefit to the state? Here are some key considerations related to tax credits and expenditures that must be made in this respect.

  • Tax credits and expenditures for business location and development generally are quite small in relation to other factors that contribute to economic profitability and are rarely the determining factor in those decisions.

The cost, availability and productivity of the labor force and the proximity to materials and markets are generally much larger considerations in business growth and location decisions than any taxes or public subsidies. Studies have consistently shown that the variation in taxes paid by businesses across the states is a small fraction of the variation in labor costs and other costs of doing business. Particularly for higher-wage industries, the quality of public services and the educational system and the overall quality of life play a very significant role in attracting and maintaining a productive workforce, and these depend upon public investments and the tax base that goes with them.

  • Tax credits and expenditures can disrupt market forces and provide an unfair benefit to one business at the expense of another.

Particularly when they are applied to new business activity, tax credits and expenditures can favor the development of a new business that may be designed simply to compete with and take market share from already existing businesses. As an example, when Wal-mart comes into a community, it may well displace existing retailers in the community. While this may result in lower prices for some goods, in terms of jobs and economic activity, it may simply displace employment and even replace higher-paid jobs with lower-paid ones. If there are tax credits or expenditures available to Wal-mart because it is “starting up” or “expanding” its activity, but no subsidies for existing companies trying to keep their doors open, the subsidies end up giving an unfair advantage to Wal-mart as well as producing a cost to the state.

  • Tax credits and expenditures often are used well beyond their original intention.

Business tax credits and expenditures are available to any and all businesses that qualify under thelaw. But the role of tax attorneys and accountants is to maximize the use of any tax credits and expenditures that do exist. As a result, credits often end up being used to a far greater extent and for different purposes than originally intended.  Direct state appropriations, grants or forgivable loans, in contrast, provide the opportunity for state agencies to use discretion and to limit the funding to the specific purposes and situations where they are most likely to be effective and that serve the original intent of the legislation.

  • Tax credits and expenditures can result in poor start-up or expansion decisions.

If the government underwrites some of the risk of start-up, this is likely to result in riskier start-ups. It is exceedingly difficult to determine, particularly through the tax code, at what point state tax subsidies constitute the determining factor in a decision to start or expand a business that could not otherwise secure financing. When the subsidy is substantial, there is an increased likelihood that it will produce unsustainable ventures. This is what happened with ethanol production in Iowa, where the state underwrote a very substantial share of the costs for new ethanol, with over $150 million in state costs over the course of 18 months. In part because of the availability of such generous subsidies, Iowa and the nation overbuilt ethanol plants, with the result that many are now in bankruptcy or being sold at distressed prices. Further, Iowa assumed a great deal of the downside risk, but would have received very little direct return (increased tax base) in any upside potential, were the plants profitable.

  • There is a point at which tax credits or expenditures made simply to promote economic activity are excessive in relationship to their benefits, even if the credit or expenditure is effective in creating new economic activity that would not otherwise occur.

While tax breaks in general provide limited leverage over investment decisions because state and local taxes are not a large cost of doing business, at some point very generous subsidies can indeed make a difference. The problem is that the level of subsidy required to make a difference may be so high that the incentive fails a cost-effectiveness test. For a number of months, Iowa advertised its film tax credit as “half-priced film-making,” with the state assuming up to one-half the costs of a film production. Since the film tax credit was based upon individual films, the tax credit did not produce permanent jobs, but ones dependent upon another tax credit to a new film to continue employment activity. Meanwhile, since Iowa has a single-factor corporate income tax, there was almost no tax revenue that would accrue to the state from any profits made by the film. In effect, Iowa established a tax credit where it could put up half the costs of production but have almost no share in any profits.

Even if such a tax credit is 100 percent effective in producing new economic activity, there is a subsidy level at which the state becomes a loser, unable to bear the costs for that economic activity. When government subsidizes any business for half their costs through the tax code, economic modeling shows a high negative return to the state in terms of overall tax revenue, even when multiplier effects on the local and state economies are considered. Government simply cannot afford to provide the public services needed to maintain its economy with such levels of subsidy. In short, it is exceedingly difficult to justify a tax or business subsidy that exceeds a small percentage of ongoing costs, but it is also very hard to make a real impact on business decisions with a small level of subsidy.

  • Tax credits and expenditures do not provide the opportunity for due diligence and oversight to determine whether they meet any broader public purposes, or to provide for repayment when they fail to meet those goals.

Direct appropriation, grant and loan programs offer the opportunity for review of the quality of the business plan, the degree to which the business is not simply competing for existing economic activity with other businesses that are not subsidized, the degree to which the business has a social utility or at least does not have social costs that government may need to address, and the degree to which there is accountability to the stated purpose. They can provide for monitoring and performance criteria related to the quality of jobs they produce, with “clawback” provisions that enable the state to recover funding that does not meet conditions agreed-upon with the state.

It is much more difficult, if not impossible, to build such review and accountability into tax credits and expenditures. The fact that subsidy and grant programs have sometimes fallen short of their goals shows the need for greater, rather than lesser, transparency and accountability provisions. In general, it is much more in keeping with transparency, accountability and enforcement of public purpose expectations to provide economic development activities within appropriations, grant and loan programs than it is within the tax code.

Further, unless specified within law, the beneficiaries of tax credits and expenditures remain unknown and therefore not available for public scrutiny, lawmaker review, or any form of real assessment of their value. There are good reasons for personal and corporate income tax reports to remain confidential, but those reasons do not extend to tax credits and expenditures that businesses can voluntarily choose to accept and use. Information about the businesses that receive tax credits and expenditures and the amount they receive can be made public. Increasingly, states have adopted transparency laws that provide for this public disclosure. Such information does not reveal proprietary information, but merely provides a public record or how public funds are expended.

  • The actual size of tax credits, expenditures, and other business subsidies may matter much less than the offer itself as evidence that the state is hospitable to and supportive of businesses.

Much has been said about the value of states promoting themselves to businesses as good places to locate and grow. Department of Economic Development marketing divisions often assume the role of showing how the state is a place for businesses to develop. The existence of some subsidies and tax credits and expenditures may play some role in this marketing, much like gifts to clients play a role in building and maintaining relationships and as evidence of appreciation and interest. Their size, however, does not need to be excessive nor should it bear undue costs to the state. Scaling back on existing subsidies and tax credits and expenditures would not eliminate the opportunity to demonstrate this interest and goodwill, but it would avoid many of the problems outlined above with the array of subsidies, tax credits and expenditures in place.

To defend the existing system of tax credits, some argue that abolishing credits amounts to “unilateral disarmament” in the competitive war for business activity. This argument is misplaced, because it sets up a straw man — no one is really arguing for the complete abolition of tax credits and expenditures or state economic development appropriations, grant and loan programs.

  • Tax credits and expenditures to attract business investment should not undermine the state’s more fundamental role in economic growth, let alone in providing essential public services.

Most important, tax credits and expenditures need to be weighed against other potential uses of those public resources.

Government has recognized public responsibilities in providing for the health, education and liberty of its people. This means a strong educational system, a good public infrastructure, public safety and a good quality of life. All these involve public investments and are public goods that individuals or businesses cannot effectively provide for themselves. They require a tax base that is fair, stable and competitive. Excessively generous tax credits and expenditures erode state revenues and are counterproductive in that they reduce state support for essential public services. In the long run, the most important thing the state does is to support education, to provide an educated work force, and to make Iowa a place companies will want to be and workers will want to settle with their families.

No one denies the competitiveness of the global economy in this day and age. But that requires that states use their scarce economic development dollars as efficiently as possible, and recognize that the economic development role of the state is far broader and more fundamental than seeking to foster direct economic activity. States can and should compete for growth on the basis of a strong educational system, sound investments in public infrastructure, and a healthy and productive workforce. All those spending priorities compete directly with business subsidies for state funding, and Iowa must recognize the opportunity cost of spending through the tax code for private economic activity and compare those costs, compare those with other state needs, and pick the most cost-effective long-run growth strategy for the funding it will make toward direct state economic development.

Some public investments are done for reasons beyond economic growth and prosperity, relating to quality of life and commitment to fairness and equity. Ensuring that seniors can live out their lives in dignity requires public funding for home health care services, nursing home care, and other supports — but these do not need to justify themselves as producing a great deal more economic productivity on the part of those seniors.

Implications for Iowa Policy

Intervening in the free-market system to encourage private-sector economic activity — through subsidies or grants or loans but particularly through tax credits and expenditures — has inherent challenges and should not be done without a great deal of consideration and it should be done very conservatively. It should seek to address all the points raised above regarding the limits to affecting economic growth through tax policy. The following represent implications for public policy regarding tax credits and expenditures.

  • Business tax credits and expenditures should be included as part of the overall state economic development budget, along with other economic development appropriations, grant programs and forgivable loan programs.

Once on the books, tax credits and expenditures have a history of growing in size and cost to the state. Unlike state appropriations, they are not part of the budgeting process and therefore are not assessed for their relative value with other economic development activities. Establishing a global or overall cap on business tax credits and expenditures and making them part of the overall economic development budget of the state will enable lawmakers to make decisions on how to structure Iowa’s overall budget for economic development and where tax credits and expenditures make sense and where other economic development tools can better achieve those purposes.

  • Tax credits and expenditures should be limited in size and duration.

The best tax credit is one that is provided to an industry that has good economic reasons to be in Iowa, so that only a small subsidy rate is needed to tip the balance in Iowa’s favor. Where such conditions exist, tax credits can be one way to jump-start an economic sector that will grow to the point that it can prosper on its own. Iowa should avoid giving credits to industries that will not locate here without very large and continuing subsidies. This is not a cost-effective use of public funds, when other economic development can be created at a much lower level of subsidy, and with promise of an eventual end to subsidies. Traditional subsidies of limited duration for investment or job creation can fit this mold; generous subsidies of ongoing operating costs should be avoided. In particular, there should be caps on the amount of refundability of any particular tax credit and Iowa should end the practice of allowing transferability of tax credits. Transferability is inefficient in encouraging the desired investment, and produces a costly secondary market that reduces the value of the credits in the first place.

  • Tax credits and expenditures should be subject to expert review and expected to show hard evidence of success.

Examination of all tax policies should be based upon recognized tax principles: fairness, competitiveness, adequacy, public benefit and economic efficiency, revenue adequacy, stability and predictability, simplicity, and transparency and accountability. Assessing the degree to which tax credits and expenditures adhere to these tax principles requires detailed, expert analysis. Anecdotal evidence or assertions by beneficiaries of the value of the credits to the state should not be considered evidence of their success. Given the size of the tax credits and expenditures and their costs to Iowa, it is imperative that the state provide for monitoring, oversight and analysis of tax credits and expenditures.

 

 
A joint effort of the Iowa Policy Project and the Child & Family Policy Center (logos).