Evaluating the Effectiveness of State Tax Incentives

States spend billions of dollars a year on tax incentives meant to encourage businesses to create or retain jobs and make investments. When designed and managed well, these credits, deductions, and exemptions can strengthen a state's economy.

But research by The Pew Charitable Trusts shows that lawmakers often approve incentives without knowing their potential cost or whether they will work. State leaders need better information to avoid unexpected budget challenges, identify programs that are effective, and modify or end programs that do not achieve their intended purpose.

Know Your Goals

To determine how well an incentive is working, it is essential to know its aim and specific goals. Yet many programs are enacted without clear and measurable objectives. When Nebraska's legislative audit office set out to examine the state's rationale for major economic development tax incentives in 2012, it found vague and overbroad statements of intent, such as, "encourage new businesses to relocate to Nebraska." Since lawmakers had not provided guidance on the economic benefits they hoped to see or how much they were willing to pay, the auditors concluded that "any activity could be deemed a success and any cost acceptable."

Motivated by this report, Nebraska is putting together a legislative committee to develop specific and measurable goals for each of the state's tax incentive programs. The committee also will be responsible for recommending metrics and developing a schedule for assessing how well each program is meeting its objectives.

Other states have taken similar steps. Vermont and Washington passed laws in 2013 requiring legislative proposals for new incentives to include plans for measuring whether goals have been achieved. Vermont went a step further by setting up a plan to identify the purposes of all tax expenditures.

Closing the Data Gap

Accurate data on performance can greatly enhance the ability of decision makers to craft policies that deliver the strongest returns at the lowest possible cost. Unfortunately, there currently is no source that has identified and compiled the best practices on how to gather the information needed to ensure that a tax incentive produces the expected outcome.

To fill this gap, Pew is partnering with the Center for Regional Economic Competitiveness, a nonpartisan policy organization, to launch an initiative that will engage teams of policymakers and practitioners from seven states over the next eighteen months. These teams will work together to identify effective ways to manage and assess economic development incentive policies and practices, improve data collection and reporting, and develop national standards and best practices that all states can adopt.

Evaluating Impact

To determine whether a tax incentive is working, state lawmakers need an accurate picture of its outcomes and how much it costs to achieve them. This requires evaluations that analyze the extent to which a program improves the state's economy by influencing businesses to make decisions they otherwise wouldn't have made, such as hiring more workers, investing in research, or locating in disadvantaged neighborhoods.

This type of evaluation can yield useful results. In Louisiana, businesses benefiting from the state's Enterprise Zone program reported creating 9,000 jobs. However, an evaluation by the state's economic development department found that the new jobs in hotels, restaurants, retail, and health care largely displaced existing jobs. The agency estimated that the program netted only 3,000 new jobs and identified several ways the incentive could be strengthened. The Louisiana legislature has adopted many of the suggestions.

Informing Policy

When incentives are enacted as permanent parts of state tax codes, lawmakers often have little impetus to review them. Unlike direct state spending, which must be renewed with each budget, incentives frequently continue indefinitely without policymakers revisiting their cost or effectiveness. By integrating evaluation into the policymaking process, states can ensure that incentives are reconsidered regularly and that elected officials base their economic development decisions on evidence rather than anecdote.

For example, Rhode Island approved a law in 2013 that builds review of tax incentives into the annual budget process. Each program will now be evaluated by the state's revenue office every three years. Informed by the findings, the governor's proposed budget will include recommendations on whether to continue, change, or end the incentives. The governor's recommendations then will be the subject of legislative hearings, where lawmakers can assess the results of the evaluations and weigh economic development investments alongside other state spending.

In March 2014, Indiana enacted a law that takes a different approach to achieving the same goal. A legislative commission will regularly review the state's tax incentives and provide detailed recommendations prior to each legislative session. The general assembly will use the results of these evaluations in policy and budget deliberations. Several other states are considering similar proposals.

Moving Forward

With better data and ongoing evaluation of their tax incentive programs, states will be able to make better use of scarce resources. Pew has been working to promote stronger evaluation practices through advocacy and technical assistance at the state level. We welcome additional partners and opinion leaders in this important effort.

This opinion piece was originally published on the Kauffman Thoughtbook 2015 Blog.