Incentives for Business Attraction and Retention

ARTICLE | Jun 13, 2012

 

Business attraction and retention strategies often employ incentives to lure new businesses or to keep existing ones in the community. This article discusses types of incentives for attraction and retention in the context of debates about their cost-effectiveness. 

Business attraction

While debate rages about the cost-effectiveness of incentives for luring businesses, business attraction with the use of financial and nonfinancial incentives remains popular. Every U.S. state offers recruitment incentives, as do most local communities. Arguments in favor of this approach emphasize the political realities of intercommunity and interstate competition for economic development.

Although many governments rely on inadequate evaluation when deciding which incentives to use and how to use them, some governments have added a new level of sophistication to the incentive process in the form of incentive negotiation strategies. Jurisdictions willing to engage in incentive negotiation recognize that businesses want to obtain the best possible deal and that government must protect itself from bad deals. These governments are starting to take an investment approach to the use of incentives: quantifying the costs and benefits of a given project, calculating an appropriate rate of return and investment level, and strictly maintaining that investment level unless it can be shown that a higher level of investment will pay correspondingly higher benefits.(1)

Most incentives are used either as a marketing mechanism to increase the number of firms that will consider relocating to the jurisdiction or as a tool for completing a deal once one or more prospects have been identified and negotiations are under way.(2) Incentives are most likely to be effective as tools of business attraction when they are targeted to the specific needs of the firms being recruited. (3)

Foreign investment

Although incentives are used in all types of business attraction deals, perhaps the most extensive use of incentives has come in those deals involving foreign investment. Foreign investment takes a variety of forms: foreign interests take equity positions in firms from another country, foreign investors acquire real estate in that country, and foreign corporations locate operations there. U.S. economic developers especially seek to lure foreign firms. In particular, state and local governments pursue foreign manufacturing operations, especially in the automotive industry, in response to the interest European and Japanese automakers have shown in locating facilities in the United States to reach the large U.S. market more effectively.

Jurisdictions use two major approaches to attract foreign corporations: one is the project approach, involving the pursuit of a particular business; the other creates and markets a business climate that is desirable to firms looking at alternative locations.

The project-oriented model tailors a package of incentives to the deal being pursued. Two well-known cases involving this approach have been Alabama’s successful effort to induce Mercedes-Benz to build an automobile plant near Tuscaloosa and the deal that brought the German automobile manufacturer BMW to South Carolina. South Carolina offered a $150 million package, and in return, BMW built a $1.2 billion plant and created three thousand jobs. (4) While most of this kind of business attraction activity takes place at the state level, local communities also get involved. One example is a successful effort by Houston, Texas, to attract a Danish wind turbine manufacturer.

The project-oriented approach has been the most common model, with dozens of cases all over the United States. Many have received considerable press coverage, making them highly visible to the public. The debate in most of these cases has been over the cost-effectiveness of these deals to the public sector. (Is this money well spent, or could it be more appropriately used elsewhere?)

In the business climate–oriented model, the incentives are not tailored to a given firm’s needs but are designed to have broad appeal (e.g., lower tax rates, streamlined government permitting processes, quality-of-life amenities, an appropriately trained workforce). 

Debate over incentives

Public incentives have come under considerable scrutiny, highlighting a rift between those who question the use of incentives as an economic development tool and those who support incentives. Opponents of incentives believe the following:

 

  • Incentives create unnecessary competition among jurisdictions and often amount to zero-sum games.
  • Companies should exhibit loyalty to their communities because it is the right thing to do, not because they are receiving incentives.
  • Once incentives are extended to private firms, those firms will continue to demand more from government.
  • Monies that go to businesses as incentives would be better spent on social, educational, and other programs.
  • Firms are rarely held accountable for staying in the community or for generating jobs or other economic development outcomes once they have received incentives.

 

Proponents of incentives believe the following:

  • New businesses generate additional tax revenue that is essential for providing public services; despite tax incentives, the community keeps most of the additional revenue generated.
  • Businesses are important members of the community; if businesses remain competitive, the community’s efforts for businesses will redound to the community’s benefit.
  • Incentives to firms amount to a community’s investment in its economic future; the return on investment makes the risk worth taking. (5)

The academic literature is divided on the appropriateness of incentives. However, most research tends to show that these divisions are based largely on differences in theoretical perspective, the research method, and the time perspective (short term vs. long term). Studies appear to agree on three key points:

  • With few exceptions, incentives will not effectively influence firm location decisions.
  • The truly important factors in business location decisions are transportation considerations, labor quality, and markets.
  • The best way for government to influence firm location is to create and sustain quality communities. (6)

Another finding is that incentives look better when used as a short-term strategy. It is interesting that more jobs are created by expanding existing businesses in the community than by attracting new businesses from outside the community. (7) A study in Nebraska found that incentives have a positive impact on economic development in counties that are already economically strong but no significant impact in counties that are economically depressed. This study concluded that incentives may be exacerbating economic disparities among localities in that state. (8)

Although economic development professionals now understand that incentives cannot mask a community’s long-term deficiencies, the public sector—with a short-term mindset—continues to use incentives for business attraction purposes. Local policy is still heavily influenced by politicians and other laypeople who seek the favorable publicity that comes with luring a major employer to the community. (9) In regions of the United States that feel they must continue to play economic catch-up, these incentives are still used extensively. (10)

Business retention

For many years, business retention as a strategy for job creation clearly has been superior to business attraction. (11) If incentives are used at all, they should be made available to existing firms as well as to new prospects. (12) When prioritizing economic development programs for funding, government should place business retention efforts ahead of business attraction.

A business retention strategy makes sense for a variety of reasons. Any community’s existing firms are important assets to its economy. They are the current employers. They also are and have been taxpayers. Business retention requires less speculation than firm attraction. The firm already is located in the community and, as a result, already has developed attachments and loyalties. Firms often will find staying and expanding easier than relocating. Packages designed to induce firms to stay and expand might be viewed as rewards for that loyalty, whereas inducements designed to attract new firms may be perceived by existing firms as implicit signals that they are either taken for granted or perceived to have less value than newcomers.

When a community elects to pursue a business retention strategy, it usually takes several steps:

  • First, it makes a complete inventory of all existing businesses.
  • Second, it contacts these firms to determine their current situation and their needs. The government prepares a simple and short survey, focused on learning what factors each firm thinks would make it more successful and how the government can help. The government will not unquestioningly provide what existing firms claim to need, but it will analyze the feedback to determine where and how best to use its business retention resources. 
  • Third, the government initiates an ongoing effort to meet existing firms’ short-term needs, and it maintains a pro-business attitude. (13)

Business retention strategies and tactics can take a variety of forms. Financial inducements, including tax incentives, loans, and loan guarantees, constitute one retention strategy. Nonfinancial incentives, also important, can include training targeted at specific labor needs.

A government in the position to do so could provide subsidized R&D assistance or access to public R&D know-how and facilities, for example, at public research universities. Research assistance is particularly useful to small and medium-sized businesses that do not have enough resources to invest in R&D but must innovate to survive. Even some large firms find the costs of ongoing, in-house R&D prohibitive. (14)This particular business retention incentive has proved especially effective in helping build high-tech industry clusters when some firms in the industry already exist in the community. Establishing these existing businesses as solid industry anchors permits the community to use these clusters to its advantage when it promotes itself to new high-tech firms.

Some retention activities include providing adequate, appropriate physical infrastructure (roadways, public transit facilities, water and sewer lines, high-speed communications networks, airport facilities, and speculative industrial buildings) and access to sufficient energy resources (water, electricity, natural gas, and geothermal or other sources of power for operations).

Various economic development issues—such as quality-of-life and environmental concerns, social costs of growth, redistribution issues, and the role of government—also affect business attraction and retention. Although government incentives still can be used as tools in economic development and retention efforts, these contemporary issues bear on many initiatives.

Notes

1 K. McEnroe, “Incentives as a Public Business Investment,” Economic Development Review 12, no. 4 (1994); Spelman, “Growth, Stability and the Urban Portfolio:” 299–316.

2 Ibid., 12–15.

3 Thomas S. Lyons and Roger E. Hamlin, Creating an Economic Development Action Plan: A Guide for Development Professionals, rev. ed. (Westport, Conn.: Praeger, 2003); McEnroe, “Incentives as a Public Business Investment”: 12–15.

4 J. Brauer, “Letters to the Editor: Auto Town Blues,” Wall Street Journal, 27 September 2000, S4; K. E. Thuermer, “The Southeast Picks Up the Pace,” World Trade 11, no. 9 (1998): 58–63.

5 McEnroe, “Incentives as a Public Business Investment”: 12–15.

6 Henry W. Herzog Jr. and Alan M. Schlottmann, “Industrial Location in the United States: Some New Evidence of Public Policy Efficacy,” Survey of Business 29, no. 1 (1993): 9–16.

7 Ibid.

8 Ernest P. Goss and Joseph M. Phillips, “Do Business Tax Incentives Contribute to a Divergence in Economic Growth?” Economic Development Quarterly 13, no. 3 (1999): 217–228.

9 Edward J. Jepson Jr., “Grappling with the Complexity of Economic Development,” Economic Development Review 12, no. 3 (1994).

10 Michael M. Phillips, “More States Reassess Business Incentives—Pullback Comes Amid Growing Skepticism about Cost,” Wall Street Journal, March 20, 1997, A2.

11 Raymond C. Lenzi, “Business Retention and Expansion Programs: A Panoramic View,” Economic Development Review 9 (1991): 7–12.

12 Henry W. Herzog Jr. and Alan M. Schlottmann, “Industrial Location in the United States: Some New Evidence of Public Policy Efficacy,” Survey of Business 29, no. 1 (1993): 9–16; A. Macpherson and M. Ziolkowski, “The Role of University-Based Industrial Extension Services in the Business Performance of Small Manufacturing Firms: Case Study Evidence from Western New York,” Entrepreneurship and Regional Development 17, no. 6 (2005): 431–447.

13 Lenzi, “Business Retention and Expansion Programs”: 7–12.

14 Lyons and Hamlin, Creating an Economic Development Action Plan, 47.

 

Excerpted and adapted from Steven G. Koven and Thomas S. Lyons, "Current Approaches to Business Attraction and Retention," chapter 5 in Economic Development: Strategies for State and Local Practice, 2d ed. (Washington, D.C.: ICMA Press, 2010. To learn more about this book, or to place an order, visit ICMA's online bookstore (bookstore.icma.org) and search for item no. 43614.

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