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A Race to the Bottom
by Barry Keating, Ph.D.
reprinted with permission of IPR- Indiana Policy Review
The tallest and most prominent building in South Bend is the Chase Tower. The Tower is also known for inoperable elevators and a crumbling façade; the occupancy rate is about 50 percent. The Summit Club, once located on the Tower's top floor, was considered the most elite restaurant in town. Now the building is only a sad reminder of a better past, but soon it could be an even more painful reminder.
The South Bend Common Council is considering a tax abatement to the company that bought the Tower out of foreclosure. A tax abatement forgives or partially reduces property taxes for a period of time. Most states award abatements of up to 10 or 12 years. The maximum abatement permitted in Indiana exempts all taxes due in the first year to finance any improvements, followed with reductions in subsequent years such that in the 11th year no deductions remain.
Tax abatements have become a staple device for local governments seeking to attract businesses. However, the effectiveness of abatements or the interest of the general public is seldom considered. My Common Council apparently makes decisions based on the recommendations of the local economic development authority and pressure from vested interests.
For cities like South Bend, abatements are likely a zero-sum game in which cities compete in offering the largest and longest abatements to potential business entrants. The only real beneficiaries are the businesses themselves and possibly the government officials granting abatements. This process truly earns the label of “corporate welfare."
When governments subsidize businesses in this manner they subvert the normal operations of a free market. Instead of firms making decisions about where to locate based upon the economic attractiveness of a location, businesses are led instead to base their decisions on which municipality offers the largest abatement package. Decision-makers, underestimating the real comparative advantages offered by the locality to particular industries, are most likely to offer abatements. And, it is precisely those firms, controlled by managers with short-term personal considerations, that will be enticed to accept abatements as opposed to locating where they could be most productive.
It is astonishing that cities actually look forward to post-abatement time when these businesses will begin paying property taxes. Ironically, these firms also look forward to the expiration of the abatement: It represents an opportunity for the firm to “go shopping” again and see what other localities might offer in terms of incentives. There is some evidence that tax abatements actually increase the likelihood that firms relocate. In addition, a University of Michigan study indicates that “a significant number of abatements have been given to companies that have gone out of business.”
So, if tax abatements are so ineffective, why do we still use them? The answer clearly lies in examining the winners and losers totax abatement. City officials are desperate to attract, or appear to attract, business activity of almost any nature. They perceive abatements as a means of competing with other towns, and thus a necessary cost. City and development officials, as well, like to believe or make others believe that they possess unique leadership ability and special insight in awarding benefits to certain industries.
The problem, of course, is that in granting exceptions to paying property taxes they make citizens and existing businesses poorer yet. Abatements actually shift the tax burden to local households and firms. Tax abatements starve municipal budgets that depend upon property-tax receipts to provide critical public services such as street maintenance, police and fire protection. In addition, they erode the parks, libraries, and community centers that form the "social cement" of a town.
Property taxes are generally thought to be regressive, i.e.,those with little income pay a larger percentage of that income in property taxes than do wealthier citizens. Thus, abatements shift the tax burden to the least wealthy. In Philadelphia, which is regarded to have the most generous tax abatement program in the country, the Pew Trust reports that 36 percent of residents indicate that they would “definitely/probably leave” in the next five to 10 years.
A public school official expressed surprise at the amount of unpaid property taxes in Indiana as compared with districts in other states with which he was associated. This writer is unaware of studies researching this issue, but noncompliance is a reasonable hypothesis to consider when so many exceptions have been made in releasing some from property taxes.
Is there an alternative to this race to the bottom?
Sixty years ago, Zug, one of 26 cantons in Switzerland, was one of the poorest areas in the country. But Zug lowered both its corporate and personal taxes; it lowered them until its taxes were about 50 percent below the Swiss average. The canon also made building permits easy to get. What happened? Businesses moved to Zug; corporate headquarters were moved to Zug. The number of firms doing business in Zug skyrocketed; jobs rose 20 percent in just six years.
Perhaps Indiana cities should at least consider that the answer to their ills might be less government (a lot less) rather than more of what has caused so much pain in the past.
Barry P. Keating, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation, is professor of finance at the University of Notre Dame. He was an expert guest at the foundation's Dec. 3 seminar on local economic development.