A new Upjohn Institute study provides guidance to governments for analyzing incentive options. In this article, Jeff Chapman and Mark Robyn of The Pew Charitable Trusts explain the study’s findings and describe the cost-benefit model behind the findings:

State and local governments commonly use economic development incentives such as tax credits and exemptions to try to boost their economies by encouraging businesses to relocate or expand within their borders. But such incentives can represent major budget commitments, costing these governments tens of billions of dollars every year. To make the best decisions about which policies to pursue, policymakers need reliable, high-quality tools and methods for evaluating their incentives and ensuring that they yield the intended results.

New research by Timothy J. Bartik of the W.E. Upjohn Institute for Employment Research offers practical guidance. In a recently released report, “Improving Economic Development Incentives,” the institute’s senior economist examines how policy design choices influence the economic impact of incentives and draws some conclusions to help state and local leaders assess and improve their policies.

To perform this analysis, Bartik developed an innovative economic simulation model to comprehensively estimate the local economic effects of business incentives. The model accounts for a range of economic impacts, both positive and negative, to determine whether the benefits of an incentive outweigh its costs or whether those resources might be more effectively used elsewhere.

Drawing on this research, which was partially funded by The Pew Charitable Trusts, Bartik offers guidance to policymakers on evaluating existing and proposed incentives. For example, he finds that governments should:

  • Account for how incentives are paid for and consider capping program costs.The cost of incentives must be offset by reduced spending or increased taxes, both of which have consequences that must be considered in a complete evaluation. For example, Bartik finds that paying for a program by cutting education spending can reduce students’ future wages, which can far outweigh the incentive’s more immediate positive economic impact. He also recommends capping the cost of incentives to avoid unexpected or excessive budget impacts.
  • Focus on high-impact industries. Bartik recommends targeting companies that will have a greater economic impact on the local economy, such as those that pay higher wages or that benefit from existing networks of local suppliers and industrial clusters.
  • Consider alternatives to tax incentives. In some cases, providing customized business services—such as job training and manufacturing extension services—may have a much larger economic impact than tax breaks. These services can be effective when targeted at small or medium-size companies that lack the financial resources or knowledge to acquire these services on their own.

Overview of the underlying model

To produce comprehensive cost-benefit analyses of incentives, Bartik developed a model that estimates how an incentive’s effects cascade through the economy as well as the impact on state and local budgets. These calculations can provide a thorough account of both positive and negative consequences.

When an incentive coaxes a business to expand or relocate, it directly results in new jobs and more income. These jobs and dollars then ripple through the local economy, creating additional jobs at suppliers and retailers. This increased economic activity can provide a modest boost to tax revenue, but will generally not fully pay for the cost of the incentive.

Moving beyond these initial positive impacts, the simulation also accounts for important factors that are sometimes overlooked. For example, building on studies on how sensitive business activity is to taxes and incentives, Bartik estimates that average-size incentives will usually not be the decisive factor in a business’ planning. Rather, many businesses that receive them would have made the same location or expansion choice even without the incentives.

More generally, incentives reduce the revenue available to policymakers and must be paid for by either increasing taxes or decreasing spending on other priorities, both of which can have negative economic impacts. The job opportunities created also can drive migration into the area, which then increases demand on public services.

Bartik’s model adds up these and other effects to determine whether the total benefits for local residents exceed the costs. This model and its underlying evaluation methodology can be a valuable resource for policymakers and government officials considering how to comprehensively evaluate their economic development policies. Future research by Pew will expand on this work to illustrate how the effects of incentives can vary depending on how policies are designed, what types of businesses receive incentives, and how those incentives are financed.

This article was originally published on The Pew Charitable Trusts website.