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The Rising Importance of Tax and Incentives Considerations

Today's bad economic news has heightened companies' awareness of avoiding high tax locations and maximizing incentives when conducting site searches.

Feb/Mar 09
Given the state of the global economy and continuous revelations of bad financial news, it should come as little surprise to even the casual reader that economic concerns are of rising importance in location decisions. As evidence, the percentage of respondents to Area Development's 2008 Corporate Survey who ranked financial considerations - i.e. "occupancy or construction costs," "tax exemptions," "state or local incentives," and "corporate tax rate" - as "very important" or "important" rose substantially from 2007. The focus of this article is the growing significance of financial aspects, primarily taxes and incentives, in site decisions.

However, it should be noted that the opposite effect on non-economic concerns is also clearly evident in the survey. For example, the effects of the ongoing recession and financial crisis - and their downward pressure on employment - are reflected in the respondents' reduced importance ratings of factors such as "labor costs" and "the availability of skilled labor." Changes in the importance ratings of the non-economic site selection factors are clearly the "rest of the story," but a story to be continued in future editions.

Consider the numbers that follow: Between 2007 and 2008, the proportion of respondents to the annual survey citing tax exemptions as a primary issue rose from 82.8 percent to 88.6 percent. This escalation represents the second-greatest gain in importance of any of the 25 site selection factors included in the survey. Those identifying the need for state and local incentives climbed nearly four percentage points from 83.4 percent to 87.2 percent, another significant gain in relation to the other factors considered. Respondents also noted their expanding focus on corporate tax rates with a 1.5 percent increase in importance from 83.8 percent to 85.3 percent.

Maximizing Returns
So, specifically, why are taxes and incentives becoming so much more important in the decision on where to deploy new assets? Combined with falling corporate revenues and profits, a result of the meltdown in the financial markets has been the decreased access to credit and project financing. With cash becoming more precious, the need to maximize returns on deployed capital has been amplified. Incentives offered for expansions and new investments can have beneficial effects on both counts. If companies are able to access cash grants or low-cost financing from public sources, it reduces their dependency upon private credit avenues or their own reserves, with the upfront monies reflecting very positively in discounted net present value models and payback period calculations. Tax rates and structures are, of course, components of structural investment and ongoing operating costs. The ability to avoid or reduce the impact of higher tax locations has ready impacts on the cost models and, ultimately, the planned operation's bottom line.

The growing importance of incentives has been readily evident in our more recent site selection experiences and changes in our clients' perspectives on distribution and manufacturing projects. Several years ago, tax offsets and financial inducements were most often viewed as secondary considerations to be used mainly for risk mitigation or as location differentiators for well-qualified, finalist sites. In the overall comparative analysis, they would not determine the final decision and would most often be explored toward the end of a search.

Today, more and more clients seek calculation of possible tax liabilities and estimated incentives potential at the early stages of region-qualification and/or site-identification processes. While early search region determinations are still primarily driven by supply-chain analyses, labor-supply concerns, or access to like-industry concentrations, now it is often just as common for clients to request inclusion of high-level tax evaluations or the history of large incentive awards at the onset of the investigation. A steady diet of project announcements referencing incentive awards totaling hundreds of millions of dollars has only added fuel to the fire.

Getting the Whole Picture
Even with this growing focus on inducements and cost offsets, we continue to counsel clients that incentives must be considered and quantified in the context of their overall impact on investment and operating cost environments, and in comparison to the non-economic considerations that will ultimately determine projects' success. If this is not done, the quoted value of inducement packages in higher-tax, higher-cost locations can be deceptive when compared to the value of incentive offerings in areas with structurally lower cost profiles.

In such cases, early-stage incentive estimates become unproductive distractions in the decision-making process, and the accuracy of the incentives valuation is also lower than during projects' later stages. Cost comparatives must be examined as a whole reflecting the entire investment and operating cost structures, tempered with the reality that various incentives would eventually expire. We also caution clients that deploying an asset in a highly incentivized or lower-cost location that cannot support the operation's operating requirements is doomed to fail.

One of the major issues we have been witnessing of late in regards to incentives is how they can best be used in the current economic environment. State tax incentives have traditionally been designed to attract capital-intensive manufacturing operations creating many new jobs; however, these projects have become increasingly rare and the competition for them among the states more intense. Meanwhile, growth appears to be concentrated in smaller, more entrepreneurial research and development opportunities, service-related projects, etc. with smaller investment profiles and employment needs.

For these smaller-scale, less capital-intensive project types, incentives based upon job creation or investment numbers do not produce as substantial an inducement impact. For many of these more entrepreneurial companies, access to lower-cost financing has traditionally been a key ingredient to support facility investment, and this consideration is amplified in the current economy. Yet, with states suffering from declining tax revenues and shrinking budgets, they must be wary of the kinds of projects in which they invest. Given this state of flux, it will be interesting to see how states may respond in terms of their attraction strategies.

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