Discussion - effect of taxes and public services on economic development - The Effects of State and Local Public Policies on Economic Development: An Overview

As a part of my comments on the papers by Ronald Fisher and Michael Wasylenko, I should like first to review the facility location process, highlighting the effects of taxation. I will then comment on the effects of public services on economic development. The analysis will be based on my practical experience at Deloitte & Touche/Fantus Consulting and on the firm's data base showing the relative importance of location factors as they have related to company location decisions by Fantus clients. These clients have hired Fantus to assist them in siting manufacturing facilities, distribution centers, office/service centers, and research and development laboratories.

Location Criteria: The Role of Taxes

The "art" of facility location was first developed by Fantus Consulting, and its techniques are now used by site seekers everywhere. The basic approach of selecting a location by the matching of company needs with community characteristics is universally accepted, as is the axiom that the selection process is one of elimination: The site seeker starts with a universe of locations and systematically eliminates those with the greatest disadvantages and the fewest advantages for the project, until the single location with the most advantages and the fewest disadvantages emerges. It is this location that is selected for the new operation.

Companies seeking a location use a myriad of criteria to evaluate locations; some have lists of hundreds, but for most, the list is usually less than 50. These factors are divided into three basic categories: operating costs, operating conditions, and quality of life. Operating costs include such items as labor costs, utility costs, occupancy costs, tax costs, and transportation costs, in the case of manufacturing. Operating conditions include quality of the work force, dependability of utilities, attitude of local officials, and executive travel times. Quality-of-life factors may include cultural activities, education capabilities, sporting opportunities, and housing availability and cost.

Location criteria are different for different business sectors and different companies within any sector, as well as at different stages of the site search. This greatly complicates any effort to discern causal relationships between any given location criterion, such as tax levels, and economic activity or growth. Indeed, what might be a direct relationship for one situation or set of studied circumstances might be quite different for another - and in fact for most others.

Site selection is a dynamic process, not a static approach. The "art" of geographic elimination requires a set of screens that systematically eliminate the least favorable locations. At each level of screening, the site location criteria are different, as is the relative importance of each criterion. This is exceedingly important to recognize when trying to evaluate the effect of taxation, or any other location criterion, on economic development.

The Location Process: Initial Screening

The initial stages of the screening process are commonly described as "defining the area of search," that is, identifying the broad region and the individual states that comprise that region. At this level, the relative importance of each location factor or criterion will be different for each individual project. The focus typically is on macro wage differentials, usually at the state level, transportation variations (in the case of manufacturing facilities), and key "fatal flaw" criteria as developed by the company/consultant; for example, right-to-work state, proximity to a university. with an engineering school, port facilities, available buildings, and so on. Taxes will be brought into the analysis, but only on a comparative basis. Usually, no detailed tax evaluation will be made at this level of screening.

In terms of taxation, the analysis usually consists of a series of tables showing the following for each state under consideration: corporate income tax (rate, federal deductibility, formula); personal income tax (rate); unemployment tax (rate, payroll); and workers' compensation (code, experience rating). If any state is not reasonably competitive with the others based upon these general tax inputs, it will probably be eliminated at this stage. For example, if most states in the defined area of search have corporate tax levies of 5 or 6 percent but one has a 10 percent levy, the latter state may be eliminated, even though actual corporate income taxes for the project have not been calculated. A state's taxes must appear reasonably competitive when compared with other areas for the area to remain under consideration for the next step in the screening process.

The Location Process: Community Selection

The next step in the location screening process is community selection. The general area of search has been defined and could represent a geographic region, a number of individual states, or a grouping of counties. It is now necessary to evaluate all potential locations within the search area. This could include as few as 15 or 20 communities, or as many as 50 or 100 or more. The focus at this stage is on preliminary operating costs. Areas with fatal flaws have already been eliminated, as have areas with noncompetitive characteristics. Now communities with reasonable operating costs that also meet other key location criteria must be identified. At this stage, tax evaluation is based on modeling actual tax costs for the specific project under consideration, as well as actual costs for labor, transportation, utilities, and occupancy. A pro forma operating cost summary is prepared for each location under consideration.

Based upon a review of Fantus data bases for clients over the past five years, the relative importance of each cost factor in identifying specific communities within the defined search are as follows, for a typical manufacturing operation and for a back-office operation:

Cost Factor         Manufacturing (%)      Office (%)

Labor                      36                  72
Transportation             35                   0
Utilities                  17                   8
Occupancy                   8                  15
Taxes                       4                   5

Total                     100                 100

It can be seen that taxes represent only a small proportion of "geographically variable operating costs," that is, costs that vary with geography. To argue a causal relationship at this level of screening between the level of taxation and a decision to locate in any of the communities under consideration would appear most difficult, given the low priority and minimum cost impact associated with taxation. In addition to a determination of "geographically variable operating costs," pertinent operating conditions and quality of life factors are also considered during this step, so that at its conclusion only a handful or even fewer locations remain.

The Location Process: Final Selection

The next level of screening is a direct and thorough comparison and ranking of the three to five locations that offer the greatest advantages and the fewest disadvantages for the proposed project. Now, all taxes and all tax abatements and incentives affecting the project are developed, evaluated, and compared, one finalist location against another. The evaluation includes the tax consequences of various forms of organization and reporting relationships, and the development of accounting procedures that will minimize the tax impact.

Corporate tax impact may be viewed company-wide and even worldwide. Incentives are evaluated against tax levies, and personal tax implications are determined for each individual likely to transfer to the new location. In addition to the impact of state taxes or county taxes, local taxes on real and personal property are calculated, as well as any unique taxes that would affect the operation, such as a local sales tax. Again, incentives reducing tax impacts are identified in order to arrive at a "net" tax for each of the finalist locations.

Pro forma operating costs are calculated for the operation at each community under consideration. Calculations are usually undertaken for 15 to 20 years into the future under various assumptions regarding production levels, profitability, inflation, and so on, in order to determine which community will have the most favorable cost structure for the company in the long term under the most likely of the scenarios.

At this level of the analysis, the "services" side of taxes is also carefully measured - what the company will receive for its tax dollars in the way of services, such as police protection, education capabilities, and the like. For our clients, education has been found to be the single most important service, greatly exceeding the value of all other services combined. A distant second is highway adequacy, followed by public safety and then infrastructure. (The second part of my comments discusses the importance of services in more detail.)

The value of education and highways should be self-evident but the ranking of public safety may be surprising. The companies' concern is not only the effect that crime levels have on the safety and security of people and property but also the effect on insurance rates. Effective crime prevention is important to companies considering locations.

All other operating conditions and quality-of-life factors important to the company and the specific operation are also generated, then evaluated and compared for each of the finalist locations. The conclusion of this process results in the selection of the specific community for the new facility.

Summary: Taxation and the Location Process

From a facility location standpoint, three key issues complicate any analysis of the effect of taxation on economic development. First is the lack of consistency among economic sectors, industry groups, and companies within the same group seeking to locate new facilities. To assume that any set of numbers provides a meaningful representation of tax elasticity from which to make generalized comparisons is questionable.

Second, in the site selection process, and hence in the economic development of any area, the role played by taxes and the kinds of taxes considered vary, depending upon the stage of the screening process. Tax implications are dynamic, and they change at each level of investigation from the general level of taxes to very specific calculations of the tax bill related to a specific project. A series of calculations at each step in the process is required to determine any meaningful elasticity coefficients.

Finally, in the facility location process, taxes are not relatively important when compared with other cost factors such as labor, transportation, and utility and occupancy costs. The only case where taxes alone could sway a location decision is a company relocation within a relatively autonomous geographic area, such as a city or metropolitan area, where labor, transportation, and utility costs are consistent. Then tax variations, and frequently occupancy costs, can be the final determinant. This has been confirmed by literature on the subject.

In summary, site selection data do not suggest any correlation between low taxes and positive economic growth, or between high taxes and slow growth. The location requirements are too many, the process too complicated, and other factors too important to justify a strong relationship.

The Effects of State and Local Public Services

With many states and local governments focused on investment and job creation, and with ever greater competition for public funds, government units throughout the country are trying to determine how best they can spend public funds to maximize results. "Where can we get the greatest economic development impact for the dollars we spend?"

The importance of this question and the complexity of potential answers is indicated by the amount of attention and literature focused on this subject. But, as demonstrated by Ronald Fisher, more work needs to be done. He notes that even using similar approaches and methodologies well established in academic literature, researchers obtain inconclusive and occasionally conflicting findings. I would like to contribute a pragmatic view of the issue, based on the experience of Deloitte & Touche/Fantus Consulting in evaluating the benefits to specific companies of public service investments made by specific jurisdictions - one state against another, one city against another, one site against another.

Jurisdiction versus Jurisdiction

The use of state averages to determine any public expenditure as it relates to population, employment, income, or the number of firms is very misleading. Our experience in evaluating services provided by public funds indicates that differences among communities, even within the same state, are greater than differences among the states. And it must be remembered that in the final analysis companies choose specific communities in which to locate, not specific states. Any analysis is further complicated by the fact that they must select a specific site or building in which to locate, and the taxing jurisdiction and the services provided could be quite different even within the same city, let alone between locations in the same metropolitan area.

Highways and Transportation

From a practical standpoint, the most important highway characteristic as it relates to facility location is distance from an interstate highway or a limited access highway. According to our data base, over 50 percent of our location clients want to be within 25 miles of an interchange to such a roadway. With just-in-time delivery the current watchword, more and more companies are shifting product from traditional rail to truck. In addition, information age companies use various forms of express service, also dependent upon highway systems, at least for pick-up and delivery. But most important, with tightening labor markets, companies must draw employees from ever-greater distances in order to satisfy labor requirements. Highways facilitate this process.

Recognizing the importance of highways and highway access to economic development, many states and local governments provide funding for highway improvements to industrial parks and to new companies locating in an area. It would seem that there is a direct relationship between funds spent in this fashion and changes in employment or new investment. The case appears much more difficult to substantiate regarding total spending for miles of new highway in an area, or highway spending as a fraction of personal income, especially when evaluated at the local level. The point made by Fisher, in which I concur, is that a fair appraisal is complicated by the interjurisdictional nature of highway impacts.

Public Safety

Companies are concerned about public safety as a location factor as it relates to people (employees, visitors, and so on), property, and insurance rates. These concerns are mostly focused at the local level since local governments usually are the delivering agencies for public safety services. Therefore, any analyses of public safety and economic development would probably be best focused at the local level.

Education

The single most important factor in site selection today is the quality of the available work force. Companies locate and expand in communities that can demonstrate that the indigenous work force has the necessary skills required by the company or that have the training facilities to develop those skills for the company.

The link between education and the availability of a qualified work force is difficult to analyze. The link between education and economic development appears even more difficult, as Fisher notes. Yet, practical location experience suggests a very strong link between the two. This is especially true in this age of broadened job content and technical skill emphasis and, in fact, a qualified work force may be the single most important determinant in the economic development success of any community.

Site selectors typically use a number of surrogates for determining the availability of a qualified work force in an area. Obviously, the existence of firms already having employees with similar skills is a positive. So are favorable secondary school statistics such as SAT/ACT scores, the percentage going on to post-secondary study, student/teacher ratios, classroom size, teachers' salaries, and a number of other traditional education measurements. However, based upon our practical experience, the single most important determinant of the potential labor quality in an area is the presence of post-high school educational facilities, along with the degree to which these institutions are working with local businesses to meet their recruitment needs.

I do not know if any attempt has been made to formally determine the linkage between labor quality and post-high school opportunities locally, or between these local facilities and economic development, but I would suggest that such efforts could prove fruitful. A study using post-high school data at the local level, not the state level, might find a strong correlation between public spending on this form of education and economic development.

Further Comments

One major location factor not discussed in the literature covered by Fisher is the effect of direct public sector incentives to companies locating or expanding in an area. I would hypothesize that these incentives are positively associated with growth and productivity. In many cases, public sector incentives substitute directly for funds that the company would pay for various infrastructure improvements. Has growth and productivity been greater for companies taking advantage of public sector funds than for firms not using such funds? What kinds of incentives seem to have the greatest impact on company-specific productivity?

Location factors vary from industry to industry and among companies within the same industry. Therefore, to attempt to model government spending in any macro sense could result in misleading or at best inconclusive results. It must also be recognized that the relative importance of location factors constantly shifts, depending upon the status of markets, resources, and technology.

Finally, I must emphasize again that differences among communities, even in the same state, are greater than differences among the states. This is true as it relates to the determinants of facility location as well as to various categories of public expenditures.

Robert M. Ady, Executive Consultant, Deloitte & Touche/Fantus Consulting.

COPYRIGHT 1997 Federal Reserve Bank of Boston
COPYRIGHT 2004 Gale Group