Economics on the Silk Road: Let's cut to the chase

Do tax cuts attract firms?

Since Kazakhstan gained independence in 1991, foreigners have invested more than $100 billion in its capacity to produce, said the country?s minister of economic development and trade, Kairat Kelimbetov. To stay on a roll, Kazakhstan is offering foreign firms some new subsidies -? even as it raises taxes on foreign firms already here. A 568-hectare industrial park in Almaty, next to the highway to Astana, would offer rail access and a terminal for containers. Not to be outdone, Astana is also developing an industrial park. Will such infrastructure subsidies attract enough firms to pay off?

Since 1960, statistical studies of this question in the United States have focused on cities and states, because of their avid competition for relocating firms. The results suggest that a city government can affect where the firm locates by spending wisely. Merely raising taxes may drive a firm away, especially if it can find a nearby local government with lower taxes. Within a city, a rise in taxes of 10 percent for one municipality may cause its business activity to drop by 10 to 30 percent, finds economist Timothy Bartik. Much depends on how the government spends the money. If it spends the additional tax revenues on providing more services, then the city economy may grow more rapidly. On the other hand, if it spends the money on programs that redistribute income, then the city economy may diminish.

Rather than raise taxes, the city may try to attract a firm by cutting them. For example, it may exempt new firms from paying property taxes for several years; or it may loan money to a developer, or guarantee a loan. Kyrgyzstan attracted a Coca-Cola plant to Bishkek in 1996 with a five-year tax break to take effect once the plant made a profit, reported The Washington Times. Evidently, Kyrgyzstan offered the tax break partly to offset the high transport costs in the country, perhaps stemming from the border that Uzbekistan closes periodically.

Some analysts fear that competitive tax-cutting may compel localities to ?race to the bottom,? where all tax rates are too low to finance worthwhile programs. In 1995, John Anderson and Robert Wassmer studied the Detroit area, where localities vied keenly for jobs in the wake of the city?s loss of market share in the global automobile industry. They found that, as more cities offered tax breaks, the remaining ones joined the pack more quickly, as if they were afraid of losing firms to their neighbors. After 15 years, the likelihood of offering tax breaks diminished, perhaps because residents began to oppose them. Indeed, richer cities were less likely to offer breaks than poorer cities, perhaps because the rich opposed factory pollution.

To avoid getting mauled in tax competition, local governments try to identify the best types of tax cuts. Studying Detroit in 1994, Wassmer found that subsidies tailored to particular firms rarely succeeded, but much depended on the city?s traits. Property tax breaks could boost manufacturing value in an old city, although they failed in the average city.

Rather than cut taxes, the city may issue bonds in order to buy land or machinery and lease it back to the firm at bargain rates. In Wassmer?s study, such industrial development bonds seemed to increase manufacturing value in new cities ? and to increase employment in old ones. In an old city, the bonds may add a few jobs but not overcome the loss in value that?s due to aging capital. The new city is more likely to attract a high-tech firm, which may use the bonds mainly to buy machinery in place of workers.

Tips for TIFs

Incentives attract few retail firms, since these must locate near their markets to survive. Only a huge tax break could persuade a retailer to leave its old market for one less profitable. In Wassmer?s study, about the only incentive that worked was using the retailer?s tax payments to finance city projects that benefited it in particular, such as new roads to its site. This is ?tax-increment financing? (TIF): The increment that the firm adds to the local tax base finances its own infrastructure.

This may sound like a good idea: The firm pays for services received, just like a customer in an ice cream store. Unfortunately, the city often will offer tax-increment financing only in a blighted area, hoping to redevelop it. But the area is blighted precisely because firms find it an expensive place in which to do business. The tax-increment financing thus induces firms to move from low-cost areas and into high-cost ones. That?s inefficient, since it reduces the amount that we can produce for a given cost. It?s like offering students a bribe if they will move from the quiet study areas of the library and into the concession room. They will study less.

Analyzing the Chicago area, Richard Dye and David Merriman found that communities adopting tax-increment financing grew more slowly, economically, as a result. Property values, measured by assessments, dropped by nearly a percentage point. The drop was not so severe for communities where the district offering tax-increment financing was larger compared to the entire community. When most of the city is in the district, then there are few opportunities to relocate a firm from the low-cost area outside the district. Hence relocations are less inefficient than in other cities.

Wassmer?s study of 25 cities in the Detroit area reached a similar conclusion. In 12 cases of a link between economic incentives and economic growth, the relationship was negative in seven: Cities that offered tax breaks grew more slowly. Wassmer suggested that slowly-growing cities are simply more likely to offer incentives to attract firms. Another possibility is that incentives persuade firms to move to the wrong areas.

Is it in the public interest for the city to offer tax breaks to try to create jobs? If markets work well, then every firm will locate where it maximizes profits. To offer a tax break may distort this decision, since the firm may impose costs on the jurisdiction that exceed the taxes that it pays. In Montgomery County, Maryland, an affluent suburb of Washington, D.C., Bartik found in 1989 that each new office job produced county revenues of $410 per year -? but required new highways that cost $347. This left little tax money to pay for sewers, water, police or fire safety. A tax break may better suit a city with a languishing economy and excess capacity, since the firm there would not congest roads and sewers.

Bartik argues that relocating jobs from areas of low unemployment to areas of high unemployment creates value. The jobless in an area of high unemployment will seek work more desperately, so they will value a job more highly. Also, relocating jobs from the growing economy will ease congestion of the infrastructure there ? and it will make better use of the empty infrastructure in the sluggish economy.

Could markets (broadly defined) handle these matters? If the jobless in the stagnant economy seek work more desperately, then they will offer to work for lower wages. That will attract firms naturally. If the infrastructure is congested in the growing economy, then the government can raise its taxes. That will drive away firms that cannot pay for the costs that they impose on the city.

Almaty, Astana and Bishkek do vie for business. But the competition that most interests Kazakhstan's government is international: Can Astana woo firms that otherwise would go to China? In the global arena, tax cuts and infrastructural subsidies don't work so well, since the foreign firm must pay high transport costs to relocate in another country. (In principle, a government could overcome this barrier by offering to pay the firm's relocation costs, but it usually finds this too expensive to try.) But the basic question -- can public subsidies to firms increase the net value of production? -- still pertains.

?- Leon Taylor, tayloralmaty@gmail.com

Good reading

John E. Anderson and Robert W. Wassmer. The decision to ?bid for business?: Municipal behavior in granting property tax abatements. Regional Science and Urban Economics 25: 739-757. 1995.

Timothy J. Bartik. Jobs, productivity, and local economic development: What implications does economic research have for the role of government? In Robert Wassmer, ed., Readings in urban economics: Issues and public policy.

Richard F. Dye and David F. Merriman. The effects of tax-increment financing on economic development. Journal of Urban Economics 47: 306-328. 2000.

Robert Wassmer. Can local incentives alter a metropolitan city?s economic development? Urban Studies 31: 1251-1278. 1994.

References

Kazinform. Industrial park of Astana city to attract private investors. Online. December 28, 2010.

Kazinform. Kazakhstan's policy in sphere of foreign direct investments attraction moves to non-oil & gas sector ? Kelimbetov. Online. May 26, 2011.

Kazinform. Over the years of independence about USD 130 bln invested in Kazakhstan - A.Rau. Online. May 26, 2011.

The Washington Times. Why do business in Kyrgyzstan? Online at http://www.internationalspecialreports.com/ciscentralasia/99/kyrgyzstan/6.html. 1999.

Source: http://centralasianeconomy.blogspot.com/2011/05/lets-cut-to-chase.html

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