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The Manageable Challenge of Tax Incentives

They don't have to produce fiscal uncertainty. States are finding ways to bring these important economic development tools under prudent controls.

Every state uses financial incentives, often in the form of tax credits or cash grants, to encourage business growth and job creation. However, this economic development strategy has led to serious budget challenges in many states.

In May, for example, Michigan officials projected that because businesses were redeeming more in incentives than the state was collecting in corporate taxes, it would suffer a net loss in revenue from its major business taxes in the current fiscal year. Hawaii ended an incentive program for high-tech businesses in 2010 amid concerns about its effectiveness, but a 2015 audit showed that the state could still be on the hook for hundreds of millions of dollars because of prior incentive commitments. Oklahoma is unsure when businesses will use more than $400 million in tax credits the state offered, a situation that one official described in an interview with Oklahoma Watch as "a huge wild card" for the budget.

Yet these fiscal challenges are not inevitable. A recent report by The Pew Charitable Trusts described how states can use incentives while avoiding budgetary surprises. One approach is to design incentives with fiscal protections. Many states have placed annual limits, or caps, on the costs of some incentives. When California created three new incentives in 2013, the state capped them at a combined $750 million annually. One way the state makes sure that the cost of the incentives does not exceed the cap is by using a competitive selection process for one of the three programs; a state board then approves incentives only for the most promising proposals.

A big part of the solution to these challenges is better data. States need high-quality data on their incentives to anticipate cost increases and long-term fiscal impacts and, if necessary, give policymakers time to prepare or change the design of their incentives. Iowa, for example, has developed a consistent approach for forecasting the costs of incentives. The Department of Revenue uses data from business tax returns to project the costs of each tax credit five years into the future, updating the numbers three times a year. These estimates are incorporated directly into the revenue forecasts that lawmakers use when they develop the state budget.

To produce reliable, up-to-date information on the costs of financial incentives, policymakers need to ensure that state agencies have the ability to work together and manage these programs effectively. Typically, more than one part of state government in involved in overseeing and administering tax credits and other incentives. For instance, economic development agencies often determine which companies receive incentives, while revenue agencies process the tax returns when companies redeem them. In Missouri, the Department of Revenue and the Department of Economic Development have joint access to a tax credit database. That way, if the economic development agency approves incentives for a new business or project, revenue officials can see that information in real time.

While both the legislative and executive branches benefit when they can take incentives into account as they develop their revenue forecasts and state budgets, this can be a challenge because some incentive programs allow companies to save tax credits and redeem them years later. Virginia's Department of Taxation has a well-established process to monitor credits that businesses are carrying forward: When a state agency issues a credit, tax officials enter the information into the state's tax processing system. As taxpayers redeem credits, the state subtracts the amount from the outstanding balance, reducing the likelihood that Virginia will be caught off guard by a sudden increase in redemptions.

Programmatic evaluations are also an important source of data. Since the start of 2012, 22 states and the District of Columbia have passed laws requiring regular evaluation of tax incentives or improvement of existing evaluation processes. These detailed studies are generally produced by nonpartisan professional staff and provide states with valuable information on both the economic results of incentives and whether they are likely to cause budget challenges.

Last year in Maryland, for example, an evaluation of a tax credit for rehabilitating historic buildings found that the program, which was scheduled to sunset in 2017, included important protections to constrain costs. However, additional measures were recommended. This year, the General Assembly extended the tax credit for another five years while also making some critical changes that the evaluation highlighted. Nebraska and Oklahoma are trying to gather information similar to that collected by Maryland. As part of evaluation laws enacted in 2015, both states will study whether their incentive programs have sufficient fiscal safeguards.

As these examples illustrate, there's a lot that states can do to keep their tax incentive programs under prudent fiscal control. Numerous states are beginning to implement policies to make the cost of incentives more predictable and to manage them more effectively. Doing so will allow states to invest in their economies while keeping their budgets balanced and taxpayers protected.

Executive vice president and chief program officer for the Pew Charitable Trusts
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