Breaks, Cuts or Reform: The Jobs and Taxes Debate

Breaks, Cuts or Reform: The Jobs and Taxes Debate

If there is one source of common ground in our fractious state government, it’s that Minnesota needs jobs and lots of them. Not surprisingly, the role of the state and local tax system in encouraging or discouraging job formation has become a focal point. The proposals currently arising out of this debate not only reflect philosophical differences but also raise a much more fundamental question: what can changes to the tax system realistically accomplish in the area of job creation?

Credit Where Credit Is Due

The opening salvo of the 2012 legislative session came from Governor Dayton’s office and the DFL in January with a proposed “New Jobs Tax Credit.” This $35 million plan would provide a one-time $3,000 tax credit to any Minnesota business for each unemployed veteran, job-seeker, or recent graduate they hire during calendar year 2012, and a $1,500 credit for each new such hire between January and June of 2013. According to the press release, it’s expected to create 10,000 new private sector jobs. As of this writing, the proposal has been introduced only in the Minnesota Senate. SF 1768 pays for this initiative by reducing the share of foreign operating corporation income that can be sheltered from Minnesota taxation from 80% to 70%.

The logic behind this proposal is a bit difficult to reconcile with the historical skepticism expressed by many supporters about reducing business taxes to encourage employment. Many who have stridently maintained that general business tax relief won’t create jobs now argue that small doses of tax subsidies will provide the marginal economic incentive necessary to tip the scale in employment decisions. If such small, one-time subsidies really do provide an incentive for adding employment, why wouldn’t general business tax relief be a much preferable and beneficial option?

The answer, of course, has everything to do with the quid pro quo – the guarantee of a behavioral return on the tax revenue foregone. General business tax relief, it’s argued, provides no assurance of employment gains that conditional tax breaks offer and thus provide less “bang for the buck.” But a mirror image problem exists with tax credits and related job subsidies: the incentives are nothing less than a direct giveaway to businesses if employers would hire these individuals anyway.

The debate about how job tax credits actually function in the economy goes back to the Great Depression era and the use of wage subsidies to alleviate unemployment. While many studies show a modest correlation between job credits and employment gains, the actual contribution of the tax credit appears much more debatable. For example, one notable study of job tax credits offered to 3,500 employers found modest levels of new hiring — about 0.1 to 0.3 new jobs per firm. However, the study also concluded “at least 70% of the tax credits granted employers are payments for workers who would have been hired even without the subsidy. Such payments represent mere transfers to employers.” ¹

The ambiguity is echoed in a 2010 report by the Congressional Research Service which flags the administrative, timing, and demand factors inherent to employment subsidies:

Evidence provided in various studies suggests that incremental tax credits have the potential of increasing employment, but in practice may not be as effective in increasing employment as desired. There are several reasons why this may be the case. First, jobs tax credits are often complex and many employers, especially small businesses, may not want to incur the necessary recordkeeping costs.

Second, since eligibility for the tax credit is determined when the firm files the annual tax return, firms do not know if they are eligible for the credit at the time hiring decisions are made. Third, many firms may not even be aware of the availability of the tax credit until it is time to file a tax return. Lastly, product demand appears to be the primary determinant of hiring. ²

Some have argued the ambivalence surrounding employment gains from job tax credits is a function of design and insufficient ambition. A national proposal by the Economic Policy Institute argues for a fully refundable tax credit equal to 15% of the net increase in a firm’s payroll for any employer (including non-profits and governments) that expands their workforce. Of course, the cost of replicating a fully refundable credit mimicking this scope and generosity at the state level would far exceed the reform of a few business tax expenditures. Moreover the inherent “but for” problems of offering a credit remain. As the authors of this proposal themselves say, “much of the credit will inevitably go to firms that would have expanded anyway.” ³

Meanwhile, on the Republican side, the primary focus for job creation is general business tax relief rather than conditional credits. The initial target, included as a centerpiece of Reform 2.0, is the Statewide Business Tax (SBT) – a statewide property tax on cabins and business properties. All business entities with real property in Minnesota pay the tax, generating about $800 million in revenue for the state in 2012. The levy increases every year by an index measuring inflation in the cost of government. As of this writing, three bills have been introduced during the 2012 legislative session to phase out the tax over anywhere from a 10 to a 20 year period.

From a tax policy standpoint the SBT is an interesting target. The tax does serve as a de facto entity tax ensuring that all businesses contribute something to the costs of services and benefits state government provides them. However, a major problem with the SBT as an entity tax is that the base is physical presence rather than the broader concept of economic presence. Basing an entity tax on ownership of real property within the state is not only increasingly problematic in a world of highly mobile capital, it also limits the tax base. Moreover, the tax is a significant factor in business property tax competitiveness. Based on our most recent 50 state property tax report, full elimination of the SBT would drop Minnesota’s ranking for a $1 millionvalued urban commercial parcel from 10th or 19th in the nation; and would drop the ranking for a rural commercial parcel of similar value from 13th to 24th nationwide.

There are very good policy arguments for reforming or eliminating this tax, but short term job creation is unlikely to be one of them. As with job tax credits, the overriding influence of demand for products and services in workforce decisions would likely trump whatever marginal cost improvement these tax reductions create.

Not Big, Not Small, but New and Growing

Are there any tax-related initiatives that are more likely to provide a substantive employment bump? According to numerous tax policy experts, answering this question begins by correcting some conventional wisdom and existing fallacies about where jobs are actually created.

It has long been an article of faith that small businesses are the engines of job growth in the economy. However, a growing body of literature finds this is simply not the case. A 2010 National Bureau of Economic Research report concluded there is “no systematic relationship between net employment growth and firm size.” A George Mason University study concluded “the claim that small businesses are the fountainhead of job creation does not hold water.” According to Census data, mature small businesses are net job losers.

Tax guru Martin Sullivan, contributing editor of Tax Notes, argues the case for tax breaks for generic “small business” is further weakened by the fact that most small business owners are skilled craftspeople, white-collar service professionals, shopkeepers and restaurateurs providing relatively standardized goods and services for existing customer bases. “They are responsible for little innovation, once they are established, they do not grow. Moreover they don’t want to grow.” ⁴

The primary source of job growth? Startups which often happen to be small. Any tax-related initiatives specifically targeting job growth should be directed toward the scale-up needs of these new and growing firms. Sullivan identifies three tax-related initiatives of particular value to these types of firms that can also be justified on good tax and economic principles:

• Research and development tax credits — when private firms bear all R&D costs, they will have a tendency to underinvest in research that is productive from the perspective of the overall economy.
• Tax incentives for venture capital – both the positive externalities from innovation and the correction of market imperfections that deny small business adequate credit can justify preferential treatment of venture capital funding
• Tax simplification – small growing firms face significant fixed tax compliance and administrative costs which are a major drain on their resources.

Minnesota made strides in two of these three areas in 2010 – enacting an angel investment credit and making the existing research and development tax credit refundable while also expanding it beyond C-corp entities. One piece of this year’s Reform 2.0 package heads in this direction. HF 1823 and companion bill SF 1774 seek to expand the existing annual limit on angel tax credits from $12 million to $20 million while creating a new program providing future credits against state premiums taxes paid by insurance companies that invest in the state-designated venture capital firms.

Yet even these highly targeted efforts are still susceptible to the possibility that either investors would pursue some of these opportunities even without a tax incentive. Or businesses whose actions would be truly influenced by the incentive find it unavailable because other firms, indifferent to the incentive, applied first and pocketed the savings. Either way, the intended job growth effects can be thwarted.

Despite its irresistibility and popular appeal, tweaking the tax code to stimulate jobs will always be fraught with uncertainty. To promote job creation it is much better to think about the structure of the tax system from a longer term perspective and pursue reforms that minimize administrative and compliance cost while creating highly competitive conditions for capital formation.