Every state offers companies tax incentives, a mechanism by which states agree to forgo tax revenue in the hope that the companies’ activities will catalyze new economic activity. These incentives collectively cost states billions of dollars in tax revenue each year.
But do states know how well these tax incentives are performing?
Until recently, most did not. But over the last 10 years, states have increasingly adopted practices to analyze the benefits and costs of their incentive investments on a recurring basis. Now, more than two-thirds of states—plus New York City; Washington, D.C.; and Philadelphia—regularly and rigorously evaluate incentive programs, helping policymakers determine whether incentives are meeting their intended goals.
As more states and cities adopt tax incentive evaluation processes, here are four things to know about the practice.
This may come as a surprise—especially to people with experience preparing tax documents or who participate in incentive programs—but most states did not previously have adequate mechanisms for viewing the effectiveness of their economic development tax incentives.
It’s true that states have systems to monitor compliance with incentive agreements, but this information tells only a sliver of the story. This performance monitoring doesn’t provide insight into how much a particular incentive is changing business behavior or whether the program is meeting its goals. Thorough evaluations, on the other hand, look at how a program is performing as a whole, consider a broad set of benefits and costs, review the efficiency of program administration, and make recommendations for how a program could work better. That’s why so many states have adopted the use of evaluations in recent years.
For many years, government officials, business groups, government watchdogs, and others were locked in a stalemate over incentives. Critics described them as corporate welfare, while supporters predicted ruin for communities that didn’t compete with other states or localities by offering incentives. And as the debate raged on, states continued investing millions of dollars and hoping for the best.
Evaluations have helped lead to more constructive conversations about incentives. Today, states are engaging in in-depth policy conversations informed by credible data; these conversations allow states to reform programs, when necessary, to get better returns on their investments; increase fiscal certainty; and better align incentives with their economic development objectives.
Oklahoma provides a case study. Supporters of incentives in the Sooner State argued for years that the programs were essential to staying competitive with other states, while skeptics viewed them as unnecessary meddling in the economy. In 2015, the state created an Incentive Evaluation Commission responsible for overseeing the evaluation process. Part of the strength of Oklahoma’s current approach lies in the range of perspectives represented on the commission, which includes people generally supportive of incentives as well as people with other viewpoints. The commission includes members of the public appointed by the governor, executive branch officials who administer incentives, and state officials with general budget and policymaking responsibility. Additionally, the outside professionals contracted to conduct the analysis regularly seek input from incentive stakeholders and present their findings at open meetings that allow for public input, ensuring transparency and participation.
Incentives aren’t free: They reduce revenue available for other spending priorities. The magnitude of this revenue reduction depends on several things: the direct cost of the incentive, the degree to which it changes business behavior, the cost to administer it, whether it generates population growth that requires expanded services and infrastructure, and how the state makes up for revenue losses. Although it’s possible for incentives to generate increased economic activity, it’s unlikely that the increased activity will fully offset the incentives’ cost. As a result, states must be judicious in how they award incentives.
That’s where evaluations come in—they help states better direct investments to projects that are more likely to succeed and provide a better return on investment. For instance, after evaluators reported that Mississippi had provided incentives to projects that are likely to fail from the outset, in 2020 the legislature made changes to the award process for grants and loans administered by the Mississippi Development Authority, requiring certain projects to provide evidence that they could meet specific goals.
States have eliminated incentive programs based on the results of evaluations, but they’ve also used evaluations to drive improvements and create new incentives. After an evaluation by Virginia’s Joint Legislative Audit and Review Commission found that the state’s Small Business Jobs Grant Fund was duplicative and infrequently used, the state repealed the program at the height of its COVID-19 pandemic response and freed up much-needed funds to help struggling small businesses. Evaluators in North Dakota identified a strategic gap in the state’s efforts to assist businesses in modernizing their manufacturing processes during the 2017-2018 interim; in response, policymakers created a new incentive program to meet the need. In 2019, Nebraska evaluators identified design deficiencies in the Nebraska Advantage Act (the state’s foremost business incentive program) that left the state vulnerable to fiscal risk. Policymakers used these findings to help craft a replacement in 2020, the ImagiNE Nebraska Act, that addressed many of the previous program’s flaws.
The use of tax incentives forces states to consider difficult trade-offs about how they invest their resources, and states need data to do so wisely. As more states adopt incentive evaluation processes, the results are clear: better designed and better performing incentives for states and businesses alike.
Alison Wakefield researches tax incentives for The Pew Charitable Trusts’ state fiscal policy project.