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Sunday, January 20, 2013

Problems with state tax incentives

A report released in December 2012 by the Pew Center on the States (Avoiding Blank Checks - Creating Fiscally Sounds Tax Incentives) points out the risks many states take in enacting tax breaks with the hope of changing behavior to benefit the state. Such incentives include tax credits for hiring workers, income tax credits for filming in the state or energy incentives.

The report includes examples of incentives that grew tremendously, causing budget problems for the state. For example, a high wage jobs credit in New Mexico cost $9.8 million on year, but $48 million the next. Unless the credit led to a tremendously broader tax base, how is the state to afford the unchecked incentive?

States can place caps on the dollar amount available for the credit, encouraging taxpayers to change their behavior quickly to better ensure they will get benefit of the incentive before it is all used up.

Key recommendations Pew has for state lawmakers:

"Ensure that policy makers understand the budget implications of proposed incentives; and Manage the size of tax incentives by setting limits on their annual price tag."

Here are my suggestions for how states can better utilize tax incentives and control their costs:

The following questions can help improve the effectiveness of proposed tax incentives. To illustrate each question set, it is applied to a made-up proposal to provide a credit to students who prepare to teach STEM topics (science, technology, engineering and math).
  1. Jurisdiction's Goals and Strategy: Have the jurisdiction's economic, societal and environmental goals been identified and articulated? To help determine if the purpose of a tax incentive is appropriate, it must be judged by how well it helps the jurisdiction meet its goals. Thus, such goals need to be articulated. In addition, answers should be provided as to why the tax incentive is the necessary and desired way to help achieve the goal and why alternative uses of the funds would not be better.
Example: What is the state goal that will be advanced by the tax credit? How will the credit help the state meet the goal – what is the connection between the program and the goal?
  1. Tax System Relevance: (A) Does the tax system hinder the state's achievement of the goal such that modification (the addition of special rule) is needed to help the state meet its goals? OR (B) Would the tax system be an effective and appropriate vehicle for delivering the benefit? What are the pros and cons of using the tax system to provide the incentive compared to alternative means (such as a grant)?
Example: It is unlikely that there is any tax system feature that hinders students preparing for STEM topics. Thus the question is whether the tax system is an effective and appropriate vehicle for delivering the benefit. Arguably, it is not because the state tax agency would have to gather information on the student's courses and major. Also, unless refundable, the credit would only be obtained if the student had a tax liability. In addition, the credit would not be delivered when needed, that is, when tuition is due. A grant program could better deliver the benefit, assuming the benefit is needed to help the state meet its goals.
  1. Tax Policy Considerations: Principles of tax policy, including equity, simplicity, neutrality and efficiency, minimum tax gap and transparency should be considered in the design of the tax expenditure.
Example: Measures would be needed to be sure the student is actually preparing to become a STEM teacher. Issues would need to be addressed as to whether the credit should be refundable and whether a student claimed as a dependent should be eligible.
  1. Budget Considerations: What is the estimated direct and indirect costs of the special tax rule? How long should the tax rule be in effect? How will the cost be controlled (such as setting an aggregate limit for a tax credit)?  Will the method of paying for the special rule hinder the ability of the special rule to meet its purpose or cause a greater detriment to the jurisdiction than would occur in absence of the special rule? Could greater benefits be derived for the jurisdiction through other uses of the funds (even if for a different purpose)?
Example: Legislators need an answer to the question – Why is this credit a good use of state resources? Data would need to be analyzed to determine how much the credit should be to serve as an incentive and an aggregate cap determined and implemented. Consideration should also be given to how the credit affects existing grant programs for higher education to be sure there is no duplication.  In addition, consideration is needed as to whether more resources will need to be directed to STEM instruction to ensure that the expected increase in number of STEM students can be served. Alternative uses of the funds should be evaluated to construct the best program to help the state meet its goal of increasing the number of STEM teachers.
  1. Accountability Measures: What accountability measures should be included to ensure that the special tax rule is properly used?
Example: Consideration should be given to including a clawback measure should a student not become a STEM teacher. A sunset date should be added to ensure that the credit will be evaluated for effectiveness.
  1. Assessment: What data is needed to determine if the special tax rule achieves its purpose? How and when will the data be collected? Should the enacting legislation also specify data collection requirements? Who will monitor collection and who will analyze the data?
Example: The enacting legislation should specify the data that is needed for evaluation purposes and who will collect it and how. The enacting legislation should also specify a measurable and appropriate goal, such as a percentage increase in the number of STEM teachers who utilized the credit.

More - see my testimony delivered to a California legislative joint committee in February 2012. 
What do you think? Should states even enact these incentives or instead just lower their tax rates?


Christopher Harrington said...

Interesting question. Pew has a good point,though I believe not all states would develop the same budgeting issues as a consequence. However, they should practice due diligence and make sure no problems develop, and possibly lower tax rates slightly as to attack the issue from both ends.

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