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Why Do Cities Offer Tax Incentives to Businesses?

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Question: Why Do Cities Offer Tax Incentives to Businesses?
Answer:

Attracting businesses, keeping them and getting them to expand operations often involves a city providing tax incentives. While this seems to some like corporate welfare, cities do not simply give away money to corporations in these deals. Cities weigh the expected benefits with expected costs to determine whether they should proceed with a particular tax incentive package.

It would be nice for citizens if local governments paid them to stay maintain residence within a city, but that’s just not going to happen. One household coming to a city is not going to make a noticeable impact on the city’s economy. Hundreds coming to a city will.

Cities usually task their economic development directors with crafting policies that allow for cities and businesses to enter into mutually beneficial agreements on tax incentives. Cities adopt these policies so that they do not have to go back to the drawing board each time a business wants to come to town or expand. Having tax incentive policies allows a city to be up-front with businesses, accountable to citizens and mitigate the appearance of cronyism. Policies allow cities to stick to what they have already determined in their best interest while enticing new businesses and retaining existing ones.

Leveraging Economic Benefits:

When businesses can boost to the local economy, they use that as leverage. They even play cities off one another like an individual planning to buy a car will play two dealerships off one another. As soon as one city offers five years of tax abatement, a business will go to other cities seeking ten years.

Businesses try to get cities to offer more than what their policies provide. City leaders must weigh the pros and cons of sticking to policy versus offering more for a really good deal.

When added up over time, providing tax incentives is bad for taxpayers, but in individual situations, cities will compete with each other. When the cities are located in different states, state officials may lend a hand in attracting a business. As long as cities are willing to play the game, businesses will keep seeking tax incentives for activities they would likely do without any assistance from local government.

While tax incentives are an important reason businesses choose to locate on one city over another one, businesses also consider non-financial factors in their decisions. Political climate, housing prices, education, parks and arts are other inputs into the decision-making process.

Analyzing the Costs and Benefits:

When tax incentives are considered, city staff project what the city stands to gain by the business coming, staying or expanding. These benefits are predominantly property tax revenue and other tax revenue associated with added employees that are expected to relocate to the city or be hired from the city’s existing population.

If a new business buys a tract of land and builds a factory on it, the business increases the city’s property tax base. The factory adds value to the otherwise vacant land. The business may propose to the city to allow it to pay a reduced property tax rate for the first few years the factory is open. This helps the business lower its tax liability while other operating costs run unusually high.

Keeping with the factory example, say that the factory expects to employ 1,000 people, 900 of whom are expected to be people who move to the town because of factory jobs. The city will experience an increase in property values because of all the new home buyers. It will also receive more sales tax and user fee revenue because these people move to town.

Such benefits are considered along with costs the city will incur because of the business activity. Those costs include infrastructure expansions and additional city employees necessary to serve the growth in population. Infrastructure costs could include widening streets, installing more street lighting, extending sewer lines and building new fire and police stations. Additional city employees could include more police officers, firefighters and employees needed to support a larger organization such as accountants and administrative assistants.

Doing the Deal:

Cities try to stick to their economic development policies because those policies have been thoroughly vetted through economic analysis, legal opinions and the local political climate. Cities risk making mistakes when they move away from what they have carefully planned.

If a city believes a tax incentive package is a good deal and that other cities may entice the business away, the city will likely make the deal even if they have to deviate from policy. The city’s goal is to at least break even. City officials want the expected revenue to exceed the costs of foregone tax revenue and added operating costs.

The city’s economic development director is usually the city’s chief negotiator in tax incentive deals. When the economic development director believes that straying from policy may be prudent, the director gathers input from other local officials and business interests such a local economic development boards, school officials and chambers of commerce. When policy is followed, additional input is not really necessary. The city manager approves any deals before they are submitted to the city council for final approval.

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