Editor’s note: This article was updated on January 6, 2024 to correct details of certain tax credit programs and offices.
Tax incentives are one of the primary ways states seek to spur business expansion, increase job numbers, and otherwise strengthen their economies. Often, these incentives target small businesses, in an effort to help them grow or attract new sources of funding.
However, incentives may not be the most effective tool for the job of helping small businesses.
State policymakers employ several tax incentive methods to assist small businesses, such as:
But evaluations conducted by state officials have identified several obstacles preventing these incentives from effectively targeting and benefiting small businesses. These obstacles include:
Just as small businesses tend to have less revenue than large ones, they also tend to have lower tax liability, which can prevent them from claiming tax credits. For example, an evaluation of the Pennsylvania Brewers’ Tax Credit observed that most small brewers’ tax liability wasn’t high enough to use the credits before they expired. Instead, evaluators noted that the program primarily benefited large brewers, who could claim the credits thanks to their higher output and tax liability.
When it comes to program minimums, an evaluation of the Maryland capital investment program reported that high investment thresholds can deter small business participation. The program’s tax credit is distributed based on capital costs and requires a company to have at least $500,000 in project expenses, thus excluding many startup companies.
Program misalignment creates another obstacle for small businesses. Although states often are well-intentioned in trying to catalyze new business formation or help small businesses expand, some program benefits don’t reflect small businesses’ needs or characteristics. For instance, the Maryland Regional Institution Strategic Enterprise Zone program aims to promote economic and community development by incentivizing businesses, especially small and emerging ones, to locate or expand near qualified anchor institutions, such as universities, through property and income tax credits. But a state evaluation found that because many emerging businesses rent their office space, employ relatively few workers, and may not yet have state income tax liability, they were ineligible for the full tax credits, which require that businesses acquire property, increase employment, and have a state income tax liability against which to claim the awarded credits.
Many incentive programs are designed to target businesses that are most likely to expand a state’s economy by bringing in new money from outside the state. This approach helps prevent incentives from boosting some local businesses at the expense of others. A 2017 report on an early iteration of the CCTC noted that many of the credits going to small businesses were in locally serving sectors where sales are limited by consumer demand, such as retail and restaurants. As a result, the funding probably disadvantaged small businesses that did not receive awards because they had to compete with their counterparts who did get program funding. In response, the state legislature amended the CCTC in 2018 to better target businesses that would expand California’s economy.
Evaluations also highlight that the administrative demands of economic development programs can present obstacles for small businesses. Complex application requirements can deter potential applicants who might have limited staff capacity or in-house expertise. And expensive or unclear compliance rules may also be cost-prohibitive for small businesses. For instance, interviews conducted for the Minnesota research tax credit evaluation revealed that small firms bore a higher “time burden” during compliance audits, probably because they had fewer staff available, and that some companies’ compliance costs exceeded what they received from the tax credit.
Fortunately, researchers have identified various modifications to make incentives more effective for small businesses, including reducing application and compliance barriers, promoting awareness of programs among eligible applicants, revising selection processes to reduce potential disadvantages for small businesses, and increasing the value of incentives to beneficiaries.
For instance, Minnesota’s Office of Legislative Auditor recommended that, to reduce compliance barriers, the state’s Department of Revenue provide ongoing training about its credit to taxpayers, offer examples of acceptable documentation, and develop comprehensive written resources regarding program credits. And California’s Go-Biz office allocated resources for outreach to small businesses and translated its reference materials into several languages to attract more applicants for the CCTC.
Research from the federal General Services Administration’s Office of Evaluation Sciences indicates that selection mechanisms can skew awards: The agency tested the impact of various selection methods (first come, first served; a point system; and a two-tiered lottery system where certain businesses are in a separate pot or weighted to give them higher odds) on award results. This research found that first-come, first-served and points systems tend to favor companies that are able to apply earlier in the award cycle and have higher revenue and more employees. Conversely, weighted lottery systems and set-asides within first-come, first-served systems increased funding opportunities for the otherwise outmatched businesses.
Finally, evaluations have recommended that states convert tax incentives to grants, refundable tax credits (which allow companies to redeem more than they owe in taxes as a refund check), or transferable credits (which let firms sell their credits to other businesses). Any of these options would enable smaller businesses with limited state tax liability to more fully capture the financial benefits of incentives. However, these options are most viable if policymakers incorporate cost controls, such as program spending caps; understand the economic loss associated with transferable credits sold between businesses; and institute tracking systems for credits transferred between businesses.
Alternatively, states might consider ways other than financial incentives to bolster their small businesses. Although funding is important, small businesses also have other needs, such as business training, assistance in connecting with new customers, or help with regulatory compliance. Providing these kinds of supports could be more impactful and avoid many of the drawbacks associated with traditional financial incentive programs.
State evaluations have revealed the limitations of incentives in supporting small businesses, but they also offer a roadmap for enhancing incentive program effectiveness. Policymakers can draw on these lessons and recommendations to ensure that incentives meet their goals and boost their state economies as intended.
Elizabeth Gray works on The Pew Charitable Trusts’ state fiscal health project.