The Private Sector: The end (or the beginning) of tax competition as we know it?

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Three decades ago, Pennsylvania won a major victory when Volkswagen announced Westmoreland County as the site for the first major foreign auto factory to be built in the United States.

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Most states in the nation fought for the plant, and the sizable number of jobs it would generate. Nearly $80 million of state incentives were needed to secure Pennsylvania's victory. It would set the precedent for the modern wave of massive government incentives that accompany all similar projects to this day.

Yet, in just a couple of months, the Supreme Court may dismantle the vast labyrinth of incentives offered to businesses by nearly all states across the country.

In 2004, the U.S. Court of Appeals for the Sixth Circuit ruled unconstitutional $281 million in corporate income tax breaks offered to DaimlerChrysler by the state of Ohio to ensure that a proposed auto factory would be located in Toledo.

Ohio was only doing what all states feel they must do in similar circumstances. Failure to offer large-scale packages of tax abatements and other incentives is tantamount to surrender in the ever-escalating competition for new investment and growth.

Arguments in the case of Cuno v. DaimlerChrysler are scheduled to be heard March 1. However the case turns out, there needs to be a fundamental debate over the role of governments at all levels in promoting economic development.

The legal challenge to such incentives is not based on any new legislation but on fundamental constitutional issues going back to the nation's founding.

The Sixth Circuit agreed with plaintiffs who argued that Ohio's incentive package violated the Constitution's Commerce Clause. That clause was meant to prevent the economic warfare between states that was seen as the great weakness of the nation as shaped by the Articles of Confederation.

Put another way, are systematic incentives a form of backdoor taxation that penalizes out of state businesses the say interstate tariffs used to?

Large incentive packages are far from rare. For major projects, the question is not if there will be such incentives offered, but how big those incentives will be.

Economic development policy at the state and local level has become synonymous with the game played between businesses and governments over the size of incentives needed to land major projects. The total amount of tax credits offered for business attraction purposes is an almost unknowable number.

The scale of some incentive packages can be enormous. In 1993, the state of Alabama offered $253 million, or $333 million in current dollars, to Mercedes Benz to build a new factory in the state. Remarkably, that government assistance was estimated to account for more than 66 percent of the $380 total investment needed for the project.

The scale of such tax incentives blurs the distinction between the roles of government and private sector in the economy. Government is often ill-equipped to make the investment-risk decisions that are best made in the private sector.

Clearly, some incentive packages result in long-term economic returns to particular regions. Others clearly do not.

Pennsylvania's Volkswagen plant would quickly ramp up to employing nearly 6,000 workers in 1981, more than justifying Pennsylvania's costs if such jobs would last into the future. They would not. What seemed like a worthwhile investment turned around just as quickly as the market for the fuel efficient Volkswagen Rabbit collapsed along with the price of oil. After just over a decade of operation, the plant was shuttered and its entire work force laid off.

A decade later, a new round of incentives would be needed to convince Sony to build TVs at the same site, but the jobs and payroll would never come close to what VW briefly attained. There would be no new automobile industry in Western Pennsylvania.

For such a widely used tool, there is remarkably little evidence that selective tax abatements and government incentives are effective at promoting long-term economic growth.

The very fact that virtually all states offer similar incentives raises questions about their effectiveness. Businesses will take free money when offered, but once they secure similar tax incentives from all prospective sites, as is usually the case, it is likely that firms look to more long-term factors when making site selection decisions.

The major challenge for state and local governments is to come up with a measurement of what these projects are worth in the long run.

Businesses will not move ahead without a clear idea of the profitability of a given project. Without such a valuation, it is unknown how much in incentives should be offered at all.

It is difficult to precisely estimate the value of individual projects and most governments do not even try. When attempted, such analysis rarely takes into account the costs of government assistance. In the end, what almost always happens is that government assumes some of the risk that businesses are paid to take upon themselves.

This type of tax warfare forces local government officials to pick and choose which projects are worthy of such incentives, and as a corollary, which ones are not.

Such ad-hoc industrial targeting may not be the best role of local governments. It is a market distortion to have local government politicians deciding which industries or even which specific firms deserve such advantages over all others.

Even school boards, which should be focused on the management of education, are often left to answer detailed questions about the scale and efficacy of tax credits for projects in industries they know little about.

It is a management maxim that it is best to "stick to the knitting.'' By forcing local governments to focus on cobbling together individual tax incentive packages, they have that much less time to concentrate on running their respective governments.

While many applaud the Sixth Circuit's ruling, others decry it as hampering tax competition among states and local governments.

The confusion comes from misconstruing selective tax incentives as anything resembling broad tax competition. With tax rebates aimed only at a few specific projects, the fundamental structure of state and local taxes can be left unaffected.

There might be a pseudo-competition for the few projects considered important enough to fight over, but as a result, there is that much less competition for all the new investment constantly flowing through the economy.

What would it mean if state and local governments could not offer such packages in the future?

Some say that it will mean the end of tax reform as we know it. But if unable to offer firm-specific incentive packages, state tax laws may be forced to address broadly the question of what tax structures promote investment and growth.

No longer would there be the distortions that are generated by project specific incentives. There will even be less need for lobbyists whose sole job is to promote particular projects and gain government support. The savings from that alone could be incalculable.


Christopher Briem, a former analyst at the Congressional Budget Office, is a regional economist at the University Center for Social and Urban Research, University of Pittsburgh. You can reach him at cbriem@pitt.edu .


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