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Well-Designed Incentives: Not a Zero-Sum Game

When the goals of both the company and the community in which it is locating are clear, incentives can be mutually beneficial.

Q1 2015
Whether it be the book The Great American Jobs Scam, the DaimlerChrysler Corp. v. Cuno case in 1998, or the series of New York Times articles by Louise Story, the practice of using tax credits, grants, and other breaks to lure corporate investment has received a great deal of external scrutiny. The press and public alike have engaged in a legitimate debate over whether incentives are in fact good public policy.

A New Push For Transparency And Accountability
Ironically, government agencies themselves have traditionally not been the parties pushing for quantitative and qualitative analysis of incentive performance. While many incentive programs have their roots in well-constructed economic development policy, few have explicit measurement and adjustment provisions written into the programs. Still others that have been in place for long periods of time may have seen their oversight and evaluation processes dismantled by other subsequent legislation or organizational reshuffling.

Governing - a magazine that covers politics, policy, and management for state and local government leaders - ran a story entitled “How Local Governments Are (or Aren’t) Examining Economic Development Dollars.” The author made the point that while there is considerable debate over the effectiveness of tax breaks and other incentives, few governments have actually put effective measurement regimes in place. This observation was confirmed by an article published in The Economist, in which the reporter demonstrated how good individual states are at evaluating their tax incentive programs, based on a 2012 Pew Research Center study. The key takeaway is that each state has implemented tax incentive programs, although none is thoroughly monitoring and evaluating the performance of the incentives awarded under these programs.

Are Incentives Good Corporate Practice?
What are the implications for corporate investors if governments re-design their incentive programs to provide for better transparency? Investors need to understand that strict audit reviews and standards imply the frequent submission (e.g., annually or quarterly) of detailed company data on the investment project and its socio-economic performance as to economic development.
Well-designed and negotiated incentives are not a zero-sum game and should be included in some way in framing the relationship between the public and private sector.
While these imposed reporting and monitoring conditions could considerably increase the administrative burden of businesses receiving incentives, they do ensure the ongoing compliance to pre-defined eligibility criteria, while simultaneously enhancing transparency among all stakeholders. This is not without risk, however. Information that is required to be publically announced might be of a sensitive or confidential nature to the companies that have received the incentives. The challenge for businesses here will be to leverage between corporate confidentiality on the one hand and the optimization of incentive benefits on the other hand.

At this point, it’s also important to reinforce a key location strategy truism: No incentive ever turned a bad location into a good one.

Proper location due diligence must precede and dictate good location investment decision-making. The ability to address core business drivers such as access to markets, skilled workforce, long-term economic advantages, proper infrastructure, efficient and flexible facilities, and regulatory and permitting environment are all essential to a proper location decision. Incentives are not essential. They can help to strengthen the bond between the public and private sector, but they are not indispensable.
As authorities have come under increased public scrutiny due to budget cuts and financial pressure, incentive programs need to prove their value of allocating taxpayers’ money to investments in the context of contributing to regional economic development.
Using Government Evaluations To Determine Corporate Risk/Benefit
From a corporate point of view, it is essential to understand the rationales of authorities behind the allocation of incentives to investors. This enables businesses to better comprehend and comply with the requirements of incentive programs to ensure qualification for these programs and optimization of the potential benefits. Companies can anticipate specific eligibility criteria by emphasizing their strengths and opportunities for economic development, with the perquisite that they have a sound understanding of the principles on which the incentive program is founded. This requires the corporate investor to carefully examine the incentive program before applying in order to truly capture its benefits.

Clearly, the legitimacy for granting investment incentives is directly associated with their function to attract and retain (foreign and domestic) investments, which act as an important conduit for economic development. As a policy instrument, officials design tailor-made incentive programs to attract investments that complement their economic development policies and strategies. Incentives are perceived to alter the decision-making process of the corporate investor in favor of a certain location and the exact specifications of the investment (e.g., new jobs, capital expenditures) by compensating for possible operational difficulties or cost disadvantages related to the considered location. However, when a solid and stable investment climate is absent, incentives simply can’t turn this bad location into a good one, nor do they address major disconnections between investors’ requirements and a location. Nevertheless, awarding incentives as part of an economic development program reflects certain policy objectives, including:
  • To overcome a competitive weakness;
  • To promote investment in deprived areas;
  • To attract particular industries; and
  • To change the image and perception of a location.
Incentive programs vary significantly in terms of policy framework (loose vs. restricted), target industries and activities (broad vs. narrow), disclosure (opaque vs. transparent), and type (e.g., tax holidays, tax credits, and cash grants). What they have in common is that authorities design incentive programs to generate the largest economic impact possible. This implies a trade-off between investment projects that create the greatest socio-economic benefits vis-à-vis lower incentive rates. To be legitimized, the relative return on the investment and the incentive(s) the investor is “rewarded” with should be in proportion. In other words, employment creation is essential, but a threshold exists as to the amount of incentives that can be granted per newly created job.
What are the implications for corporate investors if governments re-design their incentive programs to provide for better transparency?
Corporate investors should take notice of the fact that larger investment projects are no guarantee for higher incentive values: more isn’t always better. Traditionally, incentive programs pre-assessed potential beneficiaries on purely quantitative eligibility criteria such as newly created jobs, investment capital expenditures, and increased exports. More recently, as authorities have come under increased public scrutiny due to budget cuts and financial pressure, incentive programs need to prove their value of allocating taxpayers’ money to investments in the context of contributing to regional economic development. This implies measuring the economic outcome and social impacts realized by incentive programs to gauge the relative return on investment projects.

This line of reasoning has impacted the design of incentive programs in two ways. First, potential beneficiaries are more strictly examined on a range of qualitative eligibility criteria. Such indicators range from certain high-quality requirements as to employment creation (e.g., level of education, fixed wage minimum), employees (e.g., hiring personnel from certain target groups, staff training) to the direct environment of the investment (e.g., sustainability measures, transfer of R&D, and technologies).

Secondly, sound and comprehensive “monitoring and evaluation” (M&E) frameworks have been implemented, tracing businesses which have been granted incentives to ensure a durable compliance with the agreed-on criteria on which the incentives have been awarded. This requires the formulation of “key performance indicators” (KPIs) and — when the investor does not comply with the KPIs — the enforcement of so-called “clawback mechanisms.” Clawback provisions can be enforced upon incentive beneficiaries in cases of noncompliance to (partly) refund or adjust the amount of awarded incentives.
The key takeaway is that each state has implemented tax incentive programs, although none is thoroughly monitoring and evaluating the performance of the incentives awarded under these programs.
Once Again, Are Incentives Good Corporate Practice?
Of course, going to the public sector for help usually means taking advantage of incentive or credit programs. Incentives and credits have had something of a mottled reputation for some time. For some, they are an effective way of building new clusters, bringing new investment or more commitment to an area that needs it. They can be characterized as tools to build upon a region’s existing strengths. Or, conversely, they can be described as corporate welfare — readily and commonly misused by corporations and the consultants who advise them. Such perceptions — if not properly addressed or managed — can cause significant near-term public relations problems as well as difficulties with government relations in the longer term.

However, well-designed and negotiated incentives are not a zero-sum game and should be included in some way in framing the relationship between the public and private sector. It is also important to understand that incentives need not be purely financial, but may — as has been implied elsewhere in this article — affect other risks that carry a financial implication.

When both a company’s and community’s goals are clear, the desired outcomes are realistic, and the responsibility of all parties expressly laid forth, benefits can be achieved for both the public and private sector. These incentives must be evaluated in the context of the community’s other business fundamentals, the company’s obligations under the program(s), and the potential risk of clawbacks so that the program complements the other reasons for considering the community. It is critically important that any knowledge gained in this negotiation be passed along to the team who will be responsible for the project execution and future operation for the new location.
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