Recent Research: Incentives and State Fiscal Health

A recent paper published by SSRN provides a detailed look at the relationship between financial incentives and state fiscal health. The authors control for many potentially-related factors and still find significant, negative impacts of incentives. While the study helps fuel calls for critical analysis and careful implementation of tax incentives, the results may not be as clear cut as some coverage may suggest.

Bruce McDonald et al.’s, “You Don't Always Get What You Want: The Effect of Financial Incentives on State Fiscal Health” measures the incentives against current-year fiscal health. This approach is reasonable for assessing immediate fiscal impacts, which particularly matter in states with balanced-budget requirements, and also makes sense for a starting point in a potential line of research.

However, the methodology may help incentives designed for immediate impact appear to have better returns than incentives designed for long-term effects. For example, R&D tax credits encourage corporate spending in the hopes of eventual gains in efficiency or the creation of a new product that will eventually produce new sales and income taxes. In comparison, job creation tax credits are generally awarded to companies that have already hired an employee and are, therefore, immediately connected to income tax revenue.

The paper finds that R&D tax credits have a negative effect on current-year fiscal metrics while job creation tax credits have no effect. These impacts are good for policymakers to understand, but they do not necessarily mean that incentives intended for long-term effects are failing to meet their objectives. This possibility is not tested by the paper.

Hopefully, a follow up piece by the authors or others will look at incentives’ effects on future fiscal health.

The bottom line is that proponents of R&D tax credits (and other programs with a multi-year horizon) should be prepared, as always, to assess and justify their programs, but should not be ready to dismantle the incentives on the basis of this report.