Creating Fiscally Sound State Tax Incentives

Even in tight fiscal conditions, state lawmakers often approve tax incentives for economic development without reliable estimates of their budget impact or limits on their annual cost, a new report from the Pew Center on the States shows. By omitting these steps at the outset, states have created incentives that can grow in price rapidly and unpredictably, raising the risk of budget shortfalls and unplanned spending cuts or tax increases to close them.

Pew’s study, Avoiding Blank Checks: Creating Fiscally Sound State Tax Incentives, analyzed 16 major economic development bills with the potential to be among the costliest nationwide. Each piece of legislation was approved between 2007 and 2011. In only four cases were the tax incentive proposals accompanied by both rigorous fiscal estimates and caps on annual expenditures. Five of the bills were enacted without either of these fiscal safeguards. In seven cases, the legislation lacked one or the other.

Reliable fiscal estimates provide lawmakers with important projections of an incentive’s effect on state revenue and its economic impact. Estimates alone, however, cannot protect the state budget from cost spikes caused by unforeseen changes in the economy or higher-than-expected participation from qualifying businesses. Annual cost controls give the state certainty that incentives will not throw the budget out of balance, while allowing policymakers the flexibility to adjust the amount of tax dollars set aside as they respond to shifts in economic priorities or fiscal realities.

“States should consistently use these two tools together to ensure that tax credits, exemptions and deductions for economic development are affordable and manageable from day one,” said Jeff Chapman, research manager at the Pew Center on the States. “When policymakers create tax incentives without knowing the expected costs and guarding against economic changes beyond their control, they leave their states vulnerable to budget pressures that are entirely avoidable.”

These effective practices have been applied to a wide range of tax incentives. For example:

  • Arizona’s Quality Jobs Tax Credit, passed in 2011, received a fiscal estimate based on historic job growth data and is subject to annual cost limits that start at $30 million in FY2013.
  • California’s Film and Television tax credit, created in 2009, was capped at $100 million per year for five years.
  • Florida’s Manufacturing and Spaceport Investment Incentive, enacted in 2010, was restricted by annual caps totaling $43 million over two years.

The price for tax incentives created without these fiscal precautions has soared in many cases. Among them:

  • Louisiana’s tax exemption for horizontal natural gas drillers, passed in 1994, cost the state just $285,000 in FY2007. But the recent discovery of a large natural gas deposit and the swift expansion of horizontal drilling that followed pushed the price to $239 million in FY2010.
  • Michigan’s film tax credit, approved in 2008, had no fiscal estimate and no limits on the number of films that could qualify, the amount of each credit awarded, or the program’s annual price. After production companies received credits worth more than $360 million in less than three years, the governor and legislature converted the incentive to a direct grant program and capped its cost at $50 million for FY2013.

When spending limits are absent and costs escalate, remedies can be difficult to implement and slow to take effect. For example, when Oregon lawmakers sought to rein in spending on the state’s Business Energy Tax Credit, fiscal analysts projected that even if the credit were allowed to expire entirely in 2011, commitments the state already had made would cost $830 million over the next six years.

“Regular evaluations of existing incentives are essential but not sufficient to prevent the unexpected costs these policies can cause,” Chapman said. “Clear estimates and annual spending limits from the outset are the best approach to avoid unnecessary fiscal risk without sacrificing the economic returns of effective tax incentives.”