Topic:
ECONOMIC DEVELOPMENT; TAXATION (GENERAL); ECONOMIC CONDITIONS; BUSINESS (GENERAL);

OLR Research Report


The Connecticut General Assembly

OFFICE OF LEGISLATIVE RESEARCH




August 13, 1997 97-R-0856

TO:

FROM: John Rappa, Principal Analyst

RE: Tax Incentives

You wanted to know when states began using tax incentives to develop their economies and how this practice has changed over time.

SUMMARY

States use tax incentives to lure businesses to an area or induce those that are already there to stay or expand. This approach assumes that taxes drive locational decisions as much as other factors, such as energy, transportation, and labor costs. It differs from other approaches that try to create a favorable climate for all businesses by reducing corporate tax rates, improving highways and airports, or making it easier for businesses to obtain licenses and permits.

The southern states were the first to use tax incentives. During the 1930s, they used them to diversify their largely agricultural economies by attracting existing industries from other states. More states adopted tax incentives during the 1970s as a way to combat economic recession. The number continued to grow, but now many states use the incentives to retain existing businesses and to stimulate the formation of new ones.

Connecticut began using tax incentives in 1977 under the Urban Jobs Program, which targeted manufacturers in federally designated distressed municipalities. Since then, the state's policy has evolved along two separate but interconnected paths. It gradually extended benefits to more types of businesses while restricting and then expanding the areas where these benefits are available. In both cases, the state seemed to back away from a strategy to induce targeted businesses (i.e., manufacturers) to expand in specific areas (enterprise zones) and toward a broader strategy designed to reduce business costs for certain sectors in more locations.

Studies attempting to measure the impact of tax incentives have produced mixed results. Despite these findings, states are very reluctant to abandoned the incentives for fear of losing a business prospect to another, more aggressive state.

HISTORICAL OVERVIEW

National

The southern states pioneered the use of tax incentives during the 1930s as a way to diversify their economies by luring out-of-state businesses, a practice which came to be known as “smokestack chasing.” Mississippi led the pack after the boll weevil devastated its cotton-based economy. It combined tax incentives with industrial development bond financing to entice expanding companies by reducing the costs of building and operating a plant in a new location. But as the other states quickly followed suit, tax incentives became a double-edge sword:

These incentives were designed to give each state an edge in dealing with prospective industries, but the use of these devices quickly became so common throughout the region as to negate this advantage to any individual state.... As competition for industry became more heated, public officials from governors down to city councilmen were expected to demonstrate a wholehearted commitment to economic development (quoted in State Business Incentives and Economic Growth: Are They Effective?, Council of State Governments, 1989).

World War Two revitalized the national economy and temporarily dampened the spread of tax incentives. But the southern states revived the practice during the 1950s, and then it quickly spread to other regions. By 1963, 17 states offered tax incentives, in addition to grants, loans, and other types of direct assistance.

During the 1970s, more states turned to tax incentives in the wake of plant closings and layoffs. As Table 1 shows, the number of states adopting various tax incentives proliferated from 1997 to 1998. Some commentators saw this as the onset of the “second war between the states,” one in which economic development departments battled against each other to recruit new and expanding businesses.

Table 1: State Tax Incentives for Business: Changes Between 1977-88

Tax Incentive

Number of States

 

1977

1984

1985

1986

1987

1988

Changes between 1977-88

Corporate Income Tax Exemption

21

28

31

33

33

31

+10

Tax Exemption for Land and Capital Improvements

23

32

34

33

34

35

+12

Tax Exemption for Machinery and Equipment

28

32

34

35

35

39

+11

Sales Tax Exemption on New Equipment

33

38

42

42

44

44

+11

Job Creation Tax Exemption

N/A

27

30

31

32

33

N/A

Industrial Investment Tax Investment

N/A

24

29

29

30

32

N/A

R&D Tax Exemption

9

19

22

24

25

25

+16

Source: Council of State Governments, State Business Incentives and Economic Growth: Are They Effective? A Review of the Literature, 1989

As Table 2 shows, the number of states using tax incentives continued to grow during the 1990s, but many were now using the incentives to encourage businesses within their borders to stay or expand.

Table 2: State Tax Incentives for Businesses: Changes Between 1988-96

Tax Incentive

Number of States

 

1988

1989

1990

1991

1992

1993

1995

1996

Changes Between 1988-96

Corporate Income Tax Exemption

31

32

34

35

35

36

36

37

+6

Land and Capital Improvements Tax Exemption

35

35

35

36

36

36

37

37

+2

Tax Exemption for Machinery and Equipment

39

41

41

41

41

41

42

42

+3

Sales Tax Exemption for New Machinery

44

45

46

47

47

47

47

47

+3

Job Creation Tax Incentive

35

39

40

43

44

44

44

44

+9

Industrial Development Tax Incentive

32

33

35

36

37

37

39

39

+7

R&D Tax Exemption

25

36

39

39

39

40

41

41

+6

Source: Council of State Governments, State Business Incentives: Trends and Options for the Future, 1997

Connecticut

Property Tax Abatements. Connecticut laws authorize property tax abatements and exemptions for many different purposes, including economic development. Some require towns to grant the abatements while others give them discretion to do so. The state reimburses towns for some or all of the revenue they lose under the seven mandatory economic development property tax abatements, most of which are for real and personal property. All but one are limited to certain designated areas, such as enterprise zones.

Table 3 lists these abatements and shows how they evolved over time. It also shows the evolution of the state's locational policy. Two interconnected patterns emerge. During the late 1970s, the state offered abatements only to manufacturers, but it eventually extended them to other types of businesses by including them in existing programs, such as enterprise zones and by creating new programs for other sectors, such as financial services.

The other pattern involved changes in locational policy. Under the Urban Jobs Program (1977-1990), manufacturers in federally designated distressed municipalities qualified for abatements at the economic development commissioner's discretion. The number of designated cities fluctuated as the federal government periodically revised the distressed municipalities list. In 1984, for example, 28 Connecticut municipalities made the list. (The federal government used the list to qualify municipalities for the now defunct Urban Action Grant Program. The state decided to use this list to qualify businesses for tax abatements and state other economic development assistance.)

In 1981, the legislature created a new locational program that ran parallel to the Urban Jobs Program. It authorized the designation of six relatively small enterprise zones, one per municipality and required the commissioner to approve the abatement for manufacturers meeting statutory criteria. Since all of the zones were designated in distressed municipalities, the Enterprise Zone Program seemed to be a subset of the Urban Jobs Program. Both programs provided an 80%, five-year abatement on real and personal property to businesses that constructed new plants, renovated existing facilities, or moved into idle ones. In 1986, the legislature authorized four more zones and extended the abatements to certain types of service firms under the same conditions as manufacturers.

In 1988, the legislature created a new personal property tax abatement for manufacturers in distressed municipalities who acquired new machinery and equipment without building a new facility or expanding an existing one. The acquisition had to be part of a technological upgrading of their manufacturing process.

In 1990, the legislature reduced the number of towns in which manufacturers and service firms qualified for real property tax abatements. It did this by repealing the Urban Jobs Program and thus eliminating the distressed municipalities designation as an eligibility criterion. (At that time, 27 Connecticut municipalities were designated as distressed.) But it also created a new targeted investment community (TIC) designation and automatically applied it to any town with an enterprise zone. Businesses in these towns but outside of the zones qualified for the real property tax abatement at the commissioner's discretion.

By keying the TIC designation to enterprise zones, the legislature created a mechanism that automatically increased the number of TICs each time it authorized more zones. In 1994, the legislature authorized five more enterprise zones, raising the total to 15. (In fact, there are 17 zones, two of which were created under statutes allowing a town to create a zone if it border a zone in another town or a company simultaneously closes plants in the town and in one with a zone.)

In 1994, the legislature also extended enterprise zone benefits to rural areas by allowing three or more contiguous towns under 35,000 population to designate industrial districts as enterprise corridor zones. Now 11 towns have designated corridor zones. The 1994 legislature also extended enterprise zone benefits to entertainment businesses throughout a town with an enterprise zone. The town had to designate an entertainment district, which could cover the entire town. In 1996, the legislature extended enterprise zone benefits to manufacturers and service firms renovating abandoned or underutilized railroad depots in enterprise zone towns.

That year, the legislature also authorized new real property tax abatements for financial service firms located in enterprise zone towns, but outside of the zones. These abatements were based on the amount a firm spent on constructing or renovating a facility.

While the legislature added more zones and made more types of business eligible for abatements, it also authorized a new abatement and made it available statewide. In 1990, it authorized a 100%, five-year tax abatement for new machinery and equipment acquired by manufacturers regardless of location or whether the acquisition was part of a technological upgrading. In 1992, the legislature extended the abatement to newly acquired used machinery and equipment. In 1996, it extended the abatement to biotechnology firms.

Table 3: State Reimbursed Property Tax Abatement Programs

Program

Description and Modifications

Year

   

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

Urban Jobs

80%, 5-yr for mfgs in 28 towns

X

X

X

X

X

X

X

X

X

X

X

X

X

X

             

Enterprise Zones

80%, 5-yr; Eligible firms: manufacturers

       

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

 

selected service firms

                 

X

X

X

X

X

X

X

X

X

X

X

X

 

No. of zones: 6

       

X

X

X

X

X

X

                     
 

expanded to 10

                   

X

X

X

X

X

X

X

       
 

expanded to 15

                                 

X

X

X

X

Machinery & Equipment

50%, 5-yr for new machinery and equipment acquired as part of technological upgrade

Designated areas: Distressed municipalities

                     

X

X

X

             
 

Enterprise zones and targeted investment communities

                         

X

X

X

X

X

X

X

X

Manufacturing Machinery and Equipment

100%, 5-yr: new

                         

X

X

X

X

X

X

X

X

 

extended to newly acquired

                             

X

X

X

X

X

X

 

extended to biotechnology

                                       

X

Targeted Investment Community

Discretionary 80%, 5-yr in 17 enterprise zone towns for businesses located outside of zones

                         

X

X

X

X

X

X

X

X

Entertainment Districts

80%, 5-yr for entertainment businesses in 17 enterprise zone towns designating districts

                               

X

X

X

X

X

Enterprise Corridor Zones

80%, 5-yr for mfgs and services in designated corridors in 11 small towns

                                 

X

X

X

X

Financial Services

Abatement based on facility size and jobs created for financial services outside of enterprise zones in towns with zones

                                     

X

X

Railroad Depot Zone

80%, 5-yr for mfgs and service firms in enterprise zones renovating abandoned or underutilized depots

                                     

X

X

Corporate Business Tax Credits. These incentives can be divided into two groups: those that are available in designated areas and those that are available statewide. Both groups include incentives that are restricted to certain types of businesses, such as manufacturers and service firms. All of the locational incentives are offered in conjunction with property tax abatements. For example, a firm that builds a new facility in an enterprise zone qualifies for the 80%, five-year abatement and a 50% credit against its corporate taxes if it also creates jobs for local residents. The statewide incentives are for specific activities, such as job training and capital purchases.

Table 4 describes the credits and shows when they were adopted. The legislature first authorized credits during the late 1970s under the Urban Jobs and Enterprise Zone programs. The previous section discussed how the legislature eliminated the former, replaced it with a more geographically focused program, but then gradually expanded the number of enterprise zones and the types of companies that qualified for benefits. The credits under the Enterprise Zone and Targeted Investment Communities programs were for creating jobs.

During the early 1990s, the legislature authorized new credits for businesses throughout the state. Many of these were tied to expenditures for certain activities, such as job training, capital goods investments, and research and development. The legislature also authorized credits for financial institutions that constructed new facilities and created jobs.

The other tax credits listed in Table 4 are part of the locational programs the legislature authorized during the mid 1990s, such as entertainment districts and enterprise corridor zones. These credits are for creating jobs, and are offered in conjunction with property abatements.

Table 4: Corporate Business Tax Credits

Program

Description and Modifications

Year

   

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

Urban Jobs

25% for mfg creating jobs in 28 towns

X

X

X

X

X

X

X

X

X

X

X

X

X

X

             

Enterprise Zones

50%; Eligible firms: mfg

       

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

X

 

services

                 

X

X

X

X

X

X

X

X

X

X

X

X

 

No. of towns: 6

       

X

X

X

X

X

X

                     
 

expanded to 10

                   

X

X

X

X

X

X

X

       
 

expanded to 15

                                 

X

X

X

X

 

10-year for business start-ups & job creation: 100% for 1st 3 yrs and 50% for next 7

                                     

X

X

Targeted Investment Communities

Discretionary 50% credit in 17 enterprise zone towns for mfgs. and service firms outside of the zones

                         

X

X

X

X

X

X

X

X

Job Training

25% phased in over 5 yrs for increase in job training expenditures over prior year

                             

X

X

X

X

X

X

R&D

For increased in R&D expenditures over prior year: 10% 1st yr., 20% 2nd

                             

X

X

X

X

X

X

New Bldg and Job Creation

7-yr. 25% for mfgs and eco. base bus for constructing bldgs & creating jobs

                             

X

X

X

X

X

X

Capital Goods

10% for firms with less than 250 employees, 5% 250-800

                               

X

X

X

X

X

R&D

Credit based on statutory formula for current yr federal tax deductible R&D expenditures

                               

X

X

X

X

X

Entertainment District

50% for entertainment businesses creating new jobs

                               

X

X

X

X

X

Financial Institutions

10-year, 50% for building new facilities and creating jobs

                                 

X

X

X

X

Enterprise Corridor Zones

50% for mfgs and services in designated corridors in 11 towns

                                 

X

X

X

X

Financial Services

Credit based on number of jobs created

                                     

X

X

Railroad Depot Zones

50% for mfgs and services in enterprise zone towns renovating abandoned or under utilized depots and creating jobs

                                     

X

X

DO TAX INCENTIVES WORK?

No one has studied the impact of Connecticut's tax incentives or whether they actually induce businesses to make investment decisions they would not have otherwise made. (The Program Review and Investigations Committee is currently studying the impact of the enterprise zone tax incentives and will report its findings in December, 1997.)

Multi-state studies on whether tax incentives affect locational decisions have produced mixed results. Those done during the 1950s and 1960s suggested that tax incentives had little effect on these decisions, but later ones found that they did, along with education and other quality of life measures. After reviewing many studies, the Council of State Governments cited many methodological problems clouding their findings (State Business Incentives and Economic Growth: Are They Effective? A Review of the Literature, 1989).

Despite the uncertainty about the value of tax incentives, states continue to rely on them. One reason may be that state officials feel that they must publicly prove that they are actively promoting economic growth. Another may be a deep seated fear states have about being outbid by their more aggressive neighbors.

As regions, states and localities watch their neighbors attract jobs and economic activities the desire is to get a piece of the action. As more and more governmental units offer industrial location incentives to help tip business location decisions in their favor, support is lent to the belief that these incentives are necessary and that they significantly affect choices . . . . Policy makers are afraid that if they do not participate in the economic development bidding game (e.g., business incentives), their jurisdiction will lose jobs, economic stability and the appearance of vitality and robustness. (quoted in State Business Incentives and Economic Growth).

JR:lc