This article was originally published in State Tax Notes in 1992.
This paper was prepared for the National Tax Association's 84th Annual Conference at Williamsburg, Virginia, November 10-13, 1991.
The Federation of Tax Administrators is an association of the principal tax and revenue collection agencies in the 50 states, the District of Columbia, New York City, and the Provinces of Ontario and Quebec, Canada. The views expressed herein are those of the author and do not represent the position of the federation or any of its members.
My purpose is to review some of the recent discussions and writing in the area of interstate tax competition and to provide you with my perspective on that debt. I want to emphasize that I am speaking for myself and not the Federation of Tax Administrators or any individual member agency or administrator.
I do not approach the subject from the perspective of an economist, bringing sophisticated econometric and statistical techniques to defining or measuring the impact of interstate tax competition. Neither do I bring the perspective of a political science/economic theorist, positing alternative sets of reading glasses through which to view this phenomenon and debate. Instead, I approach it from the mundane perspective of an erstwhile state tax collector who has participated in and continues to observe the real world of state taxation and the real world of developing state tax policy.
The basis approach of the paper is to identify three basic forms of interstate tax competition, review some of the literature surrounding such competition, and give my evaluation of the effects of such competition. I conclude by making some suggestions for procedural or structural changes in the manner in which state tax policy is formulated and evaluated that might help to mitigate what I consider to be certain undesirable effects of the competitive mechanisms.
I. Definition of Terms or Types of Interstate Tax Competition
A principal emphasis of the recent literature is that traditional studies and analyses of interstate tax competition have been too narrow in the types of competition they analyzed and too narrow in the types of impacts or benefits they have attempted to measure. In particular, they argue that interstate tax competition is more than adjusting the tax code to attract and stimulate business development and job growth. 1 Other forms of competition include tax exporting, competition in service levels, and the like.
I tend to subscribe primarily to the "Old School," or at least intend to focus my discussion on a relatively narrow definition of interstate tax competition and a relatively narrow set of competitive measures. I will define interstate tax competition for the purposes of this discussion as the tendency among states to make adjustments to their tax code with a primary purpose of attracting new business locations directly or improving the climate for attracting such business locations in the future. This is not to say that the broader view is incorrect in any way. Rather, I believe that the most tangible (and in some cases) invidious impacts of interstate competition fall within this more narrow definition.
Within this definition, I identify three discrete forms of interstate tax competition which can be analyzed and should be considered:
- Competition with respect to overall state and local tax levels. In this form of competition, states tend to measure the attractiveness of their business climate by comparison to the overall tax burden (and in some cases for particular taxes) to those in surrounding states or those with which they feel in "competition" for business development. I term this the "Good" of interstate competition because it has a number of salutary effects on state tax systems when measured against most criteria for evaluating state tax policy. There are, however, also some negatives that need to be remembered.
- Competition for business development through special tax incentives. In this form of competition, states enact special provisions of the tax code for the particular purpose of decreasing the cost of investment or operation in the state, thereby providing a stimulus for businesses to locate or expand in the state. These incentives are available to all businesses operating in the state, provided they meet the qualifying criteria for the incentive, e.g., creating new jobs, specific levels of investment, etc. I term this the "Bad" of interstate tax competition because, on balance, I believe the overall impact on state tax policy and tax administration to be negative.
- Competition for individual, identifiable business locations through special tax concessions. In this form of competition, states are involved in developing a discrete package of tax and other concessions designed to attract a single, identifiable business to establish a facility in the state. I term this the "Ugly" of interstate tax competition since when measured against most established norms of state tax policy democratic principles, it comes up lacking. There are also negative long- term consequences to be considered.
II. The Good -- Competition With Respect to Overall State and Local Tax Levels
Probably the leading proponent of the view that states can and do "compete" with respect to overall tax levels and that this is appropriate and beneficial to the fiscal systems of state and local governments is John Shannon, former Public Finance Director of ACIR. 2 Shannon argues that states compete or define, at least in part, their tax systems by reference to other states and there is a desire to avoid being distinctly different (at least in ways that are viewed as negative by the business community). In Shannon's words, states avoid "Sore Thumbs" or being the lead ship in the "Convoy" because of the potential for being shot at.
In the view of the proponents, the benefits of this type of competition include:
- It promotes a balanced tax system or at least protects against serious imbalances;
- It promotes stability in the tax system;
- It can promote broad-based, low-rate systems.
The most commonly expressed concern about this type of competition is that it can lead to "anemic" revenue systems or act as a significant brake on the growth and development of the state and local sector. In addition, it is commonly thought that interstate competition at this level tends to lead states away from highly progressive taxes, and to some extent, away from ability to pay taxes altogether.
In a relatively new approach, Shannon looks at the mirror image of the interstate competition on the expenditure side. He argues that the combination of the "Pacesetter Phenomenon" (the desire to be innovators and leaders) with the "Catch-Up Imperative" (the fear of falling behind in the provision of quality public services and the resultant impact on development) overcome the "braking" effect of interstate tax competition to produce a state-local sector that grows to meet the needs of the citizens as expressed through their elected leaders. He sees the competitive pressures on the tax and expenditure side as the "invisible regulators" of the federal system. He generally finds the invisible hands of competition to be preferable to other forms more visible, federal regulation of federalism.
Steven D. Gold has essentially tried to document the effects of this "global" or overall tax burden competition by looking at state individual income tax rates and structures during the 1980s. 3 Specifically, he tested three hypotheses about the effects of interstate competition:
- Competition causes states to reduce reliance on the income tax relative to others;
- Competition causes states to reduce top marginal income tax rates; and
- Competition causes income taxes to become less progressive.
Gold found that only one of the hypotheses was truly borne out when viewed from the perspective of all states. Top marginal income tax rates were reduced in a number of instances. On average, reliance on individual income taxes increased and individual income taxes became more progressive over the decade. When applied to only high income tax states, the latter two hypotheses did tend to hold true, however. The net result, in Gold's opinion, was a significant reduction in the diversity of state individual income taxes. That is, they looked a whole lot more like one another at the end of the decade than they did at the beginning.
Gold acknowledges that not all of this convergence or all of these results can be attributed to independent state actions. He notes, and my experience and belief is, that the federal Tax Reform Act of 1986 contributed mightily to these state income tax trends and results. This is true for several reasons:
- The changes brought about by the Tax Reform Act were so substantial that nearly every state was forced to respond with its own income tax reform. From an administrative standpoint, it was nearly impossible not to adopt in substantial part the revised federal code if the state income tax conformed to the federal code.
- The nature of the federal changes was to broaden substantially the tax base at the upper income levels which provided states with a great deal of latitude to reduce marginal rates, preserve or increase progressivity, and increase the share of all taxes represented by income taxes. Without the federal reform, it seems highly unlikely that any significant number of states would have pursued this approach independently. 4
- The federal reform also increased substantially the "tax-free" threshold (combination of standard deductions and personal exemptions) for lower income households. Again, for states conforming to the federal code, there was a strong incentive to follow this pattern (thus increasing progressivity) because of the complexity which could face low income taxpayers if they did not.
On balance, I believe interstate competition approached from this perspective, i.e., evaluating one's own tax structure and changes therein with reference to other states from an overall perspective and to avoid features which cause one to stand out significantly from the crowd are generally positive. Generally speaking, I believe it promotes stability and balance in the state- local tax structure and promotes broad-based, low rate tax structures.
On the other hand, there are certain negative consequences of this sort of competition. In particular, I think it impedes policy innovation and experimentation with the code. This makes it difficult for a tax structure to keep abreast of changing economic and technological conditions. The prime example of this phenomenon is the Florida effort to impose the retail sales tax on a wide variety of service transactions in 1987. Nearly all economists and tax policy analysts agree that the long-term survival and vitality of the sales tax depends on the ability to deal effectively with services. Yet, even today, every legislative debate about taxing services invariably includes references to "Florida" and the negative effect on the business climate. The legend has grown so large and the ability to demagogue the issue is so great that it has substantially polluted the debate of a legitimate tax policy question.
In addition, defining one's own tax system with heavy reference to one's neighbors can have a braking effect on the ability of government to address legitimate needs. This is overcome, to some extent at least, by the growing recognition in the business community of the value of a well-educated labor pool, a quality higher education system, and adequate public facility infrastructure in improving the attractiveness of a state for investment. Examples of the business community being the leading proponent of major spending programs to improve education funding or provide infrastructure are relatively easy to find. 5
III. The Bad -- Competition for Business Development Through Special Tax Incentives
The most active or pervasive form of interstate competition is the enactment of special tax incentives designed to make it more attractive for businesses to locate in a particular state or to encourage other forms of economic development. Included within this category, I include those incentives available to "all" businesses meeting certain criteria of "good" and "worthiness," i.e., undertaking the appropriate development activities.
The approaches states have taken in this regard are literally innumerable. 6 They include tax credits for job creation, credits for investment in equipment, exemptions for equipments purchases, credits for investment in venture or risk capital funds, inventory tax exemptions, property tax abatements, enterprise zones, and the like. Included within this general category, I would include measures such as apportionment formulas, credits or tax structures which make it relatively more attractive to locate in a state than to operate in a state from an out-of-state base or otherwise provide an advantage to in-state firms (e.g., double-weighted sales factors).
The economic literature evaluating the impact and effectiveness of these sorts of incentives is quite rich. As in most such fields, the empirical analysis is not uniform in its conclusions, depending on what was being measured and how it was being measured. 7 Some of the conclusions reached include:
- Tax variables are insignificant in explaining the location of new branch plants. 8
- Individual (not business) income tax effective rates have the most explanatory power in viewing state employment growth. 9
- Most tax variables are insignificant in explaining employment growth. 10
- After-tax rates of return are significant in explaining capital investment levels. 11
- Taxes ranked last in a survey of factors influencing locational decisions. 12
The best summary is probably provided by Dick Netzer in Kenyon and Kincaid when he said:
...[E]conomic development incentives are, for the most part, neither very good nor very bad from the standpoint of efficient resource allocation in the economy. With all the imperfections, the offering of incentives does not represent a fall from grace, but neither does competition in this form operate in ways that truly parallel the efficiency-creating operations of private competitive markets. Given the low cost-effectiveness of most instruments, there is little national impact, only a waste of local resources in most instances. 13
This is somewhat the same as saying that economic development incentives are of some assistance in some cases, maybe.
My own view is somewhat less sanguine and benign. There are several undesirable side effects which also deserve consideration in such evaluations.
Because they are difficult to target effectively, the incentives tend to subsidize that which would otherwise take place anyway, rather than providing any real stimulant to development activity. Put another way, unless the incentive is a sales tax exemption for manufacturing equipment which is not otherwise available or a significant property tax reduction, the state taxes used to provide incentives are generally not sufficiently significant that a reduction of any moderate magnitude would stimulate any activity.
Benefits of the incentives tend to be concentrated in a relatively few large firms. This can have undesirable competitive effects and breed public distrust of government and business at the same time. 14
To the extent that a state attempts to target its incentives in an effort to improve their stimulative effect, the administration of the incentive is likely to be made increasingly complex. In such cases, a substantial level of resources must be devoted to enforcing compliance with the conditions of the incentive, explaining it to potential users, and working with taxpayers to insure they qualify or understand why they do not. The end result is often one of frustration for the tax department, the development agency, and the potential user taxpayer because of uncertainty of the effect of a complex incentive on business operation. 15
Efforts to benefit in-state firms at the expense of out-of-state firms through apportionment formulas, factor definitions, or other means of defining the tax base disrupts uniformity in the approach of all states to taxing multijurisdictional businesses. This lack of uniformity and in-state preference often leads to calls for federal legislation to pre-empt state taxing authority because of the inordinate compliance burden and "unfair" treatment given the in- state firm. 16
IV. The Ugly -- Competition for Individual, Identifiable Business Locations Through Special Tax Concessions
The type of interstate competition addressed here involves instances where states become involved in a bidding war with one another to attract specific, identifiable businesses, almost invariably large businesses. The states are usually bidding with a package of state and local tax concessions coupled with such other features as training programs, land deals, public facility and transportation assurances, and the like. In the bidding war, the business is holding its cards close to the vest, and the states' cards are generally face-up on the table for the next state to raise the ante.
As the boom years of the 1980s faded, the instances of these bidding wars increased. Recent examples include packages aimed at United Airlines, Sears Roebuck and Co., Northwest Airlines, General Dynamics, McDonnell-Douglas, and Air West. Earlier examples include the early U.S. plant locations of foreign automakers and the Saturn plant.
I am unaware of any systematic evaluation of these sorts of instances. There is, however, some feeling that the bidding war for the auto plants turned out to be a net loser for Kentucky. 17
Few public policy analysts view these bidding wars with any degree of favor. Most of all, they run counter to all teachings of uniformity and equality in the application of the tax law. Instead, one's tax liability is dependent on other extraneous factors such as the size of the employment base under consideration, political power, the ability to move one's installation, and the job market condition in any particular community. In short, there does not seem to be much good tax policy at work in these situations.
In addition, I believe this type of bidding war leads to additional public distrust of government and the way it works, particularly if there are later problems in meeting public service needs because of a constrained tax base.
Despite these concerns, we should expect this type of activity and competition to increase. That was the conclusion of a panel of state legislative leaders at a recent Multistate Tax Commission discussion of this issue. The need to create jobs and the negative appearance of "doing nothing" are simply too great to cause states to quit joining such bidding wars.
V. Some Modest Proposals
The question then becomes how do we, as participants in the tax policy process, promote more of the good and less of the bad and the ugly. Some modest procedural and institutional reforms which might work in that direction follow.
Improved information and analysis for policymakers. One of the key needs is to be able to improve the information available to policymakers as they make choices about tax structure and economic development. In my estimation, there is a pressing need for information on the financial picture and prospectus for various types of industries and how the overall state and local tax burden in the states fits into that picture. Too often, the debate centers around an incentive that is offered in another state or an exemption that exists there and not in your state. Unless one can view the overall tax burden on business and its relationship to the total finances of a business, there is really no way to make an accurate evaluation of whether enacting a similar measure is "necessary." In addition, evaluations of what types of incentives "work" with what types of industries or at least what might be expected under any particular incentive would also be helpful.
Sunsets and Evaluations. All too often, tax incentives are put in place, and little effort is made to systematically evaluate their impact--either in terms of state revenue, jobs created, or whatever criteria are important. This could be cured by imposing a "sunset" date on each incentive and requiring that a thorough evaluation be undertaken before it is subject to renewal. This will at least require that the analysis be done and that belief in the incentive be reaffirmed, rather than just implicitly assuming it is accomplishing what was intended.
Cooperative Analysis of Development Projects. Presuming a state wants to become involved in bidding on a development project, one of the difficulties it faces in formulating its package is estimating the impact of the installation. Too often, the policymakers can become captive to the business undertaking the development for information. A step toward resolving this would be to have the states involved work together to arrive at some common assumptions or estimates about the impact of the development in terms of the number of primary jobs, secondary jobs, service needs, and the like. In this fashion, the information base for formulating a bid would be improved. States might still choose to "overspend" on tax incentives, but they would do so knowingly rather than unknowingly.
Public Disclosure. Part of my concern with certain incentives is that they can have a tendency to breed public distrust of government, or at least increase the cynicism with which some view government. One approach to this is to "show the people what they are buying" by requiring that taxpayers taking advantage of certain incentives disclose the value of that incentive and the requirements they met to receive it (i.e., the jobs created, etc.). This might be most appropriate for the large bidding war projects than more routine incentives. As a tax administrator, I am by no means advocating full disclosure of the tax return or routine disclosure of all use of all tax preferences. However, where a firm actively seeks tax concessions for itself and for itself alone, it may be incumbent on that firm to provide the public with a periodic accounting of the value of those concessions and the benefits which the concessions helped to purchase.
- Interstate tax competition and the use of tax incentives are and will continue to be part of the state tax policy landscape. They simply cannot be eliminated.
- This paper has tried to raise some of the concerns state tax administrators believe policymakers should consider as they face competitive decisions.
- To the extent that competition can be channeled into a mode of defining our tax systems with reference to one another and keep in mind some of the beneficial aspects of this form of competition, our tax systems can be improved.
- In addition, some modest procedural reforms might help to mitigate some of the undesirable consequences of the "bad" and the "ugly."
1 See Daphne Kenyon, Interjurisdictional Tax and Policy Competition: Good or Bad for the Federal System?, Advisory Commission on Intergovernmental Relations, M-177, Washington, DC, April 1991; and Daphne Kenyon and John Kincaid, Ed., Competition Among States and Local Governments--Efficiency and Equity in American Federalism, The Urban Institute Press, Washington, DC, 1991, p. 3-4.
2 See John Shannon, "Federalism's 'Invisible Regulator'-- Interjurisdictional Competition,-- in Kenyon and Kincaid, op. cit., pp. 117-125.
3 Steven D. Gold, "Interstate Competition and State Personal Income Tax Policy in the 1980s," in Kenyon and Kincaid, op. cit., pp. 205-217.
4 Wisconsin did, however, enact a wholesale reform in 1985-- one year before the federal change.
5 The "business community" was the leading proponent of the education funding package on the Missouri ballot this November. Similarly, they were the leading opponents of a failed property tax initiative in Washington State; albeit this was in part due to potential shifts to business property as well as fear for the effect on local services.
6 A catalog of state business tax incentives exceeds 800 pages. National Association of State Development Agencies, Incentives for Business Investment and Development in the U.S., 3rd ed., Washington, D.C., Urban Institute Press, 1991. Cited in Kenyon and Kincaid, op. cit., p. 3.
7 For an excellent review of the literature, see Daphne Kenyon, op. cit., pp. 33-35.
8 D. Carlton, "The Location and Employment Choices of New Firms: An Econometric Model with Discrete and Continuous Endogenous Variables," The Review of Economics and Statistics 65 (1983), pp. 440-449.
9 Mike Wasylenko and Therese McGuire, "Jobs and Taxes: The Effect of Business Climate on States' Employment Growth Rates," National Tax Journal 38 (December 1985), pp. 497- 512.
10 Therese McGuire and Mike Wasylenko, "Employment Growth and State Government Fiscal Behavior: A Report on Economic Development for States from 1973 to 1984," Prepared for the New Jersey State and Local Expenditure and Revenue Policy Commission, July 1987.
11 Leslie Papke, "Subnational Taxation and Capital Mobility: Estimates of Tax Price Elasticities," National Tax Journal 40 (June 1987), pp. 191-204.
12 Howard Stafford, "The Anatomy of the Location Decision: Content Analysis of Case Studies," in F.E. Hamilton, Ed., Spatial Perspectives on Industrial Organization and Decision Making, Wiley, New York, 1974.
13 Dick Netzer, "An Evaluation of Interjurisdictional Competition Through Economic Development Incentives," in Kenyon and Kincaid, op. cit., pp. 239-240.
14 In 1982, 97 percent of New York State corporate filers did not claim an Investment Tax Credit, and 10 firms accounted for 50 percent of all credits claimed. Cited in Richard A. Pomp, "A New York Perspective on Tax Incentives," Multistate Tax Commission Review, August 1985, pp. 1-9. West Virginia's Super Credits have created considerable controversy in that state and have led to calls for disclosure of some or all of the corporate tax return.
15 For further discussion, see Harley T. Duncan, "State Legislators and Tax Administrators: Can We Talk?," in Steven D. Gold, Ed., State Tax Reform: The Unfinished Agenda, National Conference of State Legislatures, Denver, CO, 1988.
16 Most recent examples of preemption are in the interstate commerce and transportation industries. Examples include the 4-R Act providing property tax protections to the railroad industry, similar legislation for airlines and motor carriers, proposed legislation telecommunications providers, and 1990 legislation preempting certain methods of state taxation of interstate airlines.
17 Georgina Fiordalsi, "Did Kentucky Pay Too Much for the Toyota Plant?," City and State, June 1981, p. 13.
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