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Taxes, Incentives and Economic Development

© Allen C. Goodman 2015

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Taxes are a Cost of Doing Business

• Let’s start with a spreadsheet.

• Simple Firm• Could locate at

A or at B.• Only difference

is property tax rate.

Effects of Tax Differences

Fiscal Characteristic Loc. A Loc. B

Property Value 1,000,000 1,000,000

Property Tax Rate 5.0% 3.0%

Property Tax 50,000 30,000

Profit Before Property Tax 200,000 200,000

Federal Taxable Income 150,000 170,000

Federal Income Tax @ 35% 52,500 59,500

Net After Tax Income 97,500 110,500

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Taxes are a Cost of Doing Business

• What are the net impacts?

Effects of Tax Differences

Fiscal Characteristic Loc. A Loc. B

Property Value 1,000,000 1,000,000

Property Tax Rate 5.0% 3.0%

Property Tax 50,000 30,000

Profit Before Property Tax 200,000 200,000

Federal Taxable Income 150,000 170,000

Federal Income Tax @ 35% 52,500 59,500

Net After Tax Income 97,500 110,500

Location A - Location B

Difference in Property Tax 20,000

Difference in Federal Tax -7,000

Difference in After Tax Income 13,000

• What do these tell us?

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This leads to lots of questions

• Are local taxes the only determinants?

• Do they impact current residents?

• Do they impact movers?

• What do the taxes buy?

Effects of Tax Differences

Fiscal Characteristic Loc. A Loc. B

Property Value 1,000,000 1,000,000

Property Tax Rate 5.0% 3.0%

Property Tax 50,000 30,000

Profit Before Property Tax 200,000 200,000

Federal Taxable Income 150,000 170,000

Federal Income Tax @ 35% 52,500 59,500

Net After Tax Income 97,500 110,500

Location A - Location B

Difference in Property Tax 20,000

Difference in Federal Tax -7,000

Difference in After Tax Income 13,000

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In the early 1980s GM Built Saturn Plant

• They could locate anywhere. Why did they locate in Spring Hill TN?

• Bartik and colleagues looked at – transport costs– labor costs for local suppliers– state and local taxes (before subsidy)– total costs

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Estimated Location related Cost ($/car)

Transport

• 426

• 423

• 419

• 417

• 430

• 413

• 427

State, Loc Tx

• 118

• 106

• 134

• 162

• 116

• 168

• 169

Local Labor

• 159

• 186

• 172

• 202

• 244

• 209

• 219

Total

• 703

• 715

• 725

• 781

• 790

• 790

• 815

City• Nashville, TN

• Lexington, KY

• St. Louis, MO

• B’ton, IL

• Kalamazoo, MI

• Terre H, IN

• Marysville, OH

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Estimated Cost ($/car)

Transport

• 426

• 423

• 419

• 417

• 430

• 413

• 427

State, Loc Tx

• 118

• 106

• 134

• 162

• 116

• 168

• 169

Local Labor

• 159

• 186

• 172

• 202

• 244

• 209

• 219

Total

• 703

• 715

• 725

• 781

• 790

• 790

• 815

City• Nashville, TN

• Lexington, KY

• St. Louis, MO

• B’ton, IL

• Kalamazoo, MI

• Terre H, IN

• Marysville, OH

Kalamazoo – Nashville = 87State and local taxes were

LOWER in Kalamazoothan in Nashville

Wages were considerablyHIGHER!

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What Ec Dev Incentives are in US?

• General Idea: Reduce costs to business of locating in a certain place.

• One idea is property tax reduction – we’ve looked a little at that.

• Another idea is to subsidize borrowing of business who locate and/or expand in the locality.

• How do these work?

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What Ec Dev Incentives are in US?

• General Idea: State or local government issues bonds. Revenue stream from a private project pays the interest.

• Because interest from municipal bonds is not taxable (a conscious choice of our federal system), the private business can borrow at a lower interest rate.

• How does this work?

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Look at demand and supply of credit

• Consider a bunch of corporate borrowers.

• You have supply and demand for credit.

• Lenders are suppliers of credit!

• Suppose that owners of state and municipal bonds do not have to pay interest on their bonds.

InterestPayments

SD

r = interest rate

Volume of B

r0

B0

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• Lenders would love to get r0 and not have to pay taxes.

• But, if they were willing to lend at r0 and pay income taxes (e.g. 28%), they would be willing to accept r1 which is slightly higher than 0.72 * r0.

• Why? Because

r1 > 0.72 r0.

SDr

Volume of B

r0

B0

S'

r1

B1

Look at demand and supply of credit

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Who buys these bonds?

• Suppose you have rich and poor lenders– Rich are in 28% tax bracket

– Poor are in 15% tax bracket

• Consider a $10,000 bond that would pay 6% taxable interest.

• Annual interest payment to lender is $600.

• After-tax payment for – Rich = 0.72* 600 = $432.

– Poor = 0.85* 600 = $510

SDr

Volume of B

r0

B0

S'

r1

B1

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Who buys these bonds?

• If the interest rate fell to 5.10%, this would be the equivalent of 5.10/0.72 for the rich, or 7.083%.

• Since this is bigger than 6%, more money would come in

SDr

Volume of B

r0

B0

S'

r1

B1

5.104.32

S ' '

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Who buys these bonds?• We saw that the rich are better

off buying the bond if the yield is very slightly more than 0.72 * r0, or 0.72 * 6% = 4.32%

• They are the MARGINAL borrowers, and they determine the differential return.

• Any poor person who buys this tax-free bond would be better off buying a taxable bond and paying the taxes.

SDr

Volume of BB0

S'

r0= 6.00%

r1= 4.32%

B1

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Who buys these bonds?• Any poor person who

buys this tax-free bond would be better off buying a taxable bond and paying the taxes.

• Why? Because s/he is earning 4.32%

• If s/he bought a taxable 6% bond .85*6% = 5.10%

SDr

Volume of BB0

S'

r0= 6.00%

r1= 4.32%

B1

This is CAPITALIZATION

• We learned that capitalization is a “demand side” adjustment. Where’s the demand?

• Well … it is the demand for the BONDS, that increases their price, lowering the return.

• This comes out as an increase in the SUPPLY of credit.

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What does this have to do w/ ED,

• It allows firms to borrow money at lower costs.

• Tax breaks only help activities that pay taxes. Just about everyone borrows money.

• If a firm can borrow at a lower interest rate, the firm will increase its profits.

that is Economic Development?

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Tax Abatements

• They take the form of credits (pay less), abatements (don’t pay), and special treatments.

• One way or another, they reduce the costs of doing business within the boundaries of the particular jurisdiction (either state or local).

• Issues– Do they work?– If taxes are lowered, and you need services, who

pays the taxes?

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Excise effects

• Within a metropolitan area, property taxes are a cost of doing business.

• If the ABC Co. (currently located on the planet Venus) goes to Southfield and says, “we have a $10,000,000 project, and the property taxes in Southfield would be 2% of $10,000,000 or $200,000 per year. We’re indifferent between you and Warren. If you give us a 50% property tax abatement we’ll locate in Southfield. ”

• Suppose, now that they go to Warren and they say the same thing.

• What happens?

Mieszkowski’s EXCISE tax effect.

Mieszkowski’s EXCISE tax effect.

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Excise effects

• What are the things to ask?– Is ABC really indifferent between Southfield and

Warren? Why or why not would they be?– What are the benefits and costs to Southfield and

Warren of foregoing $100,000 per year in taxes?– What about the businesses that are already in

Southfield (or Warren)? Are they being treated the same way? Should they be treated the same way?

– Would it be better for Southfield and Warren to get together and stand firm against the tax competition?

Michigan Film Tax Credit

• Michigan's film incentives were used as "refundable tax credits." That means a production company awarded a credit got to write off all of its Michigan business tax, which is typically a tiny portion of the credit that can run into the millions of dollars.

• The state then cut a check for the balance and pays the filmmaker. Many other states competing for films also used refundable credits. California does not.

http://www.freep.com/article/20110306/BUSINESS06/110305028/Guide-How-Michigan-s-film-incentive-program-works

How companies get incentives

1. The Film Office and the Michigan Treasury Department reviewed the application of a company that intends to spend at least $50,000 in Michigan to qualify for the tax incentive. The review generally takes about four weeks.

2. The Film Office and Treasury approves or denies the application.Production-related spending in any of 136 core communities, such as Detroit, Grand Rapids and Flint, were eligible for a 42% tax credit. Spending in other communities, such as Plymouth, Grosse Pointe and Birmingham, were eligible for a 40% credit.

3. The company wraps filming on the movie, usually after about three months in Michigan.

4. The company’s accountants compile all production-related spending in Michigan at restaurants, hotels, hardware stores, caterers, retailers, etc. They submit an audited copy of expenses to the Film Office. The company requests a postproduction certificate from the Film Office.

5. The Film Office and Department of Treasury reviewed the expenses. The Film Office issues a postproduction certificate to the company. That certificate lists the tax credit owed to the company.

6. The company files a Michigan Business Tax return at the end of its tax year. The company uses the incentive to reduce its Michigan taxes, which are usually minimal. The state sends the company a check for the balance of the incentive.

Giving Refunds on the Expenses!

So … why is this bad?

• Because it gives incentives for spending, not for profitability.

• Suppose a business, spends $100, and sells for $100.

• We turn around and write them a check for $42.

• More they spend, bigger the CHECK.

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Economics

• Would these firms come here otherwise?

• On net, are we bringing in more tax revenue than we are giving away?

• Is directing aid to these businesses better policy than directing the aid to others?

Answer

• When the Snyder administration drastically reduced the incentives, movie-makers stopped coming.

• Spin-off effects were drastically overstated. • Cities like Allen Park got totally conned, and

went bankrupt supporting projects.• Look at description.

http://www.bloomberg.com/bw/articles/2012-08-23/the-movie-flop-that-sank-a-michigan-town

The results

• The bond sale—now under investigation by the U.S. Securities and Exchange Commission—doubled the city’s long-term debt, and the annual bond payments of $2.6 million are draining its $20 million general fund.

• The city officials who approved the deal all stepped down or were voted out of office.

• Voters have twice rejected property-tax increases to pay off the bonds.

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Is it a prisoner’s dilemma?

• Do we give 50% tax abatement?

• In boxes we have total expected tax receipts for the municipalities.

No Yes

No

Yes

TS = 2MTW = 2M

TS = 2.5MTW = 0.5M

Warren

TS = 1MTW = 1M

TS = 0.5MTW = 2.5M

SouthfieldTS, TW are tax receipts in Southfield and Warren

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Is it a prisoner’s dilemma

• Let’s look at dominant strategies.

No Yes

Southfield

No

Yes

TS = 2MTW = 2M

TS = 2.5MTW = 0.5M

Warren

TS = 1MTW = 1M

TS = 0.5MTW = 2.5M

• Southfield? Abate! Why?

• Warren? Abate! Why?

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Is it a prisoner’s dilemma

• Under these circumstances, competition is certainly not optimal for particular cities.

No Yes

No

Yes

TS = 2MTW = 2M

TS = 2.5MTW = 0.5M

Warren

TS = 1MTW = 1M

TS = 0.5MTW = 2.5M

• Cooperation would be better. Why?

• All of this depends on what’s in the boxes.

Southfield

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Effects of Taxes and Public Services

• Do property taxes and public services make a difference.

• Example:– Business wants to open. Has its choice

between City D, with high property taxes, and

– City E, with low property taxes.

• Do these taxes make a difference?

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Effects of Taxes and Public Services

• Solid evidence that, all else equal, local taxes have strong negative effects on local business growth. Why?

• What does the all else equal mean?

A> It depends what the people who levy the taxes are doing with the money they raise.