State investment tax incentives: A zero-sum game?☆
Introduction
Over the past four decades, state investment tax incentives have proliferated (Chirinko and Wilson, 2007a). For instance, though the U.S. federal investment tax credit (ITC) was permanently repealed in 1986, ITCs at the state level have grown dramatically. As shown in Fig. 1, 40% of states now offer a general, state-wide tax credit on investment in machinery and buildings, and the average rate of this credit exceeds 6 percentage points in 2004. The abundance of this and other state investment tax incentives raises important empirical questions — are these tax incentives effective in increasing investment and other forms of economic activity within the state? Academic research is far from a consensus on this point. Fisher and Peters, 1998, pp. 12–13) state that “[I]n the case of the first argument [economic development incentives probably can influence firm location and expansion decisions…], the literature is massive but still inconclusive; …” In his survey paper, Wasylenko (1997, p. 38) concludes that elasticities of various forms of economic activity to tax policy “are not very reliable and change depending on which variables are included in the estimation equation or which time period is analyzed.” By contrast, an overview of papers (including Wasylenko's study) presented at a conference focusing on the effectiveness of state and local taxes reports that there was general agreement that state and local policies affect economic activity within their borders, though the effects “are generally modest” (Bradbury, Kodrzycki, and Tannenwald, 1997, p. 1). A similar conclusion is reached in the encyclopedia entry by Bogart and Anderson (2005) concerning the effects of state policies on firm location. Perhaps the title of the report by McGuire (2003) best summarizes the current state of the scholarly empirical literature — “Do Taxes Matter? Yes, No, Maybe So.”
To the extent tax incentives are effective in raising investment within a state or attracting businesses to a state, a second question arises from a national perspective — how much of this increase is due to investment being drawn away from other states? As noted by Stark and Wilson (2006), surprisingly few empirical studies have addressed this question. Understanding the source of the increase in capital formation and establishment count is important for assessing whether the increase merely reflects a zero-sum game among states and for informing discussions about the constitutionality of certain state tax incentives in light of the U.S. Constitution's Commerce Clause.1
These two questions are addressed in this paper with a comprehensive new panel dataset that we constructed covering the 48 contiguous states for 20+ years (depending on the series). This dataset allows us to define variables tied tightly to theory and to utilize a variety of powerful econometric techniques. Panel data have the decided advantages of allowing us to control for factors such as land and infrastructure that are fixed or change slowly over time and for aggregate effects such as the business cycle. The relative scarcity of empirical research on interstate capital mobility and tax competition may be traceable in good part to the absence of comprehensive data. Section 2 describes the panel dataset that is drawn from a several sources, including the Annual Survey of Manufacturers, national data from the Bureau of Economic Analysis, and a variety of sources of information on state tax variables. Details concerning construction and sources are provided in the Data Appendix.
We then develop and estimate a series of models to understand the responses of capital stock and establishment count data to tax incentives embedded in the user cost of capital. Section 3 contains a Capital Demand Model motivated by a standard first-order condition relating the capital stock to output and the user cost of capital. We specify the latter as the ratio of a state's own user cost of capital relative to the user cost of capital for a competitive set of states. The user cost of capital is based on the Hall–Jorgenson concept that relies on the equivalence between renting and owning a durable asset. Based on this insight, durable capital can be assigned a rental price that easily incorporates a variety of tax variables and can be analyzed with the traditional tools of price theory. The tax variables affecting this rental price qua user cost are the investment tax credit rates (state and federal), the corporate income tax rates (state and federal), and the state property tax rate. We find that a state's capital formation (conditional on its output) decreases with the user cost prevailing in the state but increases with the user cost available in competitive states, thus documenting the importance of interstate capital flows, a necessary element for meaningful tax competition. State investment incentives appear to be a zero-sum game among the states in that an equiproportionate increase in own-state and competitive-states user costs tends to have no effect on own-state capital formation.
Section 4 develops and estimates the Twin-Counties Model explaining the location of manufacturing establishments at the county level. This model exploits both the spatial breaks, or “discontinuities,” that occur at state borders (and the resulting “natural experiment” afforded by pairs of counties in the same geographic area but separated by a state border) and the panel structure of our data to assess the effects of tax policy as reflected in the user cost. Comparing the differential outcomes of county pairs with similar nonpolicy conditions but differing state policies is akin to the twin studies employed frequently in labor economics and medical research. The Twin-Counties Model uncovers a statistically significant, though economically small, effect of user costs prevailing at the state level on the location of establishments at the county level. Moreover, this small effect vanishes as the distance between paired-counties increases. These findings suggest that manufacturing establishments are much less geographically mobile than overall capital.
Section 5 summarizes and concludes.
Section snippets
The panel dataset
The data constructed for and used in this paper measure economic activity in the manufacturing sector for the 48 contiguous states. This data set may be thought of as a state-level and county-level analog to other widely used data sets, such as the industry-level NBER Productivity Database, Dale Jorgenson's “KLEM” database, or the country-level Penn World Tables. This section provides a cursory overview of the construction of the five key series used in this paper: two quantity variables
Capital demand model
The first of the two models assessing the impact of own-state and competitive-states tax incentives is motivated by the first-order condition for optimal capital accumulation. This condition is at the core of the vast majority of econometric equations of capital formation (Chirinko, 1993). Subsection 1 contains a derivation of the estimating equation containing the relative user cost of capital, defined as the own-state user cost relative to the competitive-states user cost. Subsection 2
Twin-counties model
A key problem confronting applied work on the impacts of government policy is separating policy effects, which are the primary object of our analysis, from the nonpolicy effects, which are undoubtedly quantitatively important but not of immediate interest. In the previous section, we relied on the first-order condition for capital demand to suggest the appropriate specification. This section addresses the key problem in an alternative way by exploiting the spatial discontinuity that occurs at
Summary and conclusions
This paper is motivated by the dramatic increase in state investment incentives over the last 40 years. As documented in Fig. 1, investment tax credits have become increasingly large and increasingly common among states. In 2004, the average rate of the investment tax credit (for adopting states) is greater than 6%. This increased usage and size of state investment credits, as well as other tax incentives, leads to two questions: Are these tax incentives effective in stimulating investment
References (29)
- et al.
Estimates of the economic returns to schooling from a new sample of twins
American Economic Review
(1994) - et al.
Business location and taxation
- et al.
The effects of state and local public policies on economic development: an overview
New England Economic Review
(1997) - et al.
An Introduction to Geographical Economics
(2001) Business fixed investment spending: modeling strategies, empirical results, and policy implications
Journal of Economic Literature
(1993)- et al.
State Investment Tax Incentives: What are the Facts?
- et al.
Tax competition among U.S. States: racing to the bottom or riding on a seesaw?
- et al.
Industrial Incentives: Competition Among American States and Cities
(1998) The Economic Effects of Taxing Capital Income
(1994)- et al.
Application of the theory of optimum capital accumulation
Large sample properties of generalized method of moments estimators
Econometrica
The effect of state policies on the location of manufacturing: evidence from state borders
Journal of Political Economy
Analysis of Panel Data Second Edition
Quasi-experimental control group methods for regional analysis: an application to an energy boomtown and growth pole theory
Economic Geography
Cited by (125)
Immigrant inventors and local income taxes: Evidence from Swiss municipalities
2023, Journal of Public EconomicsThe effectiveness of job creation tax credits
2021, Regional Science and Urban EconomicsFailure to launch: Measuring the impact of sales tax nexus standards on business activity
2021, Journal of Public EconomicsInnovation, on-the-job learning, and labor contracts: an organizational equilibria approach
2022, Journal of Institutional EconomicsCorporate Taxation
2023, Annual Review of Economics
- ☆
We would like to acknowledge the excellent research assistance provided by Ann Lucas and Charles Notzon and very useful comments from participants at the IFIR/CESifo Conference on New Directions in Fiscal Federalism (especially our discussant, Hanna Ǻgren), the 2006 North American Regional Science Council meeting (especially our discussant, Georg Grassmueck), seminars at the Federal Reserve Bank of San Francisco, University of Illinois at Urbana-Champaign, and the University of Illinois at Chicago and from Richard Arnott, three anonymous referees, and the editors. Financial support from the Federal Reserve Bank of San Francisco is gratefully acknowledged. Chirinko thanks the European University Institute for providing an excellent environment in which to complete this research. All errors and omissions remain the sole responsibility of the authors and the conclusions do not necessarily reflect the views of the organizations with which they are associated.