You Decide: Should We Use Incentives to Attract Firms?

By Mike Walden

North Carolina recently received some outstanding economic news. Our state was named “America’s Top State for Business” by a major national media organization. This is, indeed, a high honor. It recognizes the attractiveness of North Carolina to both national and international firms. Experts say the state’s labor supply, educational systems – especially universities and community colleges – competitive cost of living, and attractive weather and natural amenities are some of the reasons for our high business ranking.

Yet there may be another factor at work – incentives. Incentives are a type of financial rebate available to businesses that locate in North Carolina. Usually they take the form of a reduction in taxes paid by the company over several years. The company still pays state taxes, but just less. The incentive packages can be big – even over a billion dollars – if the tax reductions last several decades. Local governments in North Carolina can also offer incentives, but they’re usually much smaller in dollar amounts compared to the state’s programs.

Recently, I talked to a local citizens group about incentives. Several questions were raised, including why incentives are used, whether incentives should be banned and if North Carolina loses money with incentives – money that could be used for crucial state programs. Let me provide the same answers in this column as I gave to the group.

Incentives are used because they work. Business incentives were first offered by a few states in the 1930s, but they have significantly expanded in the last thirty years. In particular, large, well-known companies bringing thousands of jobs and billions of dollars in economic activity will rarely consider locating in a state without incentives.

Does this mean only incentives are important? Not at all. A business will have specific requirements for labor, skills, access to suppliers, access to buyers, transportation and other factors. Research shows a business looking for a site will examine numerous locations across the country – and possibly even the globe – and then decide on a handful of sites that meet their requirements. The business will consider each of these two, three, four or five locations as equal. It’s then the size of the offered incentives package that will create the winner.

Some may say states are being used by companies to provide them with more financial benefits. If so, then why don’t states just agree not to use incentives? There have been efforts to do this, but thus far, they have failed. Why? Because even though incentives can be costly to states in terms of foregone tax revenues, they can still generate net benefits.

Consider this example. Suppose the “Big Deal Company” is offered incentives worth $250 million over twenty years to come to North Carolina, and they accept. Is the North Carolina treasury in the hole for $250 million for the next twenty years?   

Not necessarily. If the new economic activity generated by the Big Deal Company creates $350 million of new state revenue potential during the next twenty years, then even including the incentives, North Carolina’s public revenue would be ahead by $100 million.   

The gain could even be bigger if North Carolina is able to reduce spending on unemployment compensation and other economic support programs as a result of employment rising and unemployment falling.

But how do we know if the Big Deal Company will be prosperous enough to pay $350 million to the state over twenty years? Based on the company’s hiring and production plans, we could estimate their revenues, payroll and other key factors to generate forecasts of what they would pay the state before incentives. Then we could compare those forecasts to the costs of incentives. If the forecasts of new revenues and spending savings are greater than the incentives, then using the incentives could bring a net gain to the state.

Indeed, this is exactly what North Carolina does before offering incentives. For the past twenty years, the state has been using an economic model that predicts the benefits and costs of incentive packages.

But some of you may be thinking – what if the model is wrong? What if, after receiving the incentives, the company doesn’t hire as many workers, produce as much output and pay as much tax revenue to the state?

Fortunately, North Carolina has thought of this possibility and includes “clawback” provisions in the incentives contract. If the company doesn’t meet the hiring number they claimed they would, the size of the incentives is reduced – or “clawed-back” – in proportion to the number of missed jobs. North Carolina has used this clawback provision several times.

Of course, there’s always the possibility a company would have come to North Carolina without incentives. However, experience suggests this possibility may be slim. For example, recent records revealed that North Carolina was about to lose a large multi-hundred-million-dollar firm to another state because North Carolina’s incentives package was too small. The state increased the amount and the firm announced they were coming to North Carolina.

There’s much to dislike about incentives, and most people wish they wouldn’t be used. However, as North Carolina’s economy has been transformed in recent decades, with traditional industries like tobacco, textiles and furniture downsizing and new sectors such as technology and pharmaceuticals rising, the state has striven to attract new companies so that good-paying jobs can be offered to our workforce. Is it worthwhile to use incentives to accomplish this goal? You decide.

Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.