WHAT ARE TAX INCENTIVES?
An incentive is a benefit given to someone in order to encourage him to do something specific. Tax incentives are ways of reducing taxes for businesses and individuals in exchange for specific desirable actions or investments on their parts. Their purpose is to encourage those businesses and individuals to engage in behavior that is socially responsible and/or benefits the community. Perhaps the most familiar tax incentive to tax-paying Americans is the deduction for charitable contributions: when figuring your taxes, you can deduct the amount you gave to charitable, tax-exempt organizations from your taxable income. The deduction exists to help persuade people to contribute to charity.
Tax incentives can be offered by any level of government that levies taxes: federal, state or province, county or municipality. They can be aimed at businesses, organizations, individuals – any entity that pays taxes.
This covers a huge area, and overlaps with such other uses of tax incentives as affordable housing, energy conservation, health and safety, sustainable economic development, etc. Activities that affect the environment that might be managed to some extent with tax incentives include:
WHY USE TAX INCENTIVES TO SUPPORT COMMUNITY HEALTH AND DEVELOPMENT?
Federal, state, and local governments all use tax incentives for various purposes. Many states and communities employ tax incentives simply to attract businesses. That use can have many positive consequences for the public good, depending on the business: more local jobs, more tax revenue ( leading to the possibility of more funding for schools and services ), an injection of energy into the community, etc. However, it’s directly aimed at purely economic concerns, rather than the building of a healthy community in all its aspects.
There are many reasons why tax incentives can be a particularly good way to encourage the development of healthy communities, but they really boil down to one: they offer what for many people is the most desirable reward for desirable behavior.
● Tax incentives speak to businesses’ and individuals’ self-interest. Virtually all businesses and most individuals respond readily to offers that advance their own interests, and most particularly to offers of money. Our whole social structure is based on this assumption: how many of us would work if we weren’t paid? Some form of payment, therefore, is usually the most effective way to convince businesses and individuals to do something they are unsure about or might otherwise be reluctant to do.
● Tax incentives make allies rather than adversaries. They’re the policy equivalent of the old proverb “You can catch more flies with honey than you can with vinegar.” By using tax incentives rather than ( or along with ) regulation to achieve your goals, you make the businesses or individuals receiving the incentives your partners. It’s much easier, for instance, to work with a developer who wants to make sure that his project meets environmental standards so that he can get a significant amount of his investment back than with one who considers environmental regulations an unnecessary barrier, and looks for ways to get around them.
● Tax incentives can show businesses that community-building projects can be both feasible and profitable, thus leading to more of them. In a Sioux Falls, Iowa project similar to the redevelopment of the Pacific Hotel, tax incentives convinced a developer to turn an old library into affordable housing. That project, the first of its kind in the area, worked out so well that it stimulated the developer to embark on other, similar projects elsewhere in the state.
● Tax incentives can be an efficient use of taxpayer money. They can bring in far more in cash ( private investment ) and social benefits than they cost in lost revenue. Providing tax incentives to employers to help them provide health insurance for their employees, for instance, is usually far less expensive for the public than the consequences of those employees having no insurance – the cost of providing free or reduced-fee care, overuse of hospital emergency rooms, more and more serious illness because of lack of regular medical care, lost taxes because of lost work time, etc.
● Tax incentives can be directed exactly where they’re needed. They can be targeted broadly or narrowly, to individuals or to businesses, to a particular time period, etc. Policymakers can fine-tune incentives to try to achieve a very specific result.
WHEN WOULD YOU USE TAX INCENTIVES?
Since tax incentives can be aimed specifically, there are a great number of possible uses for them. How do you decide when their use is most appropriate? The general answer is that they can be used almost anytime, often in combination with regulation and other types of incentives. Some times when they come in particularly handy:
● When you’re trying to encourage, limit, or manage growth. Tax incentives can be used to encourage building and development in already-built-up areas, and thus to prevent sprawl. They can influence the size of developments, invite the preservation of open space, spur the redevelopment of abandoned sites, or foster the rehabilitation of empty buildings into affordable housing. Whatever your community’s comprehensive growth plan, tax incentives can almost always play a role in carrying it forward.
● When you’re revitalizing neighborhoods, communities, or rural areas. Here, tax incentives might be used to try to attract industry or commerce ( and local jobs ), to develop mixed-income housing, or to bring in or rehabilitate an “anchor” institution ( a theater, a museum, a sports facility ) to attract residents and businesses. In a rural area, you might employ tax incentives to create environmentally friendly tourism ( bicycle touring, farm stays, etc. ), to encourage farming, or to attract clean industrial operations.
● When you’re trying to meet community needs. Tax incentives are often used to assist in the development of affordable housing, but can also contribute to meeting needs in education ( business involvement in school systems ), employment ( job creation ), livability ( the creation of pedestrian streets and walkable neighborhoods ), health ( the development of walking and bike paths, subsidies for businesses’ health insurance plans ), and transportation ( support for needed routes ).
● When you’re trying to prevent or fix environmental problems. Green building ( using environmentally friendly techniques and materials ), the purchase and installation of anti-pollution equipment, the use of alternative energy, energy conservation, environmentally sensitive development, research into environmentally friendly industrial processes – all of these and more can be made more attractive and feasible for businesses and individuals through the offer of tax incentives.
● When tax incentives can be part of a coordinated strategy. Often, a well-thought-out combination of tax and other incentives, careful regulation and enforcement, and participatory planning can yield the best results for a community-building effort.
WHO SHOULD USE TAX INCENTIVES TO SUPPORT COMMUNITY HEALTH AND DEVELOPMENT?
Governments only benefit from tax incentives in the sense that incentives encourage actions that work toward the public interest. Maintaining and enhancing the public good is the job of government, and it therefore has a stake in doing so. The direct benefits of tax incentives, however, usually go to others. It makes sense for those who benefit to advocate with policymakers to institute appropriate tax incentives, to support government action in doing so, and to advocate for public support as well.
Nearly anyone might benefit from tax incentives, but here’s a short list of people and groups that you might see supporting them:
● Direct beneficiaries of tax incentives. These may include low-income citizens, people without health insurance, the homeless, etc.
● Human service providers and advocates for the poor. Since tax incentives can be aimed at improving life for low-income citizens, the agencies and individuals that work with that group may find themselves advocating for or suggesting them to policymakers.
● Economic developers and community planners. These folks are sometimes the policymakers themselves, and are in a position to see that tax incentives are offered for particular investments or types of development. If that’s not the case, they may still be strong advocates for incentives that further their work.
● Local officials, especially those in economically depressed areas, or areas with other problems that might be addressed through incentives. Local taxes may not present an opportunity to offer appropriate incentives, in which case these officials might lobby state legislators, the governor, or even the federal government, for incentives that would be appropriate to carry their goals forward.
● Businesses, corporations, real estate developers, etc. Since these are on the receiving end of tax incentives, it’s in their interest to advocate for them. Some corporations have a civic conscience, and want to help the communities they do business in, but also have to be accountable to shareholders. Tax incentives can help them satisfy both these needs.
● Environmental activists. Tax incentives can be particularly useful in furthering such environmental ends as pollution control, energy conservation, and alternative energy use.
● Farmers. Tax incentives for sustainable agriculture equipment and practices, as well as for keeping farmland in production, can help farmers stay on the land and preserve open space in rural areas.
HEALTH
Tax incentives can attract hospitals and clinics to a community, or help employers provide health insurance to workers. They can convince employers and businesses to adopt healthier workplace practices: incentives can be offered to businesses that provide smoking cessation groups for employees, for example, or that declare their workplaces smoke-free. They can also be used to sweeten the consequences of health regulations that could cost businesses some customers ( an incentive to help offset any loss of business from a ban on smoking in bars, for instance. ) A fairly common wellness promotion incentive is the use of tax credits or deductions to encourage developers to create walking and biking paths when they design large developments.
How Tax Incentives Promote Social Objectives
For decades, tax incentives have been a major policy tool to spur economic development and attract and retain good jobs. In recent years, however, these incentives have come under heightened scrutiny from the public, with growing concerns over lost tax revenue and localities’ fiscal health.
But tax incentives can influence economic growth and opportunity in cities if they are strategically targeted to the right businesses and business behaviors. With the COVID-19 pandemic triggering budget crises for municipal governments, there is even greater need for them to wield incentives effectively in ways that support inclusive growth, racial equity goals, and fiscal health.
The good news is that cities are experimenting with new evaluative tools and practices that help maximize economic, fiscal, and social benefits. When used together, two of these tools—inclusive incentive scorecards and equity indicators—can allow cities to prioritize areas of high need, understand existing inequities, and ultimately gear tax policies to incentivize specific strategic goals.
An underlying premise of these tools is that when a city tracks and measures specific business behaviors and inequities, it will be better able to define clear tax incentive policy goals from the start. And over time, that city will be better equipped to judge whether certain policy choices are enabling them to meet fiscal health, equity, and inclusive growth goals.
Invest in people and skills.
Skill development can improve residents’ capacities, supporting meaningful work and wages.
Focus on advanced industries.
Businesses in these industries can build local comparative advantage and deliver innovation and wage gains.
Work at multiple levels to connect local communities to regional jobs, housing, and opportunity.
Export growth and trade with other markets can deepen regional industry specialization and bring in new income and investment.
An inclusive incentives scorecard can help cities better align economic development policies to drive inclusive growth.
(1) Good job creation ( living wages/benefits )
(2) Skills training and workforce development
(3) Job access and sustainability ( e.g., businesses located in transit-accessible locations )
(4) Business ownership and governance ( e.g., diversity, equity, and inclusion practices )
The Economic Rationality for Tax Incentives
A pure case or “first best” for tax incentives ( or subsidies ) exists whenever external economies are present, that is, when, under a free market arrangement, the marginal social benefit of an activity exceeds the marginal social cost of undertaking that activity. The failure of the “invisible hand” to reach the maximization of social welfare calls for the Pigovian prescription of subsidizing such activities so that the marginal private cost equals the marginal social benefit. A Pigovian tax incentive removes a distortion from the economy and is therefore by nature welfare-improving. As to how to finance the first-best subsidies, the solution lies in a non-distorting tax system for which the financing could come from either poll taxes, which do not distort, or Pigovian taxes, which remove negative externalities.
An impure case for tax incentives arises when economic policy in general or tax policy in particular is distortionary. For political, social, or administrative considerations, economic policymakers often implement a tax system that is non-natural and adopt other economic policies that lead to distortions. Ideally, the distortions should be removed by way of tax reform or reform in other economic policies, but this may not always be feasible.
However, through economic policy ( e.g., tax incentives ), it is possible to induce behavior that can be at the margin welfare-improving. The literature on social cost-benefit analysis, aware of this possibility, has developed criteria and methods that assess whether the undertaking of an activity or a project leads to improvement in social welfare by reducing unwanted distortions and negative externalities and/or by inducing positive externalities. In this author’s opinion, this methodology can also be put to use in the design of tax incentive ( or subsidy ) policy.
Regional Distribution of Economic Activity
It can be argued that the promotion of regional development is justified on economic grounds, given that there are external economies of relocation to less developed regions and external diseconomies of concentration in already developed ones. Private agents acting on market signals will not take advantage of the external economies, resulting in an overconcentration of activities in certain areas. Tax incentives that reduce the cost of relocating to undeveloped regions, where positive externalities are generated, could increase welfare. ( See also section on “Tax Incentives to Regional Development,” below. )
The role of tax incentives in reaching this goal is complementary to the role of other instruments of regional economic policy, such as public investment, credit, and financial policy, which are often partly responsible for the overconcentration in major metropolitan areas of developing countries.
Tax Incentives to Regional Development
Consider a tax incentive scheme for the promotion of industry in a less-developed region. The tax incentive scheme should remove the negative externalities and induce positive ones ( see section on “Regional Distribution of Economic Activity,” above ). One positive externality might result from an increasing urban concentration in the developing region, which reduces the cost of public services and provides for certain economies of scale. If concentration in a particular region is a desired objective, this can be achieved through a tax incentive to investment on plant and equipment.
Another positive externality can be derived from the employment of labor that accompanies the new investment. However, prospective investors in the region take into consideration not only the direct cost of using labor, which in nominal terms can be cheaper in the backward areas, but also its productivity. The lack of skill of the local labor force is likely to pose a major obstacle for the new investment project. This problem can be reduced by simultaneously granting tax incentives for the training of the labor force in that region in the form of, for example, additional income tax deductions. Similarly, where transportation costs can also be a major problem in such areas, a tax incentive for the purchase of transportation equipment can be granted simultaneously.
Tax Incentives and International Trade
Tax Incentives to Imports
Reductions of and exemptions from import tariffs are a common form of tax incentive in developing countries. Tax incentives are frequently given to encourage the importation of both raw material and capital equipment, and in both cases they appear to be distortionary. The reduction of import taxes on inputs increases the effective rate of protection granted to domestic production by the import tariff structure. This distortionary effect is further enhanced by the effect of import tariff reductions on capital equipment. It can be shown that import tariff reductions on capital goods lead to effective rates of protection higher than the nominal protection and higher than the traditional measure of protection, which only incorporates the effect of tariffs on intermediate goods.
This form of incentive, which is widely used in developing countries, should be a matter of concern. First of all, selective import tariff reductions are often granted to individual firms, and not to all the firms in the industry. This distorts the structure of effective protection in unpredictable ways. Second, a high level of effective protection gives rise to great inefficiency in the use of domestic resources. Third, the reductions in, or exemptions from, tariffs on the importation of capital equipment and raw materials leave the domestic industries that produce these commodities unprotected and increase the level of protection of industries that produce consumption goods. Exports using imported raw materials, which are taxed, frequently receive duty drawbacks to reduce the cost disadvantage imposed on them by the levy of the tariff. Such duty drawbacks, however, do not extend to taxed imports of capital goods, whose cost disadvantage to exports can only be relieved by allowing duty-free importation of capital goods by export industries.
Throughout developing countries, the production of capital equipment tends to have rates of protection well below those granted to other industries. Hence, a case can be made, on efficiency grounds, for tax incentives to favor the use of domestic capital goods vis-à-vis imported ones. This implies that if tax incentives are given to investment, a higher rate should be granted to investment in domestically produced capital goods.
In discussing tax incentives for the promotion of exports, one needs to separate two issues. One is the problem of border tax adjustments, which implies that under the destination principle of taxation, indirect taxes apply where the goods are consumed. This means that imports are taxed and exports are exempt. In order to avoid double taxation, an individual country should adhere to the destination principle as long as everybody else follows the same principle. This kind of tax rebate is not in any sense a subsidy to exports, but rather is a way of harmonizing indirect tax systems across international borders.
On the other hand, tax incentives are frequently given to exports in developing countries to compensate for other distortions in the foreign trade sector such as protection and overvalued exchange rates. Protection changes the domestic terms of trade in favor of the production of goods that substitute for imports. This reduces the attractiveness of producing export and nontaxable goods. However, protection increases the domestic price of importable relative to exportable and of non-tradable. This reduces the demand for imports. Since, in the long run, the external balance of the country has to be in equilibrium, a policy that reduces imports will also reduce exports. Moreover, the protected sector is rarely able to become an exporter because it is being isolated from foreign competition. Tax incentives are frequently used to reduce the size of these two effects. It is worth noting, however, that if all exports are subsidized to eliminate the negative effects of protection, the relative price advantage of producing import substitutes will be eliminated. This is one reason why export promotion policy is very often selective by sector. Contriving to have a protected industry that also has the capacity to export is a difficult exercise. Few countries have been successful in promoting exports, while still protecting the industrial sector. An additional element is that many importing countries abide by the GATT rules for international trade and often establish countervailing duties and/or quantitative restrictions on those exports subsidized in the home country. In this case, the subsidy to exports becomes a transfer to the foreign country’s treasury.
Export subsidies are often used by developing countries to compensate for the trade effects of an overvalued exchange rate. Such a policy is seldom effective as it is difficult to compensate through the government budget for the distortions resulting from inadequate exchange rate policy that tend to grow over time. Moreover, export subsidies can often lead to further efficiency losses by delaying an exchange rate adjustment.
Improving fiscal health through smarter tax incentives
Along with supporting inclusive growth, economic development incentives can enhance the ability of local governments to plan, manage, and pay for critical public services and investments. For example, Providence, R.I. structured property tax stabilization agreements with businesses in a way that contributed to the city’s broader efforts to strengthen its fiscal health.
“We’ve used the agreements to expand the city’s tax rolls by incentivizing new development, not just downtown but in the neighborhoods as well,” said Lawrence Mancini, Providence’s chief financial officer. “It’s allowed us to stabilize and expand the city’s tax roll. We’ve gone seven years without a tax rate change.”
Incentives structured with targeted attention to fiscal health can also boost the level of funding for capital expenditures. This increased funding can provide valuable multiyear resources for critical infrastructure, helping to ease a long-term budgetary stressor many localities face.
Growth of “own-source revenues” is another potential fiscal health benefit. It is well documented that when incentives are structured to enable a locality to capture partial or full property taxes from firms that would have otherwise located elsewhere, this important category of revenues can grow. Expanding own-source tax revenues is integral for resource-constrained jurisdictions; tax incentives structured for a multiyear period can deliver especially meaningful results. In order to fully track the fiscal health impacts of economic incentives, localities should adopt a robust Governmental Accounting Standards Board (GASB) 77 measurement framework in their financial statements.
Conclusion
Tax incentives – tax credits, deductions, or reduction or forgiveness – can be used by communities, states, or the federal government to obtain desirable economic, aesthetic, and social ends. They can help convince developers to build affordable housing or restore historic buildings for new uses, persuade corporations to move operations into depressed areas, or encourage businesses and individuals to conserve energy and protect the environment.
Tax incentives can accomplish more than the specific purposes they’re aimed at. By being the carrot that’s used instead of, or in addition to, the stick of regulation, they make recipients into partners in trying to reach community goals, rather than adversaries. They can change the whole way developers or corporations look at doing certain kinds of business, and leave them willing to continue in directions that benefit the community as well as themselves.
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