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Many American communities seek to attract or retain businesses with tax abatements, tax credits, or tax increment financing of infrastructure projects (TIFs). The evidence for 1999 indicates that communities are most likely to offer one or more of these business development incentives if their residents have low incomes, if they are located close to state borders, and if their states have troubled political cultures. Ten percent greater median household income is associated with a 3.2% lower probability of offering incentives; 10% greater distance from a state border is associated with a 1.0% lower probability of offering incentives; and a 10% higher rate at which government officials are convicted of federal corruption crimes is associated with a 1.2% greater probability of offering business incentives. TIFs are the preferred incentive of communities whose residents have household incomes between $25,000 and $75,000; whereas TIFs are much less commonly offered by communities whose residents have household incomes below $25,000. The need to finance TIFs out of incremental tax revenues may make it infeasible for many of the poorest of communities to use TIFs for local business development.

Local governments in the United States compete with each other to attract businesses and thereby enhance the economic prospects of local residents. This competition takes many forms, commonly including offers of tax-based incentives to firms that can be induced to establish, expand, or maintain local business operations. These tax-based incentives consist of direct tax benefits, that include abatements of existing taxes or credits against potential tax liabilities, and the use of tax increment financings (TIFs) of business-oriented infrastructure projects. There is widespread use of these incentives: 56% of American communities report offering tax-based business development incentives in 1999, a fraction that rose to 59% by 2004. The US aggregate dollar value of business development incentives is not known, though journalistic accounts put the annual figure in the neighborhood of $80 billion.1 Despite the attractiveness of encouraging local business activity, many jurisdictions in the United States have been unwilling to provide tax-based business development incentives. This reluctance stems from many sources, including the potential revenue costs of such concessions, doubts about their effectiveness in encouraging business activity, a philosophy that across the board tax reductions are more effective than targeted tax incentives, and perhaps an evaluation that the benefits of greater business activity are not worth the costs. Communities with differing economies and demographics may well evaluate these tradeoffs differently. Furthermore, even governments of communities that agree on the potential value of targeted tax incentives may not all offer them, given the realities of bureaucratic and political barriers to implementing programs that require effective action. The goal of this paper is to understand why cities and counties offer the tax-based business incentives that they do. The analysis starts by identifying the characteristics of US communities that are associated with provision of tax-based business incentives. Then the empirical work considers only those communities that provide incentives, distinguishing features associated with providing TIFs from features associated with providing tax abatements and credits. Several patterns are evident in the data. Heavily populated cities and counties, those with low median incomes, and those with larger concentrations of manufacturing industries, are the most likely to offer business incentives. The correlations of these characteristics and the provision of business incentives at least in part reflect the value that communities with strong economic needs attach to attracting new employment opportunities, and the willingness of these communities to forego tax revenue in return. Communities with lower incomes are more likely than others to offer business tax incentives, but this proclivity is no more pronounced among those with higher fractions of very poor residents (below $25,000 household income) than it is among communities with higher fractions of middle income residents ($25,000–$75,000 household income). The need for economic activity may be greatest in the poorest communities, but business tax incentives somewhat less effective there than elsewhere, and more difficult for local governments to implement. Two additional noteworthy features characterize communities offering business tax incentives. The first is that communities located close to state borders are significantly more likely than others to offer incentives. Proximity to other states increases the competitiveness of the environment for attracting business, driving communities to offer attractive packages even to retain existing businesses. Furthermore, the prospect of attracting businesses and accompanying tax revenue from other states may increase the willingness of state governments to offer financial and other assistance to their own communities that provide business development incentives. The second feature is that cities and counties in states with troubled political cultures demonstrate the greatest willingness to offer business development incentives, the evidence indicating that increasing the rate at which government officials are convicted of federal corruption crimes by 1 per 100,000 residents over a 13 year period is associated with a 2.9% greater chance that a community will offer business incentives. One possibility raised by this evidence is that small numbers of corrupt and quasi-corrupt government officials in these jurisdictions provide business incentives in return for cash, political support, or other forms of payouts. A different, and perhaps only slightly more flattering, interpretation is that jurisdictions in states with troubled political cultures are more likely than others to have dysfunctional tax and regulatory systems that make it difficult for them to compete for businesses except by offering special incentives. The second part of the paper’s empirical investigation considers only those communities offering some business tax incentives, identifying the characteristics associated with provision of direct tax reductions, in the form of tax abatements or tax credits, rather than provision of infrastructure improvements (such as new roads and sewer facilities) facilitated by tax increment financing. Tax increment financing typically entails debt-financed projects for which subsequent additional revenue (arguably) attributable to enhanced business activity is devoted to paying off the debts incurred in undertaking the infrastructure improvements. Among jurisdictions that offer incentives, those with significant numbers of households with incomes less than $25,000 are the most likely to offer tax reductions rather than TIF-supported infrastructure programs, whereas those with significant numbers of households with incomes between $25,000 and $75,000 are the most likely to offer TIFs rather than tax reductions. By this measure TIFs appear not to be effectively directed toward the lowest-income communities. And political culture appears to influence the form as well as the level of development incentives: increasing the rate at which government officials are convicted of federal corruption crimes by 1 per 100,000 residents over a 13 year period is associated with a 5.9% greater probability that a community will offer tax reductions rather than TIFs. The empirical patterns are consistent with purposeful choice of business development incentives. Communities with low-income residents stand to benefit from employment and other economic opportunities that accompany greater business operations, but are often unable to use TIF programs due to the inability of even enhanced business activity to generate sufficient local tax revenue to retire debts acquired in undertaking the accompanying infrastructure projects. Self-interest of a different kind may be at work in the proclivity of communities in states with higher rates of federal corruption convictions to favor direct tax benefits over TIFs, though this pattern may also reflect bond market skepticism of the ability and willingness of troubled political systems to repay in full any obligations incurred in the course of providing business infrastructure. Section 2 of the paper discusses the challenges that communities face in using business development incentives to attract and retain business activity. Section 3 describes the available data on the practices of American communities in offering tax-based business incentives in 1999. Section 4 presents the results of estimating the determinants of who offers business incentives; Section 5 presents the results of estimating, among communities offering some kind of incentive, the determinants of who offers tax reductions or TIFs to the exclusion of the other. Section 6 is the conclusion.

American cities and counties frequently offer business development incentives; variations in this practice suggest some of their motives in doing so. Communities with low incomes, those located close to state borders, and those in states with more troubled political cultures are the most likely to provide incentives. Among the incentives provided, the poorest communities prefer to offer tax abatements and credits rather than TIFs, whereas for middle-income communities TIFs are much more likely to be the incentive of choice. It is not difficult to understand the motives of low-income communities in seeking to attract greater business activity, with its accompanying economic opportunities for local residents, even if doing so entails foregoing potential sources of tax revenue. States also face a tradeoff between business activity and tax revenue, with the added complication that incentives offered by one locality in a state may have the effect of drawing business away from other jurisdictions in the same state. Consequently, it makes sense for states to encourage local business development incentives more strongly in the case of jurisdictions located near borders with other states, since more of the impact of relocating business activity is likely to come at the expense of another state. Possibly as a result, cities and counties proximate to state borders are more likely than others to offer business development incentives. The evidence on state political culture probably reflects the operation of more subtle considerations. In the international context Dharmapala and Hines (2009) report that tax havens, which are zero- or very low-tax countries and territories, score higher on measures of governance quality than do higher-tax countries with similar incomes and populations. The interpretation they offer is that the attractiveness of a low-tax environment would be insufficient to draw significant added business activity to a country otherwise plagued by bad governance and the economic problems that accompany it. The costs of bad governance in American cities and counties are doubtless considerably smaller than they are in some other parts of the world, but their potential to influence resource allocation is nonetheless quite real. Tax havens operate by providing general tax relief to outside investors, which avoids at least some of the potential for insider deals and affords a more reliable business environment than one in which deals are individually negotiated and may need to be subsequently renewed. Similarly, American communities in states with less troubled political cultures tend to avoid offering business incentives, presumably because they prefer to tailor their general tax levels, spending programs, and other policies to attract businesses without designing specific deals for specific firms and industries. Among communities that offer incentives there are clear patterns in which those with very poor residents, and those in states with more troubled political cultures, are less likely than others to provide TIFs. TIFs can be financed only in cases in which it might be reasonably anticipated that tax revenues will rise as a result of greater infrastructure expenditures, and this design feature makes it very difficult to use them in the poorest of communities. Troubled political cultures likewise impede the ability of communities to offer TIFs, and may also influence their desire to do so, since direct tax benefits in the form of abatements and credits may hold more appeal. Communities are most likely to offer business development incentives when they stand to benefit from the resulting business activity and the economic environment makes it feasible, or – in the most competitive situations – almost irresistible, that they do so.