Asymmetric Information and Targeted Tax Incentives

July 19, 2006

We’ve long argued that targeted tax incentives aimed at luring high-profile companies are bad policy. For one, they single out politically connected firms for special treatment, which isn’t fair. And second, they carve away state and local tax bases, ultimately forcing up tax rates elsewhere in the economy.

But there’s another reason to oppose them—they create perverse incentives for corporate executives when negotiating with state and local officials.

The widespread practice of handing out special tax incentives to companies encourages them to appear as mobile as possible when negotiating with tax authorities. The more a firm can appear to be ready to “cut and run,” the more powerful its bargaining position with officials.

Since companies have better information than lawmakers about how mobile they actually are—something economists call “asymmetric information“—many targeted incentives are wasted on companies who never had any real intention of leaving town to begin with.

A classic example of this comes from the State of Illinois, where United Airlines recently scored over $6 million in tax incentives from state officials, just for doing a simple head-fake to Denver and San Francisco when moving their corporate offices from one building to another within Illinois’ borders. From Tax Analysts:

After briefly considering Denver and San Francisco, UAL Corp., the parent company of United Airlines, has decided to keep its corporate headquarters in Illinois.

The company plans to move from its current Elk Grove Village location to downtown Chicago within the next year, thus keeping an estimated 350 employees in Illinois. United will maintain a substantial presence in Elk Grove Village and consolidate some of its operations there.

Illinois was apparently the clear first choice, as officials in Denver and San Francisco said they never entered into detailed negotiations with United about a proposed move.

Tax concessions played a central role in the Illinois negotiations, including $5.25 million in tax increment financing for the new Chicago location. The state also promised $1.35 million for infrastructure and training benefits.

Read the full story here.

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