Working Papers

2006-47 | July 2008

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State Investment Tax Incentives: A Zero-Sum Game?

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Over the past four decades, state investment tax incentives have proliferated. This emergence of state investment tax credits (ITC) and other investment tax incentives raises two important questions: 1) Are these tax incentives effective in achieving their stated objective, to increase investment within the state?; 2) To the extent these incentives raise investment within the state, how much of this increase is due to investment drawn away from other states? To begin to answer these questions, we construct a detailed panel dataset for 48 states for 20+ years. The dataset contains series on output and capital, their relative prices, and establishment counts. The effects of tax variables on capital formation and establishments are measured by the Jorgensonian user cost of capital that depends in a nonlinear manner on federal and state tax variables. Cross-jurisdictional differences in state investment tax credits and state corporate tax rates entering the user cost, combined with a panel that is long in the time dimension, are key to identifying the effectiveness of state investment incentives. Two models are estimated. The Capital Demand Model is motivated by the first-order condition for a profit-maximizing firm and relates at the state level the capital/output ratio to the relative user cost of capital. The Twin-Counties Model exploits both the spatial breaks (“discontinuities”) in tax policy at state borders and our panel dataset to relate at the county level the relative user cost to the location of manufacturing establishments. Using the Capital Demand Model, we find that own-state capital formation is substantially increased by tax-induced reductions in the own-state price of capital and, more interestingly, substantially decreased by tax-induced reductions in the price of capital in competitive-states. Similarly, using our Twin-Counties Model, we find that county manufacturing establishment counts around state borders are higher on the side of the border with the lower price of capital, but the difference is economically small, suggesting that establishments are much less mobile than overall capital. Extensions of the Capital Demand Model also reveal that state capital tax policy appears to be a zero-sum game among the states in that an equiproportionate increase in own-state and competitive-states user costs tends to have no effect on own-state capital formation.

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