Scrutinizing Your Incentive Deal
5 May, 2017By: Chris Steele
Governments of all types commonly use incentives to try to draw new investment to their communities. Training programs, infrastructure grants and closing funds are all designed to enhance the community’s prospects in drawing new investment and new jobs. However, these tools have come under increasing scrutiny from watchdog groups, and companies are taking an even harder look at whether the benefit is worth the pain. As of December 31, 2016, these groups have an additional, powerful tool in their arsenal.
Incentives as Economic Development Policy
Incentives are very common economic development tools, designed simply to make companies do something they would not otherwise do. Whether the desired behavior is increased size of investment, an investment in an economically disadvantaged area or swaying a location decision from one state (or nation) to another, the implicit assumption is that the incentive itself becomes the deciding factor in the investment decision.
While incentives are rarely the true definitive factor as presented above, they do still play a strong role in the discussion of location factors and they can provide necessary assistance in lowering the bar to investment in a locality. They can address specific short-term issues like gap financing, they can help make the local workforce more prepared through training and they can make sure critical infrastructure is in place. In short, they can play an effective role both for the company and for the community if wisely designed.
However, incentives are not without risk for either communities or for the companies they are trying to lure. In some cases, communities are driven to offer incentives due to a false sense of the competitive landscape or to make up for gross deficiencies. They may be constructed in the vain hope of attracting investment to a part of the community or region that does not otherwise have the necessary inputs. They may be in place to provide a temporary reprieve against an otherwise onerous tax or cost structure. They may even be put in place as an initial but insufficient effort to build new industry clusters where they do not already exist.
Each of these situations poses its own form of risk for any company looking to make a location decision.
Incentives as Corporate Risk
The direct and indirect risks of incentive programs to communities are well-known. The distortion of natural competitive advantage, the “prisoner’s dilemma” nature of incentive negotiations and the possible misappropriation of finances from other public programs all present very real risks.
However, companies that use incentives also expose themselves to considerable risk if they have not fully thought through how the incentive package is designed, how it will be applied and how the company will be viewed as a corporate citizen in the future.
The first major risk is loss of focus: The lure of a large incentive package can act as the bright, shiny object that distracts corporate executives (or their consultants) from the core needs for a location decision. The needs for workforce or infrastructure get lost in the discussion of the multi-million-dollar grant or of “free land.”
Communities will occasionally provide large incentive packages to compete for projects where they would not otherwise have the necessary inputs. Workforce, infrastructure or tax regimen may not be appropriate to the proposed project. Similarly, the project may simply not be cost-competitive in that location (or at all) without a subsidy from the public sector. This also poses a problem for the private sector company as the location only remains a competitive one (not necessarily a “good” one) because of the public assistance. Once the assistance expires or is withdrawn, the company is anchored to a poor investment.
Let’s take the example of one of the most common forms of incentive – that of a tax credit. In this case, a jurisdiction can offer a tax rebate or credits to make up for an otherwise punitive local tax structure. The liability here for a prospect company is the underlying structural concern of a poor tax regime. No incentive will fix the overall tax structure completely and forever. At best, the incentive will provide a temporary partial shield for the company.
Incentives are sometimes used to subsidize a project that ought not to have gone forward at all. These projects carry fatal flaws with funding, with workforce or with some other liability that is temporarily and incompletely remediable through the incentive. Companies and communities alike should examine such projects with an extremely critical eye. In most cases, these endeavors should be regarded as a house of cards and the slightest breeze will make them topple. Better to stay away and to husband resources for a more sound investment.
Incentive awards can even occasionally create a systematic financial problem if the award involves sacrificing part of a community’s property, gas or other tax base to attempt to attract a business. In some cases, this sacrifice creates a critical strain on schools, roads or public services. In the short term, this creates traffic, crowding, utility stress and unfavorable local press. In the long term, such a situation can lead to overall higher taxes, hostile local press and public opinion and an impaired business environment.
The Accountants Get Involved
Accounting treatment for transactions can affect corporate behavior. This has certainly been the case for private companies – particularly for things like leases and other financial tools that may or may not have to be consolidated onto corporations’ financial statements as liabilities. Accounting treatment guidelines are written to direct companies to disclose transactions and liabilities in a manner that allows potential investors to better understand the underlying financial health of the company. A particularly strenuous set of such guidelines was issued following the Enron/Andersen events of the early 2000s and these resulted in some significant changes to corporate decision-making on investments and financial controls.
The Government Accounting Standards Board (GASB) establishes the same kinds of best practices for state and municipal reporting that the Federal Accounting Standards Board (FASB) does for companies and private institutions. As a result of much study and consideration, GASB issued Statement 77 that directs states and municipalities to disclose in their consolidated financial records the amount of revenue that has been forgone as a result of tax credits and similar instruments.
The GASB’s reasoning on this topic has little to do with a specific backlash against tax incentives, but much more to do with confidence in financial instruments that rely upon municipal or state tax income to repay bonds. Put simply, any investor in municipal or state bonds needs to be able to understand if there are limitations on state or municipal revenue due to other transactions like these incentives.
GASB Statement 77, issued in August of 2015, defines a tax abatement as resulting from an agreement between a government and individual or entity in which the government promises to forgo tax revenues. In return, the individual or entity promises to subsequently take a specific action that contributes to economic development or otherwise benefits the government, the community or its citizens.
Some states and municipalities already provide some reporting on tax credits, rebates, abatements and other forms of incentives. However this data is not always available in a form that is useful to those making bond investment decisions. As a result, the GASB has decided to make it mandatory that governments report their own tax abatement agreements as well as those negotiated by other agencies that will impact their ability to collect revenue. Put another way, jurisdiction X must report its own tax abatement deals and those that state Y has negotiated that also impact jurisdiction X’s ability to collect tax revenue.
The information that must be disclosed includes:
• Descriptive information, such as the tax being abated the authority under the Wichita to be able to provide an eligibility criteria, the means by which taxes are abated, provisions for recapturing abated taxes (if any) and the types of commitments made by tax abatement recipient
• The gross dollar amount of taxes abated during the period
• Any other commitments made by a government, other than to abate taxes, as part of a tax abatement agreement.
Finally, governments have been directed to organize these disclosures by major tax abatement programs, and may choose to disclose information for individual tax abatement agreements, which means individual deals and companies, within those programs.
The requirements are slightly different for those programs for which the jurisdiction was not a direct part to a negotiated deal or incentive, but which is subject to terms of another government’s agreement. These agreements must be listed by the government agency that entered into the tax abatement agreement and the specific tax being abated. Here again, governments may disclose information for individual tax abatement agreements of other governments (even if they were not the awarding agency) within the specific tax being abated. All other requirements are the same as above.1
All of the information presented here is also certainly of interest to the public and particularly to those who are skeptical of the value or use of tax incentives. Exposés put forth by The New York Times2 and American Prospect3 have used data already available to show the public some of the downsides of incentives and credits. Companies and incentive-granting jurisdictions alike should justly be concerned about the broad availability of data on the costs of foregone taxes. However, one also hopes that a more uniform availability of reporting also will provide insight into the kinds of incentive and credit deals that not only achieve their stated economic development goals, but also provide key data on how to refine these tools to make them a true public investment that consistently results in a positive return for the taxpayer.
By the Way, This is Happening Now
Interestingly, there has been very little excitement or overt panic from this regulation, even though it takes effect with the calendar year that ended on December 31, 2016. In other words, it’s in effect now, and the first results will be reported soon.
Even if nothing else, GASB 77 reaffirms the basic truth that nothing stays secret forever. Public scrutiny, and the need for the public to understand how its money is being spent, will mean that more and more details of incentive deals will be made available and, as stated perviously, better decision-making on when and how to offer incentive deals.
Correspondingly, companies should prepare themselves for the eventuality that information about deals and the assumptions used to award them will come into the public domain. This may include company sales projections, employment projections and revenue and tax exposure in any given jurisdiction.
This is not to say that incentives should not be considered in the location decision process or that they should be automatically and uniformly rejected. Instead, it is a call — an emphatic one — for companies to thoughtfully and comprehensively examine all of the risks and rewards inherent in pursuing tax credit deals.
1 http://gasb.org/cs/ContentServer?c=Document_ C&pagename=GASB%2FDocument_C%2FGASBDocumentPage&cid=1176166283745
2 E.g. http://www.nytimes.com/interactive/2012/ 12/01/us/government-incentives.html?_r=0