Tuesday, December 20, 2005

Tax Incentives

Suppose that the political process in each town is perfect such that the maximum amount of tax incentives the town will offer max's out at exactly equal to the increased utility to the town. How does a company decide to locate? Given that there are multiple communities bidding, it will pick a location based on the maximum of tax breaks plus profit to be derived. Without tax breaks it would maximize profit (efficiency) in choosing location; with tax breaks it maximizes efficiency + tax breaks, so it may not maximize efficiency. This has happened because the company internalizes some of the positive externalities of its being located in a given town.

We can say a few other things about company location decisions given that it maximizes profit and tax breaks:
  • A place that is more profitable will, ceteris paribus, win;
  • A place that is able to offer more tax breaks will, ceteris paribus, win;
  • If tax breaks are sufficient, a location that is less profitable might win.
This last is the interesting case. I'm pretty sure that this is still total welfare maximizing, but the distributional issues are rather interesting.
  • Within the town: the tax breaks increase everyone's taxes (or decrease everyone's services) but benefit largely those employed by the firm (though there may be spill-overs). So this is a redistribution to people who work for the firm from the other townies.
  • Between firm and town: we have stipulated that this town is a less efficient place to be. The town, because it is competing against lots of other towns, will have to bid a large portion of the benefits of having the firm located their. Hence, most of the within town benefits will go to the firm. So money is redistributed from town to the firm (given that the firm was there before).
So tax incentives serve largely to increase profit at the firm, and then redistribute money from other towns-people to the workers (unless the spill-overs are greater than the tax breaks).

This looks a lot less malicious if spill-overs are very large. Also, if the company does not stay, then the town might die; whereas if it does not come it just might not grow. So the endowment effect is at work, I'd suspect. I'm sure there is much more to say. Henry?

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