The Impact of Tax Free Zones on Economic Development Minnesota Public Finance Note #

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1 Laura Kalambokidis Extension Economist Department of Applied Economics Phone: (612) The Impact of Tax Free Zones on Economic Development Minnesota Public Finance Note # What are tax-free (enterprise) zones? Many states and the federal government have designated certain geographic regions as tax-free or enterprise zones. Whether the zones are small, large, urban, or rural, varies from program to program, but the designated regions generally are economically distressed. Under the zone program, businesses within the zone and, in some cases, individuals living or working within the zone, receive tax benefits for a specified number of years. In enterprise zones, the tax benefits typically take the form of tax credits linked to specific types of investment (such as building or installing new equipment in the zone) or employment practices (such as hiring zone residents). In a tax-free zone, businesses are exempt from some or all state and local taxes for the duration of the zone designation. In some cases taxes are abated for all businesses within the zone, in other cases benefits go only those businesses that start up in, expand in, or relocate to the zone. How are the tax benefits expected to improve economic development in the zones? Tax benefits are expected to encourage new economic activity in a zone by reducing the cost of doing business there. Lower costs should induce existing zone businesses to increase output, and to attract new businesses to start up in or relocate to the zone. These expansions and relocations result in new investment, such as equipment purchases and building construction. To produce additional output, zone businesses may also hire more workers or pay current workers higher wages. The increased economic activity (in the form of new investment, higher employment, and/or higher wages) will lead to increases in the bases for income, sales, and property taxes. Why might a zone community fail to realize the expected benefits of the program? A locality could suffer a net loss in tax revenue from zone designation. When legislation exempts zone businesses or residents from all local taxes, the potential additional tax revenue from new economic activity will be lost, at least for the duration of the program. In addition, if existing businesses or residents in the zone receive tax abatements, the locality will lose revenue that it would have collected in the absence of the program. Finally, new zone businesses and residents will demand additional public services, imposing new costs on the locality. However, these losses will be mitigated by (1) any increase in revenue stemming from new economic activity that persists beyond the period of zone designation, (2) any additional 1

2 revenue (due to new economic activity) from local taxes not abated by the program, and (3) any reimbursements by the state of lost local tax revenue. An observed increase in economic activity within a zone could be the result of activity relocating from some other part of the state. In this case, the state will have sacrificed tax revenue for no net gain in economic activity. These relocations can also pit communities against one another as they compete to attract businesses. Tax benefits might accrue to zone businesses that are simply making the investments or hiring decisions that they would have made in the absence of the benefits. Again, the state and localities will have sacrificed tax revenue without generating any increase in economic activity. Increased capital investment could result in a decrease, rather than an increase, in employment. Some types of businesses can produce the same amount of output with more (or better) equipment and fewer workers. If the zone tax benefits induce zone businesses to purchase more (or better) equipment, a company might replace workers with machinery or technology, resulting in lower zone employment. It is also possible for zone employment to increase while wages remain stagnant. Companies may be attracted to the zone because wages are lower there than in other, comparable regions. Increasing the number of low-wage jobs in the zone may do little to improve the welfare of zone residents or the capacity of the locality to generate tax revenue. Business surveys indicate that state and local taxes are secondary to other basic economic factors when a business is deciding where to locate or whether to expand. If a region is an unattractive place to do business for reasons other than taxes (such as a lack of a skilled workforce, poor infrastructure, or high utility costs), then zone designation may not induce firms to locate there. Is relocating economic activity from one part of the state to another necessarily bad for the entire state? Using tax incentives to induce a company to relocate within the state generally results in a revenue loss with no net increase in economic activity. In some cases, however, the state as a whole can benefit from such relocations. If an employer is induced to move from a part of the state that has a shortage of labor to a part of the state that has a shortage of jobs, the state as a whole may benefit. Similarly, the state could benefit from inducing businesses or workers to move from a region where the public infrastructure (such as schools or roads) is congested to a region where the existing infrastructure is underutilized. To this end, zone legislation could specify underutilization of infrastructure and high unemployment as criteria for zone designation. Nevertheless, it will be difficult to guarantee that zone tax benefits go only to businesses that relocated from high-employment, congested areas. In addition, the state might want any tax incentives for workers to work in the opposite direction of employer incentives: to induce 2

3 workers to relocate from high-unemployment areas to regions with plentiful jobs. Finally, even if tax benefits can be designed to induce beneficial moves, the benefits to the state might not outweigh the costs of the lost tax revenue. Have state enterprise zones improved economic development in the zones? The evidence on the effectiveness of state enterprise and tax-free zones is very mixed. A few researchers have found that zone designation increases employment within the zone, others have found that zone designation leads to no improvement in economic performance, and others have found ambiguous results (that zone designation brings improvements in some, but not all, economic factors). Finally, some researchers have found that zone programs increase employment within a zone, but at a very high cost per job. The results appear to vary by a great number of factors, including: the type of tax benefits available in the zone; the degree of and reasons for economic distress in the designated regions; the duration of the program; whether the program included economic development support and assistance in addition to the tax benefits; the quality of data available to the researcher; and the research approach used. This variation in results makes it difficult to use prior research to predict how a new state enterprise or tax-free zone program might affect economic development in a particular locality. Why is it difficult to assess the effectiveness of tax free zones? Early research on enterprise zones was based on surveys of businesses within the zone. Businesses were asked whether they based investment, relocation, or hiring decisions on the tax benefits available in the zone, and how much they valued those benefits. It is not hard to see why respondents who directly benefit from tax credits or abatements would respond positively to these questions. Because they have an incentive to make the program look like a success, they may indicate that tax benefits were highly influential when, in fact, other more basic economic factors were more important. Therefore, business surveys are not an adequate means to determine whether a zone program was successful. To assess the effectiveness of an enterprise or tax-free zone, we would need to know how the region performed during the period of zone designation and compare that outcome to what would have happened in the region in the absence of the program. We would also want to compare the benefits of any additional economic activity to the full costs of the program. Of course, we cannot know what would have happened in the zone, so researchers often compare the economic performance of zones with the performance of regions that are otherwise comparable, but did not participate in the program. This exercise poses a number of challenges: 3

4 The information on comparable regions is, by its nature, not experimental or random. Regions are not designated as tax-free zones on a random basis, but on the basis of whether (1) they are sufficiently economically distressed and/or (2) the program has a high likelihood of succeeding there. It is difficult to determine, therefore, whether differences in economic performance between regions are due to zone tax benefits or to some fundamental difference in the regions economies. Researchers have found that full information about the cost of the program to the state and localities is rarely available. Those costs would include foregone tax revenue (from economic activity that would have taken place even in the absence of the tax benefits, and from the induced activity); increased public services costs; costs of administering the program; and any reimbursement from the state to localities for lost tax revenue. Often the goals of the zone program are unclear. Was the legislation intended to increase employment within the zone? Increase employment of zone residents? Increase wages? Increase capital investment? Increase the local tax base? Whether or not the program is successful will depend on which of these economic indicators the program was intended to affect. What kinds of data should be collected to evaluate the effectiveness of new zones? In order to evaluate the effectiveness of a new state tax-free or enterprise zone program, several important pieces of information should be collected for the years before, during, and after the completion of the zone program. Of course, this information will be needed for zone communities. But for comparison purposes, it will also be needed for communities that qualified for zone designation but did not apply, and unsuccessful applicants. The information includes: economic activity in the region, including employment (of residents and incommuters), wages, retail sales, property values, and business investment; revenue from all types of taxes and the estimated revenue loss from zone tax credits or abatements; local government spending by type; the costs of administering the program at both the state and local levels; and the amount of any subsidy or reimbursement from the state to the locality. If a rural community qualifies for designation as a tax free zone, should they seek that designation? A community should first try to understand as well as possible why their region is economically distressed. Based on that understanding, is it reasonable to expect that tax benefits for businesses that start up in, expand in, or relocate to the community will lead to additional investment there? Or is the community s distress the result of structural problems (such as irreversible decline in a key industry, poor infrastructure, or a lack of 4

5 educational and training resources for workers) that will require a more comprehensive solution? In many cases, a community will consider applying for zone designation as a way to increase employment for local residents. However, even if tax benefits induce investment in the zone, that investment might not increase employment and wages for community residents. As explained above, tax benefits could attract businesses that use little labor or only low-wage labor. In addition, new businesses could displace existing zone businesses, resulting in no net increase in jobs. Finally, any newly created jobs could go to zone residents that are currently unemployed or not in the labor force, zone residents who currently out-commute, in-commuters from other areas, or new zone residents. Does the community that bears the costs of the program value all of these types of employment equally? The community should know what local tax revenue is earned by the properties that are in the potential zone. If the properties are undeveloped and currently raise little tax revenue, then the community has little to lose by exempting those properties from tax. If the zone includes many revenue-generating properties that stand to receive tax-free status, then the locality could lose significant revenue. The community should also consider whether their existing infrastructure has the capacity to provide services to new businesses, residents, and in-commuters. For example, new businesses and in-commuters may require new roads, and new residents may begin to fill the local schools. The costs of expanding the community s public service capacity should be weighed against the benefits of additional economic activity. In general, it is crucial for a community to try to predict whether any non-exempt tax revenue generated by the induced economic activity will be sufficient to offset the costs of providing additional public services to zone businesses and workers plus the tax revenue forgone from the zone tax benefits. Under some proposals, the state would reimburse localities for some portion of local property taxes forgone as a result of zone designation, but localities are typically not fully reimbursed. Finally, local leaders should understand how existing businesses and residents might view zone tax benefits. If the zone legislation is structured so that tax benefits go only to businesses that start up in or relocate to the zone, existing zone businesses may view the program as unfair. On the other hand, zone designation could form the core of a new economic development plan, which could energize local businesses, workers, and government leaders. 5