What Makes an Economic Development Incentive Effective?

Data visualization lets users explore 4 factors that inform costs and benefits

What Makes an Economic Development Incentive Effective?
An interactive from

States use economic development incentives to encourage companies to locate or expand. An incentive has benefits for residents when the economic gains it generates, less its costs and any negative effects, are positive. This data visualization illustrates many of the impacts that incentives can have on government budgets and state economies and shows how those effects are influenced by various policy choices. As policymakers and development officials evaluate their incentives, they should keep these factors in mind.
In Depth

States use economic development incentives to encourage companies to locate or expand within the state or a community. The to the state of an incentive program is the value of any tax reductions, refundable credits, or cash grants or the cost of customized services provided to the target businesses. When the incentive works and causes a business to move into or expand within a community, the impacts ripple through the local economy, affecting jobs, income, and population. This increased economic activity can have in the form of additional tax revenue and public spending needs, such as transportation and public safety. The usually exceeds the total value of , and that difference equals the program’s net cost. States must pay for that net cost through increased taxes, decreased spending, or both, all of which can have negative economic consequences now and in the future, such as education cuts that harm residents’ long‑term .

Although most incentives have a net cost to states, even after accounting for , and have some unintended negative effects, the potential economic impacts on , , and mean that well‑designed programs can be worth the cost. An incentive has positive net effects — measured as the change in income for local residents over decades — if the gains it generates, less any offsetting negative effects, exceed the cost. As policymakers and development officials evaluate their incentives, they should keep these factors in mind.

This data visualization illustrates how incentives can affect each of those economic measures and how those impacts are influenced by four major policy considerations: how the incentive is paid for, what type of businesses it targets, how the program is designed, and what the economic conditions are in the state. It begins with a brief optional walk‑through of the four key policy considerations examined and then asks a series of questions to guide the building of an incentive program. The resulting scenario is compared with a default configuration that represents a fairly well‑designed program with modest positive net effects. This default scenario is intended for comparative purposes only and does not necessarily represent a real or typical incentive.

The interactive is based on an economic model that estimates the impact of business expansions and relocations that include significant upfront capital investments. The model, which was developed by Timothy J. Bartik of the W.E. Upjohn Institute for Employment Research and partially funded by The Pew Charitable Trusts, considers an array of economic and policy factors, many of which are not discussed here. This data visualization focuses on a set of key economic indicators and policy options to demonstrate the complex interplay among program design, business characteristics, and the underlying economy.

Costs

  • How is the incentive paid for?

Incentives can have positive economic impacts, but they also cost money and must be paid for, either with tax increases, spending cuts, or both, all of which can have negative repercussions.

Targets

  • Does the incentive target ‘exporters’?
  • Does the incentive target high-impact companies?
  • Are the recipient companies locally owned?

The economic effects of an incentive depend in part on the characteristics of the company or companies that receive it.

Design

  • When do businesses receive the incentives?
  • Does the program offer customized business services to small and midsize firms?

Certain designs can produce incentives that deliver more benefits to companies for the same cost to government, increasing their effectiveness.

Economic Conditions

  • How high is local unemployment?
  • How readily can housing supply expand to absorb increased demand?

The state of the economy can significantly affect the ultimate impact of an incentive.

Costs

Incentives can have positive economic impacts, but they also cost money and must be paid for, either with tax increases, spending cuts, or both, all of which can have negative repercussions. The key question policymakers must ask is: “How is the incentive paid for?”

How is the incentive paid for?

Incentives must be paid for by increasing other taxes, cutting spending, or both, and each of these approaches can have negative economic consequences that offset some benefits of the incentive programs. Government spending cuts can result in fewer jobs and less economic activity, harming , and reductions to long-term government investments can be particularly damaging to future economic prosperity. For example, cuts to education can harm students’ . Tax increases can have negative effects by reducing how much money people have available to spend and by discouraging business activity.

Targets

The economic effects of an incentive depend in part on the characteristics of the company or companies that receive it. Three of the most important questions about how incentives are directed are: “Does the incentive target ‘exporters’?” “Does the incentive target high-impact companies?” and “Are the recipient companies locally owned?”

Does the incentive target ‘exporters’?

Giving incentives to companies that sell their goods locally, such as retailers, will harm other businesses in the community, because sales and jobs at the new firm will come at the expense of existing companies and undermine the program’s potential economic benefits. In contrast, incentives given to “exporters” — businesses such as manufacturers that primarily sell their products outside the state or community — are more likely to deliver local economic benefits, because those firms bring in new dollars and jobs, with notable benefits for . Sometimes companies do both, selling a portion of their goods locally and exporting the rest.

Does the incentive target high-impact companies?

When a company relocates or expands because of an incentive, the effects cascade through the economy, with a particular impact on . As the firm buys goods from other local businesses and the new employees spend a portion of their wages locally, some additional jobs are created in a process called a multiplier effect. For example, a multiplier of 2.5 means that every job created at the new company spawns 1.5 additional jobs elsewhere in the local economy. Businesses that pay higher wages or use more local suppliers will, all else being equal, tend to have a larger multiplier and thus higher economic benefits.

Are the recipient companies locally owned?

Incentives increase net revenue for the businesses that receive them, so if those companies are owned by residents of the jurisdiction offering the incentive, the additional are retained locally as a benefit of the program. In addition, job creation may be modestly higher if local owners use more local suppliers and spend some of their increased profits in the local economy. In contrast, if the business is not owned by local residents, any additional profits will flow out of the local economy, and the company may use fewer local suppliers. A comprehensive accounting of the benefits of incentives should consider these possible effects of local ownership.

Design

Certain designs can produce incentives that deliver more benefits to companies for the same cost to government, increasing their effectiveness. In particular, policymakers need to ask: “When do businesses receive the incentives?” and “Does the program offer customized business services to small and midsize firms?”

When do businesses receive the incentives?

Businesses prefer to receive a dollar today rather than tomorrow, because postponing a payment means it will be devalued by inflation, risk, and other factors and may cause a firm to defer or miss opportunities for investment and growth. Therefore, a front-loaded program is more valuable to the recipients and has more influence over their decisions to invest than if the incentive were spread over many years. Although an incentive delivered far in advance of the business’s investment can be wasted if the company does not follow through on its plans, one that coincides with agreed-upon job creation targets can help protect public resources and yield more job creation and higher benefits for than one paid out later, all of which make it more cost-effective.

Does the program offer customized business services to small and midsize firms?

Unlike tax credits and other financial incentives whose value to companies roughly equals their costs to states, high-quality business services could have a value to companies that significantly exceeds their costs. For example, manufacturing extension programs offer smaller manufacturers advice on finding new markets and improving productivity, and job training programs work with businesses to ensure that they have access to a qualified workforce. Therefore, when tailored to help small and midsize companies overcome barriers to growth, such services could also have much larger positive impacts on business expansion, job creation, and ultimately than financial incentives.

Economic Conditions

The state of the economy can significantly affect the ultimate impact of an incentive. Two of the most salient and practical questions to ask about the local economy are: “How high is local unemployment?” and “How readily can housing supply expand to absorb increased demand?”

How high is local unemployment?

When unemployment is high, there is an increased likelihood that new jobs will be filled from the large pool of unemployed local workers rather than by workers moving between communities, providing a boost to and positive via increased tax revenue. However, when unemployment is low, fewer workers are available, and more of the new jobs will be filled by people moving from outside the local area. Because many of these new arrivals would have been employed in their previous location, their income gain — and therefore the impact on — is smaller than that for formerly unemployed local residents. At the same time, the increased population leads to greater demand on local government services.

How readily can housing supply expand to absorb increased demand?

The economy is made of many interrelated parts, and changes in one area will affect others. For instance, growth in economic activity, employment, and population tends to increase , especially when housing supply is slow to respond to changes in demand, such as in areas where new construction is more restricted. Rising prices benefit property owners but also increase rental costs, including for local businesses, which can result in job losses and lower .

Construct an incentive scenario to see an illustration of how each economic and policy factor can influence the costs and benefits of incentives. For simplicity and comparability, all scenarios have the same initial cost to the government, $100 million. To get started, use the colored tabs on the left to navigate between questions or see and modify all your selections at once by clicking “All Answers.”

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Issue Brief

What Factors Influence the Effectiveness of Business Incentives?

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Issue Brief

What Factors Influence the Effectiveness of Business Incentives?

Policymakers around the country use economic development incentives such as tax credits and exemptions to encourage companies to locate or expand in their state or community, with the ultimate goal of boosting the job prospects and income of local residents.