US state and county economic development agencies hand out more than $50bn in investment incentives every year but their methods are mysterious. Charles Olivier reports.

Two years ago, South Korean car manufacturer Hyundai decided to build a plant in the US and hired KPMG to find a suitable location. The accounting firm drew up a list of potential states and contacted their state economic development agencies.

“We got a call saying there was a car manufacturer looking for a 1600-acre site and good interstate access,” recalls Todd Strange, executive director of the state economic development agency of Alabama.

Subsequent meetings revealed that the company was planning a plant that would create 2000 jobs and cost $1bn to build. So, in November 2001, the governor of Alabama and a team of government officials visited Korea to make a presentation.

By December 2001, Hyundai had narrowed the short list down to six sites in four states – Mississippi, Alabama, Kentucky and Ohio – and asked each state to put together their best possible incentive package.

This put Mr Strange in a difficult position. If he offered too little, Alabama would lose the project (as it had lost the Nissan factory to Mississippi the previous year). If he offered too much, the state would pay out more than it got back in tax and employment benefits. “Our finance and budget office had to do extensive cost-benefit analysis,” he says. As it turned out, they got their numbers right.

In April 2002, after extensive negotiations, Alabama agreed to grant Hyundai a $252.8m incentive package including $76.7m in tax breaks, $61.8m in training grants and $34m in land purchase assistance.

Investment incentives have been used by southern US states to attract companies from the more industrialised northern states since the 1930s. But during the past 20 years, as global competition has increased and corporate tax planning has become more aggressive, the use of incentives has become widespread across the US.

Today, every state, county and city in the country has an economic development agency (EDA) and extensive funds available for investment incentives. Most large US companies employ incentive specialists, whose job is to obtain the maximum amount of tax breaks and grants from the EDAs of the states where they operate.

Liberal economists, such as Art Rolnick of the Federal Reserve Bank of Minneapolis, say that these specialists are so successful that some large US companies end up paying no tax.

Competition is fierce

With more and more companies on the prowl for incentives and the majority of states seeking to attract investment, competition for big-ticket deals has become intense. When Boeing announced last year that it wanted to relocate its headquarters from Seattle, for example, more than 30 states submitted proposals.

Competition has, in turn, forced EDAs to offer increasingly generous incentive packages to “win” investment projects. This is particularly noticeable in the automobile sector. In 1978, for example, the state of Pennsylvania gave Volkswagen incentives equivalent to $3550 per job created to set up a factory in the state.

Two years later, in 1980, Tennessee paid Nissan $11,000 per employee. And in 1993, Alabama paid Mercedes Benz $150,000 per job created.

“Since the mid-1990s, [EDAs] have been on a spending binge like drunken sailors,” says Greg Le Roy, founder of Good Jobs First, a Washington DC think-tank that specialises in investment incentives.

Accurate statistics on the average size of incentive packages are impossible to obtain but according to David Donovan, a partner at Wadley Donovan, a location consulting firm based in New Jersey, $5000 to $10,000 per employee is common.

“If the company is going to build a facility employing 100 people, it can expect to get a package totalling $750,000,” he says. “But if it is a major project, it should be looking for a package equivalent to 20% of the capital expenditure.”

Mr Le Roy says that many EDAs try to conceal the amount of incentives they give out to make their record on investment attraction and job creation more impressive.

Kenneth Thomas, an economist at the University of Missouri in St Louis, calculates that in 1996 US states granted around $48.8bn in incentives. This figure includes sales tax exemptions and incentives paid to existing investors as well as new ones, and is based on the state (but not county) incentives granted by eight states.

“I obtained data from the state governments of California, Iowa, Louisiana, Massachusetts, Michigan, Minnesota, Ohio and North Carolina (whose GDP is approximately 30% of the national total) and extrapolated them,” says Mr Thomas.

He estimates that European Union governments and regional authorities, by way of comparison, spent E37.7bn on corporate subsidies and investment incentives each year between 1995 and 1997.

“The idea that the US spends less on incentives and business subsidies than Europe is completely wrong,” says Mr Thomas. “I would say that US incentives are now running at more than $50bn a year.”

If the incentive system in the US is more generous than it is in Europe, it is also much more complicated.

First, there is no national investment promotion body responsible for setting and granting incentives. The federal government does have a budget for promoting employment in particular communities and industries, but it shares this money out among the country’s 50 states each year and has no power to grant incentives.

Instead, every US state, county, major town and suburb has its own EDA with its own investment promotion budget and board. These agencies are usually autonomous, although most are controlled by the state governor and legislature. A list of the 80,000 agencies can be found on www.ecodevdirectory.com.

Interstate variety

Second, incentive levels vary considerably from state to state and from suburb to suburb according to unemployment rates and political persuasions. Amarillo County in Texas, for example, offers an $8m cash grant to any company that creates 700 new jobs. And some counties in New Hampshire offer no incentives at all.

Third, the power of state governments also varies. In Kentucky, for example, the state finance authority takes almost all investment incentive-related decisions. This authority is controlled by the Cabinet for Economic Development which, in turn, is controlled by the governor’s office, the chamber of commerce and various state business associations.

In Texas, by contrast, incentives are not granted at state level but by county and city EDAs. Under state law, every county has the right to impose an economic development sales tax of up to 2% that they can spend more or less as they wish.

Some states (like North Carolina) give their governors $15m deal-closing funds. Others (like Texas and New Hampshire) prohibit this activity.

There are millions of different incentives available to investors in the US but most tend to fall into one of three categories: tax breaks, cash grants and cheap loans. Mr Thomas says that unlike in Europe, where grants are the most common form of subsidy, tax breaks are the dominant form of incentive in the US. His paper “Competing for capital” reveals that in 1996, the state EDA of Minnesota spent $20m on loans and grants but $1.1bn on tax breaks.

Forms of incentive

There are two forms of incentives: statutory incentives, which are established under state or county law and must be granted to any company that meets the pre-set requirements, and discretionary incentives.

“There is sometimes a squabble over whether companies are eligible for statutory incentives but, generally, if you meet the criteria you get them,” says Mr Donovan. “The discretionary incentives are only available on a case by case basis. It depends on the attractiveness of the project to a particular community and state.”

Every state and county has its own list of statutory incentives but almost all include some kind of property tax abatement (levied at the county level) and manufacturing investment tax credit (levied at state level). The latter allows companies to offset a fixed percentage of their capital expenditure against their state corporate income tax bill.

In New York State, for example, manufacturers can offset 5% of their first $350m of investment and 4% on any additional investment against their tax bill.

Many states have additional statutory incentive benefits for companies investing in high unemployment areas or in particular industries. In Pennsylvania, the job creation tax credit gives companies $1000 for every “leading-edge technology” job created, providing 25 jobs are created within three years.

A growing number of states, notably New York and Michigan, also have special investment zones where companies are guaranteed tax holidays and grants.

Discretionary incentives can (as the name suggests) be almost anything from free country club memberships for directors to cut-price landing fees for corporate jets. In practice, they tend to be utility bill subsidies, one-off cash payments for land purchases, and cash grants or tax credits linked to the number of jobs created.

Rules vary from state to state but, typically, incentives are only available to companies establishing distribution or manufacturing facilities.

“Anything that creates spin-off jobs is likely to be eligible for something,” says Mr Donovan. “You would be lucky to get any incentives for setting up a retail store, a hotel or a local warehouse.”

Historically, the most generous incentive packages have been offered by southern states, such as Kentucky, Louisiana, Mississippi, South Carolina, Georgia and Alabama. “All of these states will cut you a cheque if you create a certain number of jobs at an agreed salary level,” says Mr Donovan.

However, in recent years – as US industrial firms have begun to feel the pinch – many north eastern and mid-western states have begun to compete more actively. “North Dakota and Nebraska have some tremendous programmes,” says Mr Donovan. “Meanwhile New York, Michigan and Pennsylvania all offer decent incentives in their economic zones.”

The least generous states tend to be those in the Rocky Mountains and New England, such as Arizona, Utah, Idaho, California, Colorado, Vermont, New Hampshire and Massachusetts. But even these states will offer something if the deal fits their economic development strategy. “You can usually cut a deal with most of them,” says Mr Donovan.

Whether EDAs will continue to grant incentives as large as those handed out to Hyundai in the coming years is a matter of some debate. EDA officials (like economists) are divided over whether incentives work but most agree that in recent years the amount of money handed out has been excessive.

“Personally I would favour the restriction and elimination of incentives,“ says William Moseley, director of the Texas EDA.

But no EDA official appears willing to abandon incentives unilaterally or enter into an informal agreement to do so with neighbouring states.

Unstoppable force

It is widely agreed that the only way to stop states and counties from competing for business by offering ever-more generous tax breaks and grants is for the federal government to ban incentives. Attempts to get Congress and state governments to do so on the grounds that incentives interfere with state commerce have failed, however.

There are a number of proposals on the drawing board, such as a federal tax on incentives and a reduction in federal grants to states that use incentives excessively. But none has much political support and it seems certain that EDAs will continue to use incentives widely across the US for the foreseeable future.

What does seem likely, however, is that EDAs will adopt a more rigorous, result-oriented approach to the incentive negotiation process.

During the past three years, dozens of US companies that obtained grants and tax breaks from EDAs have gone bust or failed to meet their job creation targets. As a result, many of the agencies have introduced claw-back provisions into their contracts, under which companies must pay back their incentives (with interest) if they fail to meet pre-set targets.

Mr Le Roy expects claw back provisions to become standard practice in incentive packages. “They are an excellent way of ensuring that incentives yield economic benefits,” he says.

Agencies that are using claw-back provisions already are also expected to become more aggressive in pursuing contract-breakers following a series of successful court actions by EDAs in states such as Indiana and New York.

Some location consultants now advise companies receiving money with claw-back conditions to book the income as a potential liability. Some suggest refusing to accept the money altogether.

“Claw-backs are a lose-lose proposition,” says Mr Donovan. “If you don’t meet the target, you end up in protracted negotiations with the EDA and are exposed to a lot of bad publicity.”

Disclosure demands

Another development that could make it harder for companies to extract huge incentive packages is the growing number of states demanding greater disclosure by EDAs. Since 1999, nine states, including North Carolina and Minnesota have passed laws forcing EDAs to publish regular reports detailing their investment incentive operations.

The short-term picture is also confused. Some economists argue that EDAs will cut back on incentive spending because of slowing growth in the US economy and the deteriorating financial position of their respective states and counties. “The majority of US states are running large budget deficits and are under huge pressure to curb incentives and tax loopholes,” says Mr Le Roy.

However, many EDA officials argue that the reverse is true and that incentive spending goes up during recessions, not down. “The cooling off of the economy has made states more inclined to look at ways to attract jobs,” says William Moseley, director of the Texas EDA.

“If you are unemployed, do you buy a new suit for a job interview or continue to wear your old suit? I think Texas is going to buy a new suit,” he says.