Tax Incentives and the City

William Seward made a much better deal than anyone realized. The former U.S. Secretary of State was bent on buying Alaska, which he did in 1867, paying $7.2 million for the swath of seemingly-barren land. The majority of observers thought the United States had gotten a raw deal, labeling the purchase as “Seward’s Folly.” A few decades later, however, prospectors struck gold and oil in the territory and what looked like folly turned fortuitous.

Chicago recently struck what first appeared to be a raw deal. In 2001 Chicago and the state of Illinois spent $50 million in tax incentives to bring Boeing’s corporate headquarters to downtown Chicago. With only five hundred employees, most of them transplants from the old headquarters in Seattle, Chicago’s move seemed odd. Why would the city spend so much?
When a city wants to attract a company, it often competes with other cities to offer the best tax incentives. This competition drives the incentives higher and higher, and soon no city is getting a very good deal. Economists describe this problem as a race to the bottom.

But according to Therese McGuire, professor in the Kellogg School’s Management and Strategy department, and Teresa Garcia-Milà (Universitat Pompeu Fabra), a race to the bottom may not be as bad as people think. In a 2002 paper published in the Brookings-Wharton Papers on Urban Affairs, they argue that classic models of tax competition between cities do not consider one important advantage: Tax competition helps companies and cities to find the best match.

“A typical analysis would argue that if Chicago decides to lower taxes in order to attract firms, they are not considering the fact that Denver and Dallas are being hurt by losing them, so they drive taxes down lower than they should,” McGuire said. “Our contribution is to say that firms differ in terms of what they are bringing to the table and cities differ in terms of what works for them. When you recognize that, there is the possibility for certain matches to be beneficial and others not to be.” When cities compete to lure a particular firm, the loser’s loss may not be as large as the winner’s gain. One reason for that is agglomeration economies, which describe benefits that certain firms bring when they cluster in certain cities.

McGuire says she first considered this idea when she was asked to write about the race to the bottom in 2001 for an upcoming conference, the same year that Chicago brought Boeing’s corporate headquarters to the city. “I sat down with my co-author and we started reading some of the literature, and then the Boeing thing happened,” she said. “That put this idea of agglomeration economies in our heads.”

To examine this question, McGuire and Garcia-Milà set up a theoretical model of tax competition within agglomeration economies, and then used the model to examine the Boeing case. The starting point for the basic model is a production function augmented by a representation of economies of agglomeration. The authors then set up the problem faced by city governments that recognize the positive spillover benefits of an increase in private capital. Spillover benefits are caused by new investment from a firm already operating in the city or by investment from new firms entering the city. The city government must choose an optimal tax rate that takes into consideration the welfare of its constituents, the competitive conditions in the labor and capital markets, the budget constraints for the city government, and the public affected by the provision of public services and tax rates. In equilibrium, the optimal tax rate becomes equal to the additional (marginal) benefit to the firm of the public input minus the marginal agglomeration benefit of additional capital. In the absence of spillover benefits, the optimal tax rate would be higher. Different cities and different companies may be subject to different levels of spillover benefits received and offered. Thus, these differences justify selective, rather than across-the-board, incentives.

But what agglomeration economies did Chicago gain by luring Boeing to the city? “Theoretically, we are talking about knowledge spillovers,” said McGuire. “When a number of firms get together and interact in their business dealings, production costs can decline and workers can learn new skills.” When the Boeing corporate headquarters moved to Chicago, its highly skilled, highly educated employees began working on deals with local business services firms. Local law firms worked on Boeing contracts and local advertising firms helped with marketing. Such high-profile contracts make those types of firms better at their jobs. Ultimately, the economy will be stronger and the city will be more appealing to future businesses. “Business services firms in the city are going to get much better at what they do,” said McGuire. “That’s our new idea.”

City character is also crucial to forming agglomeration economies. McGuire and Garcia-Milà note that Chicago’s concentration of financial, advertising, and other business services firms made the city a perfect match for Boeing’s headquarters. Denver, which has a much less dense concentration of business services firms, only offered Boeing $10 million in tax incentives compared to Chicago’s $50 million.

The character of the company also matters. At the same time Chicago rolled out the red carpet for Boeing, Brach’s candy manufacturing plant shutdown quietly in the city at a loss of one thousand Chicago jobs. “The Brach’s case is further evidence that jobs may not be the main concern of politicians, at least not in every case,” McGuire and Garcia-Milà state in the paper. “The wooing of Boeing and the simultaneous spurning of Brach’s are consistent with the notion that some firms, but not others, provide valuable spillovers to existing workers and firms in Chicago.”

Like William Seward, perhaps Chicago got a better deal than the critics thought. Although McGuire and Garcia-Milà do not go as far as to state that the Boeing deal was good for Chicago, they do conclude that such tax breaks are sometimes justified. “If our theoretical model is capturing reality, or bits of it, then selective tax incentives can be justified in some instances,” they write. But McGuire is careful to note that the paper is based on theory, and she is eager to see whether evidence of agglomeration economies can be found in the real world. “The next step is an empirical study, and we are working on that now,” she said.