Job creation tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s. Investment taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. credits. Research and development tax credits. Payroll withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. tax rebates. Property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. abatements.
Those are just five of the major categories of tax incentives states offer with the goal of encouraging new investment and economic development in their state. Nearly all states offer at least one of those major tax breaks, with most states offering two or more. But just because most states offer numerous incentives doesn’t mean doing so is the best approach.
One of the key concepts illustrated in our Location Matters study—an apples-to-apples comparison of the state tax costs of doing business in all 50 states and the District of Columbia—is the fact that incentive-heavy tax structures undermine tax equity, with tax breaks for new firms driving up the tax burdens established firms pay.
Some states like South Dakota and Wyoming largely forgo tax incentives because they do not levy corporate or individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. es in the first place; other states like New Hampshire, North Carolina, Utah, and Indiana have relatively low reliance on tax abatements as a share of their state tax collections, despite levying corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. es.
But in most states, tax incentives abound, usually offered as a way of promoting new investment or attracting certain industries by shielding them from the full impact of otherwise high tax rates. Altogether, state and local governments give out an estimated $95 billion a year in business incentives. By way of comparison, state and local governments collected less than $66 billion in corporate income taxes in FY 2019.
While proponents of incentives view them as a tool to promote desirable economic activities—like job creation and new capital investment—their effectiveness at achieving desired outcomes is dubious and difficult to measure. Numerous studies have shown that tax incentives often fail to live up to expectations for inducing job creation and growth.
Furthermore, while incentives are often promoted in the name of economic development and touted for the tax relief they provide to some firms, there is relatively less public discourse surrounding the fact that these incentives only reduce taxes for qualifying firms engaging in qualifying activities, meaning non-favored activities and businesses remain on the hook to bear the full impact of the state’s tax code.
In any discussion regarding incentives, it is important to keep in mind that tax policy is all about trade-offs; when special tax breaks are given to some taxpayers, other taxpayers are left to pick up the tab. In some cases, it is particularly easy to see how subsidies for new firms result in higher tax burdens for mature firms, a concept that Location Matters helps illustrate.
For Location Matters, we designed eight model firms representing diverse industries. We then placed these model firms in all 50 states and the District of Columbia and calculated each firm’s state and local tax liability, once as a new firm eligible for many incentives and once as a mature firm no longer eligible for most incentives. This study not only allows us to see how corporate tax burdens differ across states, but also to see how corporate tax burdens differ within states, depending on the business’s industry, how long it has operated in the state, and whether it is eligible for various incentives.
New businesses in many industries face higher effective tax rates than mature ones because they have undepreciated property and are making investments that have yet to pay off. This can be a problem in its own right and argues against too heavy of reliance on taxes imposed without regard to ability to pay, and in particular against reliance on taxes on capital investment. But in Alabama, Delaware, Illinois, Kansas, Louisiana, Mississippi, Ohio, and Oklahoma, a majority of the mature model firms in our study face decidedly higher total effective tax rates than their new firm counterparts, in large part due to heavy reliance on incentives. Seven of those eight states offer three or more of the major incentive types, while Illinois offers two. This is an overcorrection, and an economically inefficient one, as it doesn’t reverse the tax code’s disincentives for investment but instead replaces them with new distortions.
Furthermore, if business owners see that they will face favorable tax treatment in a state during the company’s first few years in operation but will face much higher burdens later on, this nonneutral tax treatment may discourage that business from investing in the state at all. This is especially true for businesses that invest with long time horizons in mind, such as capital-intensive manufacturers, which are far less mobile than service-oriented businesses that can relocate their operations from one state to the next relatively easily when incentives run out or when the state tax climate changes.
Take, for example, Louisiana, where the model new technology center faces a negative effective tax rate of -26.1 percent, the only state in which that firm type faces a negative tax burden. A negative effective tax rate means that on net, the new technology center receives much more in tax subsidies from the state than it pays in taxes. In contrast, the mature technology center—which has been in the state for at least 10 years and is no longer eligible for incentives—faces the seventh highest effective tax rate in the nation. This is just one example of how businesses that are looking to invest for the long haul may have cause to be wary of states that too substantially prioritize attracting new industries over maintaining modest rates for established operations. Many businesses may in fact find it advantageous to invest in a state where their tax burden will be more stable over time, even if that means fewer targeted tax breaks during the first few years.
States that make the mistake of relying too heavily on incentives will find that this makes it more difficult to maintain competitive tax burdens on established operations. Even worse, some of the investment decisions businesses make in response to the availability of those incentives will be less economically efficient than the ones they would have made in their absence, with businesses adjusting their economic decision-making to take advantage of tax incentives even when, absent that incentive, they would make a different choice.
Policymakers that resist the pressure to create or expand targeted carveouts in the tax code—and ultimately work to phase out these carveouts over time—will find they have more revenue flexibility to create a tax system that treats all businesses favorably, regardless of industry or how long they have been in operation, and without distorting the economic decision-making of those firms. States that maintain a competitive underlying tax code will then find they can attract business investment and experience strong long-term economic growth without picking winners and losers and without cluttering their tax code with complex carveouts, a goal all states should work to achieve.
Note: This is the final installment of a four-part series highlighting key takeaways from our Location Matters report. To view the report in full, or examine any particular state or industry, click here. For a closer look at the major tax incentives your state offers, see Tables A-1 through A-5 in the Appendix to the report.
Stay informed on the tax policies impacting you.
Subscribe to get insights from our trusted experts delivered straight to your inbox.Subscribe