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Too Good To Be True: Determining if Taking Incentives is a Good Strategy

10 Mar, 2015

By: Christopher Steele

Using incentives to chase industry is a time-honored and well-documented strategy. Indeed, the public debate about the usefulness of such tools has been discussed in many channels over the past several years. However, the private-side of the discussion has been less covered and corporate decision makers must understand that such incentives do not come for free. A good deal of due diligence should be used when determining whether or not to accept incentives as part of a location selection project.

Incentives as Helpful Tools

Before we go into the possible risk and pitfalls, it’s important to remember why and how incentives can work. While corporate executives can and should exercise the highest scrutiny and judgment when accepting incentives, credits and other public inducements, these programs can help to produce positive outcomes for both the public and private sector.

From the company’s perspective, tax credits, grants and training funds can help to offset or underwrite necessary startup costs and can help projects proceed with necessary haste. They can help to identify and train a workforce with the talents necessary for specific tasks. They can help to install needed infrastructure such as road and utility extensions. They can help to lower overall investment hurdles and allow a project to move forward in the first place, as well.

From the public-sector’s perspective, a well-designed incentive regime not only increases a community’s ability to compete with other communities offering similar inducements, but also creates an environment where – even if the identified company’s private-sector investment fails or leaves for some reason – the community is better off. This comes in the form of a better-trained workforce, improved infrastructure or some other investment in something that becomes a tangible long-term advantage.

Incentives as Unnecessary Liabilities

The preceding paragraphs included the terms “well-designed incentive program” and “highest scrutiny and judgment." Unfortunately, the pursuit of incentive dollars often becomes an end in itself rather than only a component in the larger location strategy problem. This risk represents itself in several ways.

  • Distraction from Core Drivers

Occasionally, 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.” 

This lesson often goes unlearned even with repeated experience. Occasionally, consultants will receive requests to find new locations because a company is unable to attract a skilled workforce at their current location. When asked why the current location was chosen, they will note the incredible package they received from the state. They also will then note that a key criterion for the new location is a large incentive package. 

  • Masking Location Deficiencies

As implicit in the above example, communities occasionally need to provide large incentives as they cannot compete on the basis of traditional business factors. If access to skilled labor is a problem, perhaps a training grant will be offered. If infrastructure is inadequate, a low-cost loan or infrastructure bonding might be available. In some cases, the community will not address the incentive package to any specific known shortcoming and will simply offer cash, allowing the company executives to decide for themselves the most critical shortcoming to address.

The most frequent deficiency/incentive balance involves offering tax rebates or credits to make up for an otherwise punitive local tax structure. The liability here for a prospect company is the obvious 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. The taxman will eventually get his due.

  • Creating Systemic Financing Problems

Incentives can create bad financial habits for both the public sector and for private companies.

Private companies need to be careful about how incentives affect the overall financial viability of a business or location decision. Yes, sometimes an incentive deal can make a project move faster than it would otherwise. However, a project that cannot happen at all but for an incentive program should probably be a cause for worry. In the best case, the incentive means the company will be partially or completely beholden to the host community. In the worst case, such a situation is merely the result of poor corporate planning and will invariably leave both parties worse off.

Perhaps the more insidious case of creating a systematic financial problem involves a community sacrificing part of its 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 (and unfavorable local press).

  • Public Scrutiny

Earlier this year, Governing – a magazine that covers politics, policy and management for state and local government leaders – ran a story titled “How Local Governments Are (or Aren’t) Examining Economic Development Dollars.”[1] The author made the point that while there is considerable debate over the effectiveness of tax breaks and other incentives, few governments have actually put effective measurement regimes in place. This observation was confirmed by an article published in The Economist[2], in which the reporter demonstrated how good (or poor) individual states are at evaluating their tax incentive programs, based on a 2012 Pew Center study. The key takeaway is that while each state has implemented tax incentive programs, none is thoroughly monitoring and evaluating the performance of the incentives awarded under these programs.

This situation is changing. States are increasingly making transparency and accountability a priority in their incentive and economic development policies. Leadership in companies should ask themselves the following questions as these changes take place:

  1. Do I have the administrative bandwidth available to ensure my incentive compliance reporting is done completely and properly?
  2. How much of my corporate financial data (possibly including items of payroll) will I have to make public? How much am I comfortable in making public?

  3. Will such disclosures be a competitive liability for me and my company?

  4. Do I really want my company’s financial details in the news during times of continued pressure on state and local public finances?

Best Practices for Negotiating Incentives

Once again, it’s important to stress that the incentives negotiation can provide a very effective forum for developing a mutually beneficial relationship between company and community. However, the company must absolutely approach such discussions with a proper level of due-diligence and informed self-interest. There are at least four key areas to consider:

  • Is It a Good Business Location?

First and foremost, remember that no amount of incentives, credits, loans or other assistance can turn a bad location into a good one. Companies and their consultants should focus first and foremost on:

  1. Overall business strategy and the role the proposed facility will play within that strategy;

  2. Access to key inputs, including (but not limited to) workforce, key talent, business partners, suppliers, customers, key infrastructure;

  3. Total cost to establish and run the facility; and

  4. Regulatory and tax exposure.

Any additional conversation regarding incentives should be viewed within the “given” of the universe of the information already highlighted here. Incentives can enhance or alter these items, but they cannot fundamentally or permanently change them.

  • Will I be Able to Meet My Obligations Under the Program?

Any incentive program has attracting investment and/or jobs as its core reason for being. As a result, the company will need to commit to creating this investment and or employment base as a condition of the incentive program. How this happens depends on the structure of each program, and sometimes the awards are made after the company has proven it has achieved given benchmarks.

The greatest corporate risks come with incentive programs that provide up-front payment on the promise of prospective investment and employment targets. Conversely, clawbacks – the need to repay incentives gained if targets are not met – have been standard practice for years and communities and states alike are facing increased pressure to ensure companies are living up to their end of the incentive bargain. Performance-based, after-the-fact incentive awards are safer than those offered up-front (and also are more publicly palatable). 

True, up-front incentives are sometimes preferable depending on the problems they are meant to address, such as training and infrastructure investments. However, in these cases, companies are well-advised to be conservative in their investment and employment estimates. As always, it is better to under promise than to under deliver!

  • How Onerous are the Reporting Requirements?

States and communities are progressively improving their reporting, performance and transparency regulations. Companies receiving incentive awards should be prepared to provide employment and payroll records, investment program and purchasing details in addition to tax and depreciation filings.  Companies also may be asked for information on broader corporate structure details, such as where revenues are booked and taxes are paid outside of the awarding jurisdiction. These details will need to be prepared and filed in exactly the forms and means requested by the awarding jurisdiction.

There are at least two major concerns here – those of the administrative burden and of the sensitivity of the data itself. 

Companies should perform an honest appraisal of the administrative burden of compliance itself. While the data required will be collected in the due course of business, please note that the jurisdiction will want this information prepared and presented in very specific ways.In addition to the basic paperwork, the forms might require different arrangements and computations of the amounts.

Whenever government collects data, there is also a chance the data in question will be made public – either the specifics or in aggregate.This should be expected and prepared for by any company accepting incentives.Taxpayer advocates the world over have learned the power of FOIA (Freedom of Information Act) requests and will be working hard to make sure their taxes are being used wisely.Your data will be their target.

  • Are the Public Relations Risks Worth It?

Last – and highly related to the previous point – there is the risk that by maximizing incentive value, the company may expose itself to public judgment, justified or not. On top of the criticism of so-called “corporate welfare,” increased reporting requirements will mean the public will know more about the companies receiving and using public funds. On one hand, a well-designed and executed incentive deal will showcase how public-private partnerships can be constructed to further the aims of both parties. However, it is just as likely company practices and data will be put under a spotlight, causing considerable discomfort for executives.

In the end, the question fundamentally rests on the degree of natural, unaided fit between company and community. Anything beyond this is welcome, but should be unnecessary to a certain degree. Groucho Marx once famously stated he didn’t want to belong to any club that would want people like him as a member. While the presentation is slightly flip, companies might wish to consider the sentiment when offered incentives that look too good to be true.

 

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