Economic developers and policy makers seeking advice on creating tax incentives that are effective yet fiscally responsible have another resource at their disposal. Following our summary last week of an IMF report on national tax incentives, this week’s post describes findings from a new research report by the Pew Charitable Trusts that addresses ways to use data and design to make state tax incentives more predictable.

Gather and share high-quality data on the costs of incentives

Easier said than done, but important steps are to forecast the costs on a regular basis with frequent updates, monitor commitments of large or high-risk programs – especially those that lack protections that would limit costs, and share information across agencies that authorize or issue incentives and those that process tax returns.

These seem like obvious steps, but several barriers prevent easy implementation. Agencies are often reluctant to share information or find it hard to do so given legacy information systems that are not well-integrated across state government. Many incentive programs still use paper applications, making data sharing even more difficult. Important concerns over confidentiality can also hinder the gathering and sharing of tax incentive data. The report provides several examples of how states are addressing these challenges.

Design incentives in ways that reduce fiscal risk

Program design can make it easier to forecast costs and limit runaway program use. Ideas include:

  • Annual caps on program costs – States are increasingly applying caps to some of their programs but it is not a universal practice. Iowa has taken an interesting approach by providing an aggregate limit across several economic development tax credits to maintain some flexibility in use among individual programs.

  • Control the timing of redemptions – Putting time limits on carryforwards, capping redemptions, and specifying the redemption schedule are some options for states.

  • Require lawmakers to pay for incentives through budget appropriations – The report acknowledges that the appropriations process is “far more common for cash incentives than it is for tax incentives.”

  • Restrict the ability of companies to redeem more in credits than they owe in taxes – Many states make credits transferable or refundable so that small and new businesses that don’t have a substantial tax liability can benefit from the programs. The report notes that since refundable program rules can result in companies receiving more in benefits than they owe in taxes, the net cost to the state can escalate.

  • Link incentives to company performance – Performance based incentives in which tax benefits are not received until the company starts paying taxes are becoming more standard.

  • Require businesses to provide advance notice of program participation – Requiring companies to apply in advance for tax credits creates an opportunity to anticipate costs.

You can download the full report here: Reducing Budget Risks: Using data and design to make state tax incentives more predictable (December 2015, Pew Charitable Trusts).