Incentives Watch: Managing the Fiscal Challenges of Tax Incentives

Tax incentives come at a huge cost for many jurisdictions. In some states, costs have unexpectedly increased tens or hundreds of millions of dollars in just a few years. Several states have had to make significant changes to help curtail slashes in spending on education, health and welfare and other public services. In the face of the current budget crises, states such as Louisiana and Oklahoma have had to take a good look at the tax incentives which have increased dramatically and have caused significant strain on state budgets.

In Louisiana, a state that encountered a $2 billion dollar shortfall for the year, tax expenditures and incentives are facing significant cuts. As a result of tax incentives, lower gas prices and tax cuts that occurred after Hurricane Katrina, among other things, the state distributed $229 million more in tax incentives to businesses than it collected from corporate income tax as of November of the 2015-2016 budget year, according to The Times-Picayune.

In recent years, tax incentive expenditures have increased dramatically, causing stress on state budgets. In Oklahoma for instance, it was reported that between the 2010 and 2014 tax years the costs of key industry tax incentives more than doubled, growing from $356 million to $760 million. In addition, earned but unused tax credits totaled more than $400 million at the end of 2014, according to Oklahoma Watch, a nonprofit organization dedicated to reporting on public-policy and quality-of-life issues in the state.

According to a December 2015 Pew Charitable Trusts report , these budgetary issues can be managed or avoided all together. Over the years, several states have implemented safeguards to help manage the fiscal impact of tax incentives. These safeguards include strict deadlines for claiming credits, annual limits and use of application processes for determining in advance who qualifies for credits. States have also implemented credit evaluation protocols to review incentives regularly. 

Strict deadlines for claiming credits help to control costs and allows for accurate reporting of metrics in a timely fashion. Hawaii, for instance, has a strict “twelve-month rule” for claiming tax incentives. The rule requires taxpayers to claim credits within 12 months after the close of the taxable year in which the credit was earned. The rule disallows any adjustments to the credit by the taxpayer after the close of the 12-month period.

In addition to strict deadlines, annual limits or caps have been a vital instrument used to help control the cost and fiscal impact of tax incentives, according to the Pew report. California, for instance put caps on several of their incentive programs such as the California Competes Tax Credit and the California Film & Television Tax Credit Program. Annual caps allow the state to use an incentive to attract business to the state without the fiscal risk associated with uncapped incentives. Caps also provide states with the flexibility to increase or decrease the amount available for the incentives from year to year.

Another tool in the arsenal for controlling the impact of tax incentives is the use of application processes, which require taxpayers to submit an application and be approved for incentives in advance. Application processes can serve multiple purposes. In some states, application processes allow taxpayers to vie for a limited amount of funds. In other states, where the incentives are not capped, it allows states to anticipate costs associated with incentives as well as to intervene before incentives cause budgetary challenges, as discussed in the Pew report.

Additionally, evaluation processes for tax credits have been implemented in many states, according to an article published by the Pew Charitable Trust. Evaluations are conducted to determine the effectiveness of the tax credits by looking at costs and benefits to the state. This process allows states to analyze the fiscal impact of incentives and develop policies to make costs more predictable and easier to control. In 2015, Oklahoma enacted laws that created the Inventive Evaluation Commission to evaluate current Oklahoma incentives and submit recommendations for changes.

Amidst growing concerns regarding the effectiveness of tax incentives and looming budget shortfalls, states are employing some or all of the aforementioned safeguards to manage tax incentives. Going forward, it appears states will continue making changes to their tax incentives in an effort to decrease volatility, reduce fiscal uncertainty and to more accurately forecast the long-term impact on the economy.

Continue the discussion on Bloomberg BNA's State Tax Group on LinkedIn: What safeguards should states implement to help manage the fiscal impact of tax incentives?

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