Question

Tax on risk and capital. Some city-level officials argue that targeted tax breaks will be good for their city. Other officials argue that there should be a state law that bans the use of targeted state-level tax breaks.

Explain why both arguments are reasonable. Would it be reasonable for the same city-level official to make -or at least to believe in- both arguments simultaneously?

Answer 1

Targeted tax incentives are those laws that provide preferential tax treatment to a limited number of taxpayers and are not readily available to taxpayers in general. Such incentives offer special tax treatment to specific companies in return for some specified business activity in the state. These incentives often include property tax abatements, sales and use tax exemptions, job and investment credits, and accelerated depreciation deductions.

Tax incentives can have both, positive and negative impacts. Among the positive benefits, if implemented and designed properly, tax incentives can attract investments.

Theoretically, 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 ways or “corrupt” ways to minimize tax liabilities.

The benefits of tax breaks include increased employment, higher number of capital transfers, research and technology development, and improvement to less developed areas. Though it is difficult to estimate the effects of tax incentives, they can, if done properly, raise the overall economic welfare through increasing economic growth and government tax revenue.

Targeted tax incentives fail for many 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.

As per one of the reports, Economist Sarah Hamersma of the University of Florida surveyed the research on targeted tax credits for the Urban Institute Brookings Tax Policy Center in 2005. She found “no meaningful job creation as a result of these programs.” One of the programs was a $2,400 tax credit, available from 1978 through 1994, for employers who hired economically disadvantaged people, including Vietnam vets. But a 1992 Labor Department Inspector General’s audit found that it ”was not an effective or economical means of helping target group members obtain jobs.”

Disadvantages of targeted tax breaks are significant compared to its advantages. Both arguments might get considered but much will depend on the actual economic scenario of the specific region. What most of the economists believe is that 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.