How States Can Consider and Design Effective Tax Incentives

When state legislators consider proposals for new economic development tax incentives, they face hard choices. Subtle differences in the design of business incentives—such as how benefits are structured or how states determine which companies are eligible—can make the difference between programs that achieve their goals and ones that prove ineffective.

These programs, which are often linked to pledges that thousands of jobs will be created, can cost states tens of millions of dollars. To be confident that the promises are worth the investment, lawmakers need robust information to judge the merits of various proposals.

Research by The Pew Charitable Trusts has identified three practices that can guide these considerations. Policymakers can:  

• Establish principles for designing tax incentives. Lawmakers can agree on general principles for incentive programs, establishing rules for creation and design. Then they should assess the extent to which the proposals adhere to these principles.
• Develop procedures to consider proposed incentives in a deliberative manner.  Some states have procedures for considering new incentives that ensure that staff members have adequate time to conduct fiscal analyses or that proposals are accompanied by specific information to help lawmakers decide on their value.   
• Conduct upfront analysis of proposed incentives to forecast their effectiveness. States can commission formal studies that assess proposals’ design and likely results. Some have focused on detailed studies of the largest proposed incentives rather than analyzing every bill in depth.  

States implement these practices differently, but effective processes help to make incentives more likely to serve their intended purpose.

In Arkansas, contractors conducted detailed incentive analyses

Under one incentive program created in 2004, the Arkansas Development Finance Authority (ADFA) is authorized to issue bonds to help secure large-scale private sector investments. Lawmakers have a chance to exercise oversight on the potentially costly deals because the bonds require legislative approval. To inform these decisions, state law empowers the president of the Senate or speaker of the House to contract for a cost-benefit analysis on incentive deals.

The ADFA has issued bonds under the program only once—in 2013 to attract the Big River Steel facility to northeastern Arkansas.  Legislative leaders contracted with two consulting firms to assess the project, which potentially involved hundreds of millions of dollars in grants, loans, and tax credits. One analysis vetted the executive branch’s economic assessment, providing  information to help lawmakers decide on the project’s merits.  It also assessed whether the steel plant would be economically viable, considering national competition.

In Maine, legislative staff analyzed incentive design

In 2017, Maine lawmakers approved an incentive program to encourage business headquarters to locate in the state, but they delayed implementation until 2020 to give the state’s Office of Program Evaluation and Government Accountability time to evaluate the program’s design.

The study provided lawmakers with information they needed to amend the program before it went into effect. Based on the findings, they strengthened reporting requirements for participating businesses and clarified the process for recapturing credits when necessary.

New Mexico checks that tax expenditures follow policy principles

New Mexico’s Legislative Finance Committee developed a framework in 2016—officially adopted last year—for judging the merits of proposed tax expenditures, including tax incentives and other types of tax credits, exemptions, and deductions. Committee staff members now provide an analysis of each proposal, stating whether it complies with six policy principles. Each should be: 

• Vetted. Was it sent through appropriate interim committees, the panels that review proposals between legislative sessions?
• Targeted. Does it have a clearly stated purpose?
• Transparent. Will costs be reported annually?
• Accountable. Can it be evaluated easily?
• Effective. Will it fulfill its stated purpose?
• Efficient. Is the tax expenditure the most cost-effective way to achieve the desired result?

For each principle, committee staff members indicate whether the tax expenditure meets the criteria, or whether the answer is unclear. For example, the fiscal impact report on 2017 legislation to increase the annual cost limit on New Mexico’s film incentives found that the proposal lacked a clearly stated purpose, long-term goals, and an expiration date. The authors noted that the program’s efficiency was debatable and that it had not been vetted through the appropriate interim committees. Lawmakers decided not to move forward with the bill.

Virginia panel sets tax credit principles and procedures

In Virginia, the Senate Finance Committee sets principles for how it considers tax credits. All tax credits should expire after five years—unless they are renewed—and cash grants are preferred over refundable or transferable credits.

The committee also has adopted procedures designed to ensure that lawmakers have high-quality information on the expected costs of any proposed tax credit before they vote. For instance, the panel schedules votes on tax credit bills in the final week of committee action on legislation. This approach maximizes the time available for professional staff from the executive and legislative branches to analyze their fiscal impact.

Legislative procedures in Washington require goals and metrics

The state of Washington enacted legislation in 2013 that requires all proposed tax expenditure measures to include performance statements. The bills must make the general legislative purpose clear; outline specific, measurable goals related to that purpose; and identify sources of data that can help evaluate whether the goals have been reached.

These requirements have encouraged lawmakers and advocates for incentives to think carefully about the proposals’ design and goals. For any incentives that lawmakers adopted, the performance statements serve as a starting point for later evaluations of their effectiveness conducted by the staff of the Joint Legislative Audit and Review Committee.

Given the complexity of designing effective economic development tax incentives, lawmakers need tools that help them judge whether proposals can efficiently achieve their goals. By putting systems in place to make those determinations, policymakers can help ensure that they are thoughtfully approaching the design, administration, and execution of economic development programs.

Josh Goodman is a senior officer and Khara Boender is an associate with The Pew Charitable Trusts’ state fiscal health initiative.