Tax incentives: An effective development strategy for rural communities?

Journal of Agricultural and Applied Economics, Aug 2002 by Rainey, Daniel V, McNamara, Kevin T

As national and local economies become more globalized, many rural areas are going to find it more difficult to compete for private capital investments. A traditional tool, modifications to tax policy, of state and local governments will not be as effective (for many communities it has never been effective) in the future. These communities will need to seek other avenues of growth. However, for many rural communities even alternative avenues will not lead to enhanced economic opportunity.

Key Words: agglomeration, rural development, tax policy

JEL Classifications: R51, R58, O21, O23, R11, R38

The use of tax modifications' as a tool to enhance local economic growth has existed for over half a century in the United States. During the 1980s and 1990s, state and local governments were making bigger modifications and making them more often (Anderson and Wassmer; Gabe). Competition between communities and states is the primary reason for the growth in the use and size of industrial incentives. When one community increases the value of its package, oftentimes surrounding communities will increase their package as well in an attempt to stay competitive (Bartik; Fisher and Peters).

Despite the increased efforts in modifying industrial taxes, there is still a great deal of debate as to their overall effectiveness. Many argue that the industry that is attracted by incentives (or other tax policy changes) would have located in the area without the use of the incentives (Bartik; Papke and Papke; Fisher and Peters; Schmenner). To the extent the investment would have come without the aid of the incentives, local governments will have needlessly foregone tax revenue. Many opponents of development incentives argue very strongly that this is the situation that exists in most recruitment cases, whereas proponents of incentives argue that new investment would not come to the area without the incentives.

Also, as states race to become more competitive, many argue that this is a race to the bottom, because competing and surrounding states quickly meet each increase. Thus, as states continue to increase their incentive packages, they are simply decreasing their ability to provide public services in the future.

The purpose of this paper is to examine the current state of knowledge concerning taxes and their impact on the location of industrial investment. The next section will briefly review the theory of the firm and will be followed by a section on the relative importance of taxes as a cost of production. Then we will examine the benefits provided by taxes. The fourth section will look at taxes relative to other location factors. The fifth section will look at some of the problems faced by rural areas and how these problems may hamper their ability to manipulate tax policy. We will conclude by summarizing the main tax policy findings and constraints.

Firms Maximize Profits

A firm's primary goal in selecting a new industrial site is to find a location that will allow the firm to maximize its profits (Gerking and Morgan). Profits are emphasized because firms that do not maximize profits will not be able to compete in the long run. The profit maximization approach to industrial location states that a firm will locate where sales can be maximized at the least possible total cost (Shaffer).

In many instances, production costs are not the only consideration in searching for the new site. In addition to labor and input costs, much of the early work on industrial location focused on transportation costs and agglomeration forces (Smith).2 Future location decisions are going to be more dependent on access to advanced communication technology.

However, Greenhut hypothesized that firms' location decisions may not be based entirely on profit maximization. He believed that the personal goals of persons involved in the site selection decision have a major impact on the location choice. This is particularly the case for many small or single-establishment firms in which the owner's personal preferences weigh heavily in the final decision.

Taxes as Production Costs

There are many factors that a firm examines when deciding where to make its next investment. To make the search process more manageable, a firm is hypothesized to undertake the search process in two steps (Schmenner, Huber, and Cook). The first step involves the regional search, or selection of a particular region or state (Schmenner, Huber, and Cook; Smith, Deaton, and Kelch). In the regional search, the firm is looking for the location that will achieve the firm's location objectives; taxes are not likely a consideration at this point. During the initial process, the firm is interested primarily in securing adequate access to input or output markets or both. A firm may also seek some longer-term objective, like establishing market share in a particular region.

Once the region is determined, the firm searches for a specific site within that region. This site would provide the best mix of low costs and appropriate quality labor, good utilities, and low taxes. Good infrastructure (highways, water treatment systems, communication networks, and mass transit) is also important in the second stage of the search process. Furthermore, amenities such as parks, libraries, museums, and other cultural attractions will have an impact on the location decision.