The Tricky Political Economy of Business Tax Incentives

I’m doing some guided self-study this summer, and today I read a very thought-provoking paper by David Wildasin on “fiscal competition”.  Fiscal competition is most well-known at the local level, for example when two cities offer tempting tax breaks to corporations in order to lure their new factory.  It’s extremely common at the state level as well – most notably, Texas just lured a new Toyota factory with 4,000 jobs for a whopping $40 million in incentives.  However, Wildasin points out that there is another side to these fiscal incentives – subsidies must be paid for with taxes elsewhere, particularly in cities without the power to run large deficits.  Since localities almost never charge income taxes, the main way this is done is via taxes on particular types of property.  In his simplified model, there are four key results.

  1. Capital within a locality is fixed in the short run.  A tax doesn’t affect the real resources available or real output, but it does reduce the rate of return to capital.
  2. In the long run, a local property tax can’t reduce the net return to capital because capital will leave or enter so as to equalize net returns to capital inside or outside.
  3. However, it does affect the owners of immobile resources within the locality, particularly landowners.
  4. The loss of income to the immobile resource owners exceeds the revenue collected, because of the deadweight loss of taxation.

An interesting extension to this reasoning is to consider what happens once the factory moves in.  The move might well be popular, particularly if there are relatively more non-land-owning workers vs. landholders.  It’s an obvious win for the politicians – and the net benefit to the community might be positive, depending on how savvy they were at negotiating terms.  Here’s the neat thing about this, though: after Toyota comes in, the game changes.  We’ve introduced a large new player to the game, one that controls a fairly large proportion of the capital available to the community.  However, it has a characteristic that distinguishes it from the landowners, namely that its capital is more mobile.  It thus can extract rents from the community, because it can threaten to relocate if its taxes go up and take the equipment with it to whatever new city offers it better incentives.  We would expect that future tax increases will continue to fall mainly on immobile property and also that Toyota’s tax incentives long outlive their currently scheduled expiration date.

This actually has a fairly interesting and counter-intuitive empirical prediction – that we should see business incentives that are stronger, and possibly more long-lasting, the more mobile capital is.  There is a spectrum here, and a Toyota factory is much more mobile than a farm but relatively immobile compared to a textile factory, and extremely immobile compared to a bank, insurer, or software company.  The latter are extremely poor targets for taxes because they can relocate their capital extremely easily – whereas a city government might get a couple good years out of Toyota until a replacement factory can be built, or Toyota might decide to stay if relocation costs exceed the new tax.  So we would expect the more mobile businesses to have firmer public incentives, and to extract more rent from the public.

This logic should make us pessimistic about the returns from higher taxes on the ultra-wealthy, by the way.

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