Tom Fellrath POLS 620 - Literature Review November 23, 2009

An examination of economic development incentives and academic literature on the topic

Introduction As this review is being written, the United States has emerged from the brink of financial disaster through a Federal bailout of the American financial services sector, billions of dollars in Federal loans to manufacturers and a massive economic stimulus bill. It is unclear if these Federal investments have reversed the decline in the American economy, but it appears that the negative momentum has slowed considerably. Despite all this flurry of activity, however, Ohio is still struggling. The states governmental leaders have suggested repeatedly that robust economic development will deliver the state from the crisis that it currently faces. This renewed focus on economic development makes now the ideal time to learn more about this topic, assess its merits and uncover its weaknesses.

This literature review will pursue the question, Do economic development incentives serve the interests of the people? In other words, Do the financial incentives to individual business entities provide sufficient benefit to the taxpayers to warrant public investment? In tight budgetary times, the use of public dollars for any purpose be it health care, education, public safety or economic development demands fresh scrutiny and a realistic assessment of the return on investment of those dollars. Keeping this in mind, this review will consider a sampling of

available literature on the topic of economic development incentives and share their findings with the hope of answering our research question.

This review is divided into component sections. First is an overview and definition of economic development with a complementary definition of economic development incentives. Next, this review will consider the three main categories of economic development incentives. The review will conclude with an overview the large body of criticism and commentary about that which has been learned.

Definitions What is economic development? Economic development is a broadly-used catch-all in the modern parlance, and little emphasis has been placed on what the term actually means. In fact, Miriam-Webster Online does not offer a definition for the term. A search of Google.com reveals fifteen unique definitions of economic development from governmental, business and academic sources across the globe including such diverse concepts as any effort or undertaking which aids in the growth of the economy, growth that is planned and or desired, raising the productive capacities of societies and Qualitative change and restructuring in a country's economy in connection with technological and social progress (define:Economic development, 2009). This lack of an accepted standard is a significant challenge to conducting any analytical review. Without a commonly shared definition of a concept, is it possible to determine if the available literature offers any guidance on whether the research question can be tested?

Tom Fellrath

Having to choose one definition when no commonality exists (and no peer-reviewed definition was identified), this literature review will follow in the spirit of the Indiana Economic Development Corporations 2006 strategic plan, which suggests that, The bottom line is wealth creation (Accelerating Growth, p. 2). This makes sense at an intuitive level; a fostering of wealth will take the form of job creation (both direct and indirect) and lead to corresponding tax revenue growth for government (Downing (2004), Bartik (2005)). The focus on wealth creation does not include or exclude any specific industries, activities or behaviors. Thus, we will use the following definition as our foundation: Economic development is the act of using public sector tools to build wealth for the larger population of citizens and businesses, as well as the government. It is those tools, in pursuit of this goal, that this review will consider.

Economic development can be conducted either through encouragement of expansion of homegrown entrepreneurial activity or retention of incumbent employers who could leave the community or close their doors altogether. It also can take the form of attraction or recruitment of new employers to the locality (Fleming and Leonard (1994) and Downing (2004)). Most entities that focus on economic development implement a multipronged strategy that is disproportionately weighed toward retention and recruitment activities.

Regardless of the approach, it appears that the likelihood of success of economic development activity depends on the fiscal health of the municipality or state, the governmental structure, the extent of professionalism in the economic development function and level of competition among cities for economic development (Reese, 1999). To illustrate the counterpoint, rural localities have a host of unique challenges to achieving economic development success, including the

Tom Fellrath

obvious (remote locations, low population density and little means to develop meaningful incentive packages) and the less obvious (education levels, poverty levels and lack of professionalism among rural economic development staff like administrators, grant writers and land use planners) (Dewees, Lobao & Swanson, 2003).

Governments conduct economic development activities for a host of reasons, chief amongst them is the increasing challenge for American localities in attracting capital in the era of globalization (Dewees et al, 2003, Clark and Montjoy, 2001). Other factors include the desire to build community wealth through the expansion of jobs and tax revenues, revitalize older urban areas and reverse urban decline and disinvestment (Downing, 2004). In keeping with that theme, it appears that older and larger cities are more active in economic development activities (Reese, 1999, Reese, 2006, Reese & Sands, 2006, Man, 1999). While a government can use many tools for economic development purposes, research has found that economic development activity clusters around tax incentives and abatements, site acquisition and preparation, industrial revenue bonds, downtown revitalization, community public relations and boosterism, and investment in infrastructure (Reese, 1999). As this list of tools suggests, economic development largely is a localized activity in the purview of municipalities and county governments.

Local economic development can be conducted by any of a host of entities. Municipal governments often host their own economic development departments with professional staff. Private sector entities, like Chambers of Commerce, are also likely sources of economic development expertise. Challenges can arise, however, when the economic development interests of the government do not overlap with those of the private sector. In an effort to foster

Tom Fellrath

collaboration, some communities have built public-private partnerships - quasi-governmental entities that operate with the flexibility of a private firm yet carry the authority of speaking for local governments. Some such public-private partnerships embody collaborations between multiple governments across community and state lines (Fleming & Leonard, 2004). Surveys and in-depth interviews indicate that the more successful leaders of these public-private ventures, however, bridge the gaps between the two sides of the partnerships (Rubin, 1990).

States are unique actors in the world of economic development. Unlike municipalities, they can take a two-pronged approach of promulgating systemic policies that support a nontargeted industrial promotion/recruitment strategy and a more aggressive approach that specifically targets entrepreneurs and growth-producing economic sectors on a more transactional basis (Saiz, 2001). In both instances, a state can demonstrate partnership with, and support of, its communities which are conducting economic development activities of their own.

What are economic development incentives? Economic development incentives are the unique financial incentives for private businesses from states and localities (who, working with their partners at the state, are often driving the utilization of or ever administering state-issued incentives themselves) that are intended to achieve economic development goals within their jurisdictions. These public sector incentives have many of the same goals of private sector incentives the public sector hopes to obtain new employers or maintain existing employers whereas the private sector uses incentives to obtain new customers or maintain existing customers (Downing, 2004). These targeted incentives, as

Tom Fellrath

opposed to systemic improvements in areas like infrastructure and education, are more likely to offer faster payoff to the community (Gorin, 2008).

Economic development incentives serve two primary purposes in support of the larger goal of supporting economic development within a given jurisdiction: 1) To influence where an employer will locate their place of business or 2) To provide financial assistance that will enable a business project that would otherwise not be possible (Downing, 2004). Without these public sector incentives, which serve to selectively expand, attract or retain wealth-generating employers, the concept of interurban competition suggests that the expansion, attraction or retention would happen elsewhere (Giloth, 1991).

Categorizing the differing types of economic development incentives is nearly as challenging as defining economic development itself. The ways in which the categories are divided are many, but common themes emerge when comparing the different authors. Giloth (1991) suggests a broad set of categories that includes loans, guarantees, tax holidays, and infrastructure and land write-downs that lower the costs of business operation, start-up, or expansion. Downing (2004) suggests a combination that includes property tax abatement, tax increment financing, state income tax credits, infrastructure investments, workforce training funds, and reduced utility costs. Gorin (2008), building on Fisher and Peters (1997), suggests the possibility of six categories: 1) Individual negotiated with firms; 2) State grant and loan programs; 3) Local economic development programs established by State authorization; 4) Entitlement (or blanket) incentives, whereby an incentive is automatically authorized provided that the company meets the stated requirements and thresholds; 5) Unique state code attributes that serve to differentiate

Tom Fellrath

states as unique or distinct and thus more worthy of a specific sectors investment and 6) Revisions in state statutes that make the state more attractive to targeted industries (Gorin, 2008). This review, however, will contemplate three broad categories of economic development incentives that appear to broadly embody the subsets stated above: interest subsidies, subsidies for production inputs and tax abatements as advanced by Rasmussen, Bendick and Ledebur (1984). Regardless of the category, however, most incentives have the potential for application on an entitlement basis, or at the discretion of the government (Downing, 2004).

Interest subsidies Interest subsidies can include a number of government-supported financing supports. At their core, the recipient of this type of incentive is able to pay a below-market interest rate on any of a number of financial lending options. They include industrial revenue bonds, subsidized direct loans and loan guarantees (Rasmussen et al, 1984). Such tools enable businesses to procure

equipment, purchase land and construct facilities with financial terms that they would not have otherwise been able to obtain without government support. Those receiving interest subsidies may have already attempted to obtain financing through private markets and found insurmountable challenges such as lender redlining of entire industries like the hard-hit manufacturing sector (Gilroth, 1991). Through its subsidization of the recipients bonds and loans, the government assumes financial risk by either directly lending money or guaranteeing full and prompt payment of the recipients loan package. All interest subsidies are not equal, however; industrial revenue bonds are more costly to the government per dollar of benefit than any alternative (Rasmussen et al, 1984).

Tom Fellrath

Subsidies for production inputs Subsidization for production inputs includes government underwriting of land, plant, equipment and worker training. Such direct subsidies, applied wisely by the recipient, can be applied in a manner that not only reduces the cost to the business of the input(s) in question but also reduces their tax burden (Rasmussen et al, 1984).

A unique production input subsidy is tax increment financing, which was first put into practice in California in 1952 (Wassmer, 1994). TIFs, as they are called, pay for economic development costs out of future net new increases in tax collections. In theory, the tax revenues from the incented employer that would have gone to the general fund of the state or municipality are instead captured to pay for the economic development costs (Wassmer, 1994). This model generally is applied on a geographic basis to encourage development within specific areas of a community, often those that are blighted or require redevelopment to maintain an acceptable level of prosperity. Key considerations in establishing a TIF district include the municipalitys fiscal condition, the currently-available economic development programs, tax competition from other communities, the electoral environment in the community and expected gains in property values (Man, 1999). Most TIF districts operate with an entitlement philosophy; qualifying employers that locate their business within the district boundary are automatically entitled to the offered government benefit. Through academic study, TIFs have been shown to be effective in mitigating the effects of urban blight, but they also can be of benefit to communities with no blight at all (Dye and Sundberg, 1998). They also have been found to be useful in bolstering local retail economic development (Wassmer, 1994). Other research finds that economically

Tom Fellrath

distressed cities are be more likely to establishment of TIFs, and that growing cities, with past accumulated wealth, are less likely to establish TIFs of their own (Man, 1999).

Tax abatements Governments use property tax abatements, which are applied on a per-recipient basis, to offer the recipient a lightened tax burden over the course of a defined period of time as long at the recipient fulfills whatever obligations are negotiated in the issuance of the abatement. Because the incentive is applied against the recipients tax bill and not against a specific production input or financial loan, this form of economic development incentive is popular amongst recipients for the flexibility that it provides.

Academic literature pertaining to tax abatements is extensive (Reese 1999). While the reasons for this are many, one possible rationale is that tax abatements are another reasonably easy form of economic development incentive to analyze. One company asks for a tax abatement from a municipality, and the deal is consummated in a reasonably measurable transaction. If a state tracks their abatement transactions never a given considering the quasi-confidential world of public sector economic development then meaningful comparative research can be conducted. The abundance of research in a few states (like Michigan) yet absence of research in so many others reinforces this view.

Research from Michigan suggests that tax abatements are particularly useful when the community is in good fiscal health, the applicable governmental structures have not undergone reform and the economic development executives conduct themselves more professionally

Tom Fellrath

(Reese (1999), Reese (2006)). These communities are more likely to offer tax abatements, and companies are more likely to look fondly on these attractive communities when considering a relocation of business operations. As Reese says, the greater the attractiveness of the city, the greater the growth, the greater the demand for abatements and the greater the numbers granted (1999, p. 176).

As such, tax abatements are heavily trend-driven. Municipalities that engage in tax abatements are more likely to offer other tax abatements. In addition, companies considering relocating will look to communities that offer abatements potentially within their industry cluster, giving the company a stronger feeling at an abatement request would be positively considered - and make the same request of them. Also, recidivism in corporate abatement requests is a significant factor. Some discretionary abatements are offered with such consistency that they could be considered de facto entitlements (Bartik, 2005). Taken together, it is reasonable to assume that municipalities that have built industry clusters of like employers on the backs of tax abatements will be more likely to receive abatement requests from similar businesses and, using past practice as a guide, be more likely to grant the abatements (Reese, 2006).

Criticism Academic criticism abounds regarding economic development and whether economic development incentives actually serve the interests of the citizens to whom the government is responsible. The social scientific community lacks consensus that economic development activities result in business relocations, entrepreneurial activity and healthier local economies that would not have occurred if not for the work of economic development and its incentives

Tom Fellrath

10

(Giloth, 1991, Reese, 1999, Saiz, 2001, Reese & Sands, 2006). Incentive performance is very inconsistent, even within the same community (Wassmer, 1994). Perhaps the most damning criticism, however, is that economic development activity in the pursuit of new business attraction diverts municipal attention from existing businesses the largest source of new jobs (Dewees et al, 2003). If economic development is about wealth creation and by extension, job creation, why would one want to divert attention from those who create jobs?

Researchers question whether economic development incentives largely are too small to have a meaningful impact on the behavior of a firm that is looking to relocate, implying that the incentives themselves may be wasting the peoples monies (Giloth, 1991, Reese, 1999, Reese & Sands, 2006, Gorin, 2008). Local officials often overstate the benefits of the incentive offered, perhaps for greater political effect (Bartik, 2005). A sharper critique suggests that incentives exert no effect, or are only positively associated with further economic decline of distressed communities (Wassmer, 1994).

Employment growth, a main rationale of economic development in pursuit of community-shared wealth, is subject to similar criticism. Empirical research has shown that economic development incentives have a minimally positive-to-negative effect on employment growth among companies receiving incentives (Giloth, 1991, Gabe & Kraybill, 2002, Peters & Fisher, 2004). Furthermore, companies that received incentives were more likely to overstate employment projections, presumably to garner a larger discretionary incentive (Gabe & Kraybill, 2002). Job creation per capita in central cities tends to lag behind their suburban municipal counterparts (Reese & Sands, 2006). Governments have also received criticism for offering incentives to

Tom Fellrath

11

employers whose jobs do not improve the wealth of their residents (Peters & Fisher, 2004, Bartik, 2005). In poorer communities, the residents appear to suffer from a mismatch in skills possessed when considering the skills required for employment in the incentive recipients places of work (Peters & Fisher, 2004).

Economic development incentives also have been shown to be distortionary, or leading employers to expand in suboptimal places (Giloth, 1991, Gorin, 2008). Part of this behavior might be explained by considering how dramatic drops in the costs of transportation, telecommunications and technology have made companies increasingly mobile in recent years (Bartik, 2005). The revolutionary shift alluded to in the mobilization of industry cannot be understated, as it disrupts the economic development bargaining balance between incentive grantor and recipient. This mobilization has allowed incentive seekers to exploit fixed-base municipalities (McFarlane, 2003).

Further consideration of the issues of effectiveness and exploitation of municipalities leads to the increasing size of economic development incentives. A given economic development package, or combination of incentives, for a major employer like an auto manufacturer, has risen from the tens of millions of dollars in the 1980s to the hundreds of millions of dollars today (Gorin, 2008). This raises the serious concern that public sector incentives have grown to the point that the public will never recoup a sufficient amount of tax revenue and jobs for the incentive it has provided from an increasingly scarce pool of discretionary resources (Reese, 1999, Downing, 2004, Bartik, 2005, Reese & Sands, 2006).

Tom Fellrath

12

There appear to be two distinct schools of thought on the relationship of a municipalitys fiscal health and the application of economic development incentives, both using empirical research to defend their positions. One group suggests that growing, healthy communities use incentives to enhance their positions, and the other suggests that economically-strapped municipalities are more aggressive in offering incentives to jump-start their communities turnarounds (Reese, 2006). This schism in evaluation speaks to the aforementioned lack of consensus. Additional research suggests that a communitys health generally is inversely proportional to the level of tax abatement activity. This trend is bucked by exurbs, which use abatements liberally and are experiencing growth on a number of fronts (Reese & Sands, 2006). There is disagreement as to whether the incentive-community health research itself is flawed or based upon flawed data (Gorin, 2008).

Criticism pours down on poor economic development incentive program design and execution. Programs with multiple and vague goals, insufficient administrative capacity and lack of control over key decision-making like underwriting and final incentive approval are less likely to produce a positive answer to the research question (Gilroth, 1991). Economically strapped communities, and those with substandard economic development staff, may conduct inadequate or inaccurate evaluations of incentive requests, further reducing the likelihood of economic development success (Wassmer, 1994). The data and methods of assembling the cost-of-doingbusiness analyses upon which economic development incentive decisions depend can be questionable at best (Luger & Suho, 2006). The contracts in which economic development incentives are granted are sometimes poorly written and inadequately enforced, in part due to poor accountability structures (Weber, 2002). Another considerable stumbling block is the lack

Tom Fellrath

13

of publicly available data on incentives awarded by states and municipalities (Bartik, 2005, Reese & Sands, 2006, Gorin, 2008). Given this lack of technical expertise, data and analysis, policymakers often ignorantly consider any economic development to be good development, and that is not always the case (Bartik, 2005).

A unique criticism of economic development incentives involves the fact that nearly every incentive results in some additional income tax for the recipient as a result of increased profits or lowered costs. As the Federal government is the largest recipient of employers taxes and does not offer incentives itself, it can be argued that those who offer economic development incentives are simply subsidizing the Federal government (Rasmussen et al, 1984).

While application of economic development incentives may be useful for one communitys purposes, it often comes at the expense of another community making economic development attraction efforts a zero-sum game (Reese & Sands, 2006, Gorin, 2008), which raises the point that a state that subsidizes the relocation of an employer within the state through an incentive incurs a loss in revenue (Peters & Fisher, 2004). On the inter-state front, we are faced with a subsequent legal criticism. Some legal professionals suggest that such a zero-sum environment of inter-urban and inter-state competition to poach each others employers and their jobs may violate the Commerce Clause of the United States Constitution (McFarlane, 2003). While this author is not qualified to analyze such an argument, it still warrants a mention.

Positive discussion of economic development incentives is harder to find, but it appears that more recent research has concluded that there are circumstances under which economic

Tom Fellrath

14

development incentives can be proven effective (Reese, 1999, Gorin, 2008). Also, a reactionary thread of research, which is focused on dispelling what it contends are incorrect conclusions regarding economic development and the use of economic development incentives, suggests that potential flaws in past analyses can be corrected (Gorin, 2008). The implication of this school of thought is that optimized analysis will result in a rosier view of economic development and economic development incentives.

Conclusion The available peer-reviewed literature regarding economic development and economic development incentives was largely neutral-to-negative on the general idea of economic development and application of economic development incentives to achieve economic development goals. This came as a surprise. At the same time, the overwhelmingly one-sided criticism, backed up by empirical research, forces any rational reader to reconsider the widelyaccepted premise that traditional economic development methodology especially the use of economic development incentives is the ideal approach to grow local, regional and state economies. Thus, future research should either look to improve the existing models or embrace entirely different concepts in economic development. There has to be a better way.

Tom Fellrath

15

References Accelerating Growth: Indianas Strategic Economic Development Plan. (2006). Indianapolis, IN: Indiana Economic Development Corporation. Bartik, T. (2005). Solving the problems of economic development incentives. Growth & Change, 36(2), 139-166. Clark, C., & Montjoy, R. (2001). Globalizations impact on state-local economic development policy. Policy Studies Review, 18(3), 5-12. define: economic development. (2009, November 20). Retrieved November 20, 2009 from Google website: http://www.google.com/search?hl=en&safe=off&rlz=1C1GGLS_enUSUS291US303&defl=en&q=define:Economic+development&ei=9vsGS_HmOoKCnQf TzJW_Cw&sa=X&oi=glossary_definition&ct=title&ved=0CAcQkAE Dewees, S., Lobao, L., & Swanson, L. (2003). Local economic development in an age of devolution: The question of rural localities. Rural Sociology, 68(2), 182-206. Downing, M. (2004). Incentives for economic development. Economic Development Journal, 3(2), 73-80. Dye, R., & Sundberg, J. (1998). A model of tax increment financing adoption incentives. (Cover story). Growth & Change,29(1), 90-110. Fisher, P., & Peters, A. (1997, March/April). Tax and spending incentives and enterprise zones. New England Economic Review, 109-137. Fleming, R., & Leonard, L. (2004). Regional collaboration and economic development, St. Louis style. Economic Development Journal, 3(2), 11-20. Gabe, T., & Kraybill, D. (2002). The effect of state economic development incentives on employment growth of establishments. Journal of Regional Science, 42(4), 703-730.

Tom Fellrath

16

Giloth, R. (1991). Designing economic development incentives: The case of industrial development bonds in Chicago: 1977-1987. Policy Studies Review, 10(2/3), 161-171. Gorin, D. (2008). Economic development incentives: Research approaches and current views. Federal Reserve Bulletin, A61-A73. Luger, M., & Suho, B. (2006). Speaking falsehoods to power: States' misguided use of "Cost-ofDoing-Business" studies in economic development policy. Review of Regional Studies, 36(1), 15-43. Man, J. (1999). Fiscal pressure, tax competition and the adoption of tax increment financing. Urban Studies, 36(7), 1151-1167. McFarlane, A. (2003). Local economic development incentives in an era of globalization: The exploitation of decentralization and mobility. Urban Lawyer, 35(2), 305-316. Peters, A., & Fisher, P. (2004). The failures of economic development incentives. Journal of the American Planning Association, 70(1), 27-37. Rasmussen, D., Bendick Jr., M., & Ledebur, L. (1984). A methodology for selecting economic development incentives. Growth & Change, 15(1), 18-25. Reese, L. (1999). Modeling economic development decision-making: The case of tax abatements. Policy Studies Review,16(2), 175-193. Reese, L. (2006). Not just another determinants piece: Path dependency and local tax abatements. Review of Policy Research, 23(2), 491-504. Reese, L., & Sands, G. (2006). The equity impacts of municipal tax incentives: Leveling or tilting the playing field?. Review of Policy Research, 23(1), 71-94. Rubin, H. (1990). Attitudinal effects of public-private cooperation in economic development. Policy Studies Review, 9(4), 787-802.

Tom Fellrath

17

Saiz, M. (2001). Politics and economic development: Why governments adopt different strategies to induce economic growth. Policy Studies Journal, 29(2), 203-214. Wassmer, R. (1994). Can local incentives alter a metropolitan city's economic development?. Urban Studies, 31(8), 151-158. Wassmer, R. (1992). Property tax abatement and the simultaneous determination of local fiscal variables in a metropolitan area, Land Economics, 68(August), 263-282. Weber, R. (2002). Do better contracts make better economic development incentives?. Journal of the American Planning Association, 68(1), 43-55.

Tom Fellrath

18