Funding Economic Development

Paul Byrne, PhD
Assistant Professor of Economics
Washburn University School of Business

Photo by Megan Rogers Photographie

Funding Economic Development Paul Byrne PhDThis fall Shawnee County residents will have the opportunity to vote on extending a county-wide ½-cent sales tax, which, in addition to funding a number of infrastructure projects, will set aside $5 million per year for economic development programs meant to entice new businesses to locate in Shawnee County and to retain current businesses. As voters consider their decision to fund economic development, let us consider how businesses supported by economic development incentives impact the local economy.

Economic Multipliers

The impact of a business on the local economy extends well beyond its physical location and impacts more than just the businesses and households in which it has a direct relationship. When a business pays local workers, those workers spend a portion of their income at local grocery stores, restaurants, car dealerships, and other local businesses. They also pay more in local taxes and may increase donations to local non-profits. Similarly, the business may purchase goods and services from local suppliers, who themselves may hire workers and make purchases from other local businesses. As a result, the initial business under consideration has an economic ripple effect on the local economy, illustrated in the figure below, as the initial demand for its product generates smaller and smaller subsequent rounds of economic activity that work its way through the local economy.

Funding Economic Development BimboPolicymakers often rely on economic multipliers to take into account these type of interactions when estimating the total economic impact of a business. The concept of economic multipliers is somewhat straightforward. Most estimates rely on multipliers created by the US Bureau of Economic Analysis (BEA), which examines input-output flows throughout the economy for various industries and geographies, down to even the county level and smaller.

Industries differ in the extent to which they rely on out-of-area suppliers. An industry where a larger proportion of costs go to out-of-area suppliers and workers (red arrows in figure) will have a smaller multiplier as more spending “leaks” out of the local economy, resulting in a smaller ripple effect (blue and green arrows in figure).

Multipliers vary by geography as well. A Topeka manufacturer making a purchase from a Wichita supplier is considered local spending when measuring the economic impact on the State of Kansas, but out-of-area spending when measuring the economic impact on Shawnee County.

Funding Economic Development GoodyearThe BEA estimates multipliers based on actual economic transactions for hundreds of industries for each state and county in the country. These multipliers simply estimate the total impact that an initial round of economic activity will have on an area. For example, a multiplier of 1.5 means that $1 million of initial spending will generate an additional $500,000 in additional economic activity. In Shawnee County, multipliers may vary from 1.4 for general merchandise stores to 1.7 for financial services.

Shifting of Economic Activity

Although estimating a business’ economic impact seems somewhat straightforward, these estimates give only part of the picture. A crucial question that needs to be answered before we can rely on economic multipliers is: Where would the initial economic activity take place if the business being examined was not located in Topeka?

Funding Economic DevelopmentTo see why this is important consider what would happen if a new grocery store opens in Topeka. This business would benefit the local economy by giving its customers added conveniences, such as savings on driving time and a greater diversity of goods. However, since grocery stores cater to local spending, most of the spending taking place at the new business is offset by less spending at other local grocery stores. As a result, any increase in economic activity, such as sales, employment and tax revenue is not considered a net gain to the local economy, as it would likely be offset by lower sales, employment and tax revenue at other local businesses. For this reason, economic development practitioners typically avoid offering incentives to businesses that cater to local spending and instead target businesses that draw economic activity into an area.

Mars’ manufacturing facility, for example, does not suffer from the problem of shifting economic activity within the Topeka economy. The opening of the facility in Topeka will not shift chocolate production from other parts of the Topeka economy, but instead shifts economic activity from some other part of the national or global economy. Similarly, if Goodyear were to shut down its tire manufacturing plant, there would not be an offsetting increase in tire production at other Topeka plants. 

The Impact of Economic Development Incentives

Perhaps the most difficult to assess and controversial issue regarding economic development incentives is whether or not the incentives truly influence a business’ decision to operate in a particular location (see Fall 2011 TK Magazine article). While we can be fairly confident in estimating the economic impact of a business or event that draws economic activity from outside Topeka, it is more difficult to determine whether the economic activity and corresponding multiplier effect can be attributed to an economic development incentive.

A business that receives an economic development incentive could have a large, positive impact on the local economy that far exceeds the incentives and tax breaks given to it by local governments, but if the business would have located in the area with or without the incentive, then that economic activity cannot be fairly attributed to the incentive. Businesses seeking incentives know with certainty how much of an incentive, if any, they need in order to locate or remain in Shawnee County. However, economic development practitioners and policy makers must make their decision to offer incentives with limited information on just how much of an incentive is necessary to ensure that the local economy receives the substantial benefits of having the targeted business locate here.

Many who oppose such incentives believe that they do not impact businesses’ location decision and unnecessarily divert valuable tax dollars from other local businesses, households or public spending options. On the other hand, many proponents of incentives believe that, fair or not, failing to offer certain businesses incentives will result in an even greater loss of valuable tax dollars and jobs as these businesses would locate in other cities.

Do Economic Development Incentives Work?

Shawnee County voters are being asked to pay $5 million per year to fund economic development incentives meant to attract and retain businesses to help maintain a strong local economy and job market. A reasonable question for voters to ask is whether taxpayers are receiving a profitable return on their investment.

The first condition necessary for a positive return is for those incentives to be focused on supporting activities that draw new economic activity into Shawnee County or prevent existing economic activity from leaving Shawnee County. This means refraining from supporting activities that simply shift economic activity from one area within the local economy to another.

The second condition depends on how effective economic development practitioners and policy makers are at focusing incentives on businesses whose location decision is, on the margin, more sensitive to receiving the incentives.