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United States Small Business Administration
Office of Advocacy
RS 166
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The Differential Impact of State-Local Tax Incentives
on Small versus Large Firms

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Purpose

The use of public funds to finance state economic development tax incentives is an important and controversial policy issue. In debates about the effectiveness of subsidies in influencing investment location, inter-business equity is a recurring theme. Small domestic firms protest that tax incentives benefit primarily large multi-state corporations. This study examines several dimensions of the proposition that small businesses are treated unequally by business tax structures at the state and local levels.

The goals of the analysis are to offer an alternative way of evaluating the impact of state and local business tax policy on small versus large firms, to focus attention on the major types of tax incentives shaping the current economic development agenda, and to illustrate the application of comparative tax burden analysis for the benefit of citizens and government decision makers.
 

Scope and Methodology

The research progressed through four stages: the development of a conceptual framework for the investment location decision; the formulation of a firm-relevant measure for comparing the incentive effects of differential tax burdens across jurisdictions and firm sizes; application of the measure to the tax structures of the six states in the U.S. Small Business Administration's Region V; and discussion of the study's policy implications.

The major determinants of comparative tax burdens are firm operating characteristics, particularly the composition and location of capital assets and the geographic distribution of product sales. The relevant standard for measuring the incentive effects of tax-cost differentials is the after-tax rate of return on an incremental investment. This measure captures the combined weight and interrelationships of federal, state, and local taxes with respect to capital income in the context of the investment decision process.
 

Highlights

• State and local taxes account for approximately one-third of the combined federal, state, and local tax burden. Their effects on business investment, therefore, are not trivial.
• General tax incentives(e.g., investment tax credits and property tax abatements)have only marginal effects on the net returns from new investment.
• The distribution of tax burdens across firm size and industry type appears to be converging toward regional equality. The implicit policy of business tax collaboration is explained by competitive emulation and defensive strategies for retaining domestic firms and the leveling effect of the deductibility of state business taxes from the federal income tax.
• Removing the state and local tax deduction from the federal tax computation results in a significant increase in tax differentials across jurisdictions and firm sizes. Absent the current federal offset provision, the tax-bidding war between the states for plant location would escalate.
• No consistent evidence emerges to support the proposition that small firms are disadvantaged relative to large companies in their state and local business tax burdens under the current system. The tax costs on prospective investment projects are approximately equal across firm size and industry.
• Federal tax reform proposals for a flat tax, general sales tax, or universal savings allowance tax system would significantly disadvantage small business enterprises unless some special provisions were made for the deduction of state and local taxes.
• Absent deductibility and graduated rates, small firms would be differentially handicapped in their ability to invest.
• General tax provisions such as the apportionment formula and the treatment of sales under corporate income taxes are more quantitatively significant than tax preferences.

Ordering Information

The complete report is available from:

National Technical Information Service
U.S. Department of Commerce
5285 Port Royal Road
Springfield, VA 22161
(703) 487 - 4650
(703) 487 - 4639 (TDD)

Order Number: PB96 13121

Cost: A09/$27.00; A02/$12.50 Microf.

*Last Modified 6-11-01