The Problem with Targeted Tax Incentives

July 20, 2011
By 

Business taxation is an important and contentious topic in state fiscal policy. Tax competition is a fact of life in state fiscal policy. But there is good competition and bad competition.

The bad form of tax competition involves targeted tax incentives. The economic literature is not kind to targeted tax incentives. At best their economic effect is minimal. At worst is zero or negative. In any case, the benefits secured are not worth the cost.

Targeted tax breaks are expensive and inefficient. They increase compliance costs for businesses and enforcement costs for the government. They can result in similar firms having vastly different effective tax rates that are hard to justify. Larger firms have a level of political and economic influence that is not enjoyed by smaller firms, and are more likely to secure special treatment. Similarly, firms are often able to secure special tax breaks for relocating to the state, while loyal firms are stuck with the bill.

Targeted tax incentives fail for a number of reasons. First, states end up wasting a significant amount of revenue on jobs or economic development that would have occurred even without incentives. Secondly, firms that relocate to a state might bring jobs and economic activity, but if they crowd out other business or investment the net economic gain will be reduced. Finally, giving tax incentives in one area means that the revenue will have to be made up in another area: either higher taxes or lower spending elsewhere, both of which would have an economic impact as well.

What does all this mean? Simply counting the number of companies or jobs that receive a tax incentive does not tell you whether it is worth the cost. You must compare it to other uses of the same revenue.

Good tax competition involves competing to provide good, efficient government services while keeping taxes as low as possible. “Low taxes” here means not just the overall burden, but also statutory tax rates. High tax rates are economically damaging because they increase the incentive for firms to behave in economically inefficient, but tax minimizing, ways.

The way to avoid this is to eliminate special tax breaks and reduce statutory tax rates. The recent tax increases in Illinois have highlighted the need for this type of reform. When rates increase, the demand from businesses for special tax breaks increases as well. The way for Illinois to compete in this way is to broaden the tax base and lower the tax rate. This type of reform will allow all businesses to benefit from lower tax rates and will signal that Illinois is friendly to all businesses, not just the politically influential ones.

[Note: Mark Robyn testified yesterday before a hearing of the joint House-Senate revenue comittee of the Illinois General Assembly in Chicago.]

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