Economic Development


Frequently Asked Questions

Understanding what economic development tax incentives are—and what they are not—is essential to measuring the results of these policies and making informed choices about the use of them. Decisions about the usefulness of these incentives, their design, and costs depend on a clear sense of their purpose, as well as the risks of deploying them.

Here are some answers to frequently asked questions about economic development tax incentives and related terms such as tax expenditures—a broader category of tax policies that includes incentives. We plan to add to this list and invite you to send us your questions. 

What are economic development tax incentives?

Economic development tax incentives are exceptions to regular tax rules meant to achieve an economic goal by encouraging people or businesses to do something that they otherwise would not have done. Often, that “something” is to locate a company in a certain area, create or keep jobs, or invest in equipment and facilities.

When policymakers offer tax breaks to lure businesses from other states, they often are using economic development tax incentives. The same is true when they offer tax credits to companies that hire more workers. Enterprise zones are a case in point (see box).

Enterprise Zones

Enterprise zones are one type of economic development tax incentive that many states use to spur the growth of businesses and jobs in certain geographic areas. Policymakers offer lower taxes and sometimes reduce regulations on companies locating or expanding in these areas. In 2012, Maryland had 28 enterprise zones, from a 64-acre industrial park in rural Garrett County to more than 21,000 acres of Baltimore neighborhoods designated for commercial, retail, and industrial projects. State leaders recently began an effort to evaluate the effectiveness of these zones and other economic development tax incentives.

States together spend billions of dollars annually on economic development tax incentives. These policies take many forms, including tax credits, deductions, and exemptions that allow recipients to reduce the amount they owe in taxes. In some cases, tax credits result in cash payments from the state to qualifying businesses.

Pew helps state leaders implement policies to make their economic development tax incentives effective, accountable, and affordable.

What are tax expenditures?

Tax expenditures are special deductions, exemptions, and other provisions that allow people or businesses to reduce the amount they owe in taxes. The term “tax expenditures” reflects that these policies are similar to direct spending in government budgets. By reducing the revenue governments collect, these policies leave fewer budget dollars to invest in schools, health care, and other services or to pay for broader cuts to tax rates.

Deductions for mortgage interest payments and charitable donations are among the more well-known tax expenditures, but hundreds of these provisions exist in federal, state, and local tax codes. In many states, retail shoppers do not pay sales tax on some food items. The policy choice to exempt necessities such as food from sales tax is a tax expenditure.

Economic development tax incentives are tax expenditures meant to achieve an economic goal by encouraging people or businesses to do something that they otherwise would not have done.

Is economic development the purpose of all tax incentives?

A Tax Incentive to Discourage Development

Virginia’s Land Preservation Tax Credit is a tax incentive, but environmental conservation — not economic development — is its primary purpose. The program offers property owners a break on their taxes in exchange for keeping ecologically valuable land undeveloped, a choice that they might not otherwise make.

No. States create tax incentives for many purposes besides growing the economy. Some are meant to prompt people to contribute to retirement accounts or college savings plans, while others promote charitable giving, restorations of historic buildings, or environmental conservation.

The common feature that makes these policies tax incentives is lawmakers’ intent to encourage people to do something that they otherwise would not have done. Economic development tax incentives are a subset of this group meant to spur the growth of businesses and jobs.

Some of the incentives mentioned above may produce economic benefits for related industries (investment firms that handle retirement funds, colleges, or charities). But they are not necessarily considered economic development tax incentives because these benefits were not the main motivation behind the policies (see box).

Are tax incentives and tax expenditures the same thing?

No. A tax incentive is one type of tax expenditure. A tax expenditure is a tax incentive only when it’s meant to prompt people or businesses to do something that they otherwise would not have done.

The goals of tax incentives vary. Some are meant to grow the economy and jobs, while others aim to inspire charitable giving or environmental protection.

Are all state tax rules that help businesses considered economic development tax incentives?

No. A tax rule can help businesses and not be an economic development tax incentive. This fact is important because it affects how the results of different tax policies should be measured by states.

A key feature of tax incentives is that policymakers intend for them to influence businesses’ decisions. Many states offer tax credits as incentives to companies that hire new workers because they want to encourage job creation.

Other times, states create tax credits, deductions, or exemptions to reduce the influence of the tax code on people’s decisions. States, for example, often do not apply sales tax to businesses’ purchases of materials used to make other goods. Such a policy, though helpful to businesses, is not a tax incentive, because lawmakers’ goal is to prevent the sales tax from influencing whether and how companies buy the items that go into their products.

Understanding these distinctions helps states ask the right questions when evaluating tax policies. Some sales tax exemptions may be judged a success if businesses were neither encouraged nor discouraged to take certain actions.

In contrast, evaluating a tax incentive meant to encourage a company’s relocation requires the state to determine whether it was a deciding factor in the firm’s choice—and then weigh any benefits against negative effects, including harm done to other businesses not receiving incentives.

How does an economic development tax incentive affect a state budget?

Unexpected Incentive Costs

The design of a tax incentive is a major factor in how it affects the state budget. In Louisiana, state leaders created a tax incentive program for horizontal natural gas drillers and did not set an annual limit on the amount of tax revenue that could be lost.

Consequently, the program was able to grow rapidly and unpredictably, straining the state budget. In 2007, the incentive cost the state just $285,000 in forgone revenue. But the discovery of a large natural gas deposit and the swift expansion of horizontal drilling that followed pushed the price to $239 million in 2010.

An economic development tax incentive’s impact on a state budget depends on how the incentive is designed and how well it works.

Ideally, tax incentives encourage businesses to hire, build, and invest more than they would have without these policies, generating additional economic activity that, in turn, produces more tax revenue.

But policymakers should not assume that tax incentives will pay for themselves. If a business would have created the same jobs or bought the same equipment without receiving the incentive, then the state passed up tax revenue it otherwise would have collected for no economic gain. Likewise, if an out-of-state company would have moved in regardless of the incentives provided, the state has forgone tax revenue it could have invested in other priorities.

Even when incentives influence a company’s decision, the resulting economic growth may require more spending on roads, schools, and other public investments as businesses and people are drawn to the area.

Lawmakers also should not assume that an incentive that has generated a positive return for the state budget in the past will continue to do so. Changes in the economy, for instance, can significantly alter the state’s return on investment from year to year (see box).

To address these uncertainties and help ensure that these policies are both effective and affordable, states should establish reliable cost estimates for new proposals, set annual spending limits on incentives, and regularly evaluate the economic outcomes of these programs. See Pew’s reports "Evidence Counts" and "Avoiding Blank Checks” for more on these policy tools.

How much do states and the District of Columbia spend on economic development tax incentives?

The 50 states and the District of Columbia together spend billions of dollars each year on economic development tax incentives, but the precise amount is unknown because many states do not regularly and reliably report such information.

The use of tax incentives for economic development appears to have increased substantially over the past 20 years. Today, every state has at least one economic development tax incentive program, and most have several, as Pew reported in "Evidence Counts."

Studies by other groups give a sense of the scale of incentive spending by states. One study by Good Jobs First looked at a limited set of major tax incentives, including ones from nearly every state, and found the combined cost exceeded $9 billion per year. Another analysis by the Tax Foundation showed that states spent about $1.3 billion in 2011 on incentives for the film industry alone.

Tax incentives can have major implications for states’ budget stability. Every dollar allocated to a tax incentive is one that cannot be spent on education, health care, and other investments in a state’s economy. And if policymakers do not take proper precautions, tax incentive costs can grow rapidly and unexpectedly.

Pew helps state leaders implement policies to make economic development tax incentives effective, accountable, and affordable. We work with leaders in selected states to advance policies that protect budgets from unexpected tax incentive costs, evaluate all tax incentives on a regular schedule, and inform lawmakers’ choices with evidence from evaluations.