- Tax Incentives and the City
The General Assembly has determined that the relocation of the international headquarters of large, multinational corporations from outside of Illinois to a location within Illinois creates a substantial public benefit and will foster economic growth and development within the State.State of Illinois Public Act 92-0207, May 2001
On May 10, 2001, the Boeing Corporation announced its selection of Chicago as the new home for its corporate headquarters. The city of Chicago and the state of Illinois had teamed up to offer Boeing a generous package of tax incentives and other subsidies. The high-profile competition for Boeing was reminiscent of many others before in which city and state governments had opened their purses to lure or retain businesses. Why would Chicago be willing to offer tax breaks to attract Boeing? After all, there are plenty of other deserving businesses already located in Chicago or potentially interested in locating in Chicago. Moreover, is this sort of competition among cities not just a zero-sum game? In this paper we maintain that in some cases—arguably in the Boeing case—tax competition in the form of firm-specific tax breaks to lure or retain businesses can be welfare improving for the city and a positive-sum game.
Within the existing theoretical tax competition literature, it is difficult to justify tax incentives. As we interpret the literature, tax competition either [End Page 95] results in benefit taxes being imposed on mobile capital or in inefficiently low taxes on mobile capital. Neither strand of the theoretical literature would seem to support tax incentives. We expand upon this argument below.
In addition, there appears to be very little empirical evidence to support the notion that tax incentives are effective, let alone efficient. We are unaware of any direct systematic evidence on the effect of firm-specific tax incentives. Then again, there is a large empirical literature that asks whether differences in general tax burdens are a significant factor in explaining differences in various measures of aggregate economic activity, including firm locations. The evidence is inconclusive, although some recent surveys and at least one recent paper conclude that taxes are, in some instances, statistically significant determinants of state and local economic growth.1 Whether it is appropriate to infer from these studies of the effect of overall tax burdens that firm-specific tax breaks are effective is debatable.
Most empirical studies of the effect of taxes on aggregate economic activity measure economic growth as an increase in employment or investment. Courant argues that increases in employment do not necessarily translate into increases in welfare.2 In the present study we ask a different question, but we argue, too, that cities might be interested in attracting firms for reasons other than jobs. From this perspective, the focus of the existing empirical literature may reveal little about the desirability of tax incentives.
Still, tax breaks in the form of property tax abatements, sales and income tax breaks, and other subsidies from state and local governments to attract or retain firms are pervasive. Why? The answer may simply be politics. No mayor or governor who seeks electoral success will risk being seen as the one responsible for losing the big automobile plant or high-technology firm. In Wolman's survey of the recent literature on the politics of local economic activity, he suggests that protection of tax base is a primary reason for economic development activities.3 Pagano and Bowman argue that even fiscally healthy cities may offer tax breaks and subsidies for symbolic reasons to maintain a city's image.4 Another possibility is that the theory may need to be modified to accommodate more realistic assumptions. Within the existing theoretical economics literature, one can find arguments that real world taxes may be higher than the efficient level because, for example, governments [End Page 96] maximize an objective function other than social welfare. Thus tax breaks may be needed to pull tax levels closer to the efficient level.5
Within a simple model of tax competition we ask whether tax incentives, defined as a tax rate lower than the marginal benefit of the public...