KY Policy Blog

Report’s Findings Suggest Kentucky’s Business Tax Incentives Not Very Cost-Effective Way to Create Jobs

By Jason Bailey
July 19, 2012

Put into context, the findings of a consulting group report to the Kentucky legislature suggest that state economic development incentive programs are not a very cost-effective way to create jobs—a result that is in line with other studies on this topic.

The report is the outgrowth of House Joint Resolution 5 in the 2011 Kentucky General Assembly, which required a study of the state’s incentives to attract business. Anderson Economic Group produced the report under contract with the legislature.

A challenge in determining whether incentive programs are cost-effective is the “but for” question—which site locations wouldn’t have happened “but for” the incentives? This question is essential because other factors are considered much more important than tax breaks in business location and investment decisions—including access to markets, suppliers and related businesses; skills of the workforce; and quality of the physical and support infrastructure. Incentives can just reward companies for choices they would have made anyway.

However, answering the “but for” question definitively is difficult to impossible—in part because companies are unlikely to be completely honest about their reasons for choosing a location.

Anderson’s approach to this question is to ask what share of the new jobs created would have to be caused by the tax incentives in order for them to be more effective at creating jobs than an alternative use of the funds. The alternative use Anderson chose was an across-the-board tax reduction for all businesses. The report finds that more than 35 percent of the jobs associated with the tax incentive programs would have to be caused by the incentives for them to be more cost-effective than the alternative.

While Anderson says that a result of greater than 35 percent is “certainly plausible,” the report is not conclusive on the question of whether the state’s tax incentives are more effective than reducing business taxes across-the-board.

That finding is troubling, and is even more disturbing once you consider that general business tax cuts themselves are not a very effective way to create jobs.

In a summary of research on that issue, University of Iowa economist Peter Fisher says that claims of a strong relationship between business taxes and economic growth “are vastly overblown and sometimes completely misleading.” He notes that business taxes are a very small part of the cost of doing business in a state—about 1.8 percent of total business costs on average for all states. Such taxes also differ little from state to state—especially compared to the differences in other factors that affect businesses’ cost, productivity and sales. As we have reviewed elsewhere, the research shows that the reductions in public services that result from business tax cuts can be more harmful to a state economy than any modest economic gains from the tax cuts.

A 2007 University of Kentucky study cited in Anderson’s report also examined the cost-effectiveness of Kentucky’s tax incentive programs and found that they were expensive for the resulting impact. The researchers estimated that the state spends about $26,775 per job created through its tax incentive programs compared to only $2,510 per job created on a job training program.

Economist Timothy Bartik, a leading expert on state economic development, says that financial incentives are one of the most expensive ways to create jobs. In his paper “What Works in State Economic Development” he identifies which alternative economic development strategies have stronger evidence of cost-effectiveness.

Among the strategies Bartik identifies are:

New business development

Bartik says that providing entrepreneurship training “has the most rigorous evidence for effectiveness of any economic development strategy.” He also positively cites programs that provide small business advice and support—such as Small Business Development Centers and business incubators.

Customized job training

Bartik says that the provision of training tied to business needs can be 10 to 16 times more effective in jobs created per dollar spent than tax incentives. The cost-effectiveness of job training is supported by the Anderson study, which finds that the state’s Bluegrass State Skills Corporation (BSSC) is more cost-effective than tax incentive programs.

Manufacturing extension services

Bartik notes that programs that assist existing businesses have demonstrated success. He particularly cites manufacturing extension programs, which provide smaller manufacturers with information to increase productivity through new technologies and different ways of doing business. Bartik cites research suggesting each dollar spent on such services reduces business costs by over three dollars.

High tech development

Bartik cites university technology transfer programs (also mentioned in the Anderson report), increased broadband access, training programs for high tech industries and access to venture capital as effective economic development strategies oriented toward innovative new industries.

In addition to the above categories, Bartik also emphasizes the importance of policies that increase the skills of the workforce. He specifically identifies: the role of community colleges in providing needed training; the provision of on-the-job training, public employment and subsidized jobs for disadvantaged workers; and the need to improve K-12 education.

He also puts emphasis on the power of early childhood education in long-run economic development, noting that universal preschool “has, in the long run, over twice the projected annual impact on jobs of business subsidies.”

As we have shown in previous work, the state’s economic development strategy has long focused narrowly on providing tax and other financial incentives to attract industry. There are good reasons to diversify the state’s approach. In recent years, the budgets of public programs in education and other areas that have an economic development impact have been cut dramatically by the state, while business tax incentives have been expanded even further. Properly understood, Anderson’s report is part of the mounting evidence that demonstrates the need to re-think what we are doing to create jobs.

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