Greensboro News & Record

December 17, 1995

Is incentives race slowing?

Elle Benoit

Copyright © 1995, Corporate Finance Magazine

States still are wooing firms to relocate. However, there are signs that both businesses and governments are becoming disillusioned about incentives.

When Quaker State announced in July that it was leaving its hometown of Oil City, Pennsylvania, for Dallas, the company also left a parting gift: $ 250,000 to help Oil City find a new corporate resident to replace some of the 300 jobs that went south.

Whether inspired by guilt or loyalty (Quaker State was born in Oil City in 1931) or both, the gesture stands in marked contrast to standard negotiations between governments and corporations. Usually it's the company that demands a government handout in return for promises to move into town, or to stay put if they're already there.

Every state boasts an economic development agency and the decades-long practice of luring businesses with tax breaks and other benefits, if anything, is heating up. With reason: Handouts and giveaways are the weapons of necessity for states faced with sluggish economies and competition from low-cost Third World labor.

Small wonder all this combines to make communities hungry - and more ruthless in their competition with each other. Or that Alabama had to produce a jobs- incentive package worth an estimated $ 150,000 to $ 200,000 per job to successfully woo Mercedes-Benz.

No one knows with any accuracy how much is being spent nationally on business incentives. Tax breaks still are the most commonly used enticement. These amount to forgone revenue rather than budgeted expenditures and that varies with the recipient companies' financial performance.

What is clear is this: Excessive competition among cities and states to attract and keep business has proved expensive and risky for some governments.

In fact, the game has become so expensive and hazardous that some change seems inevitable. Already a few states are beginning to tie strings to their incentives, hoping to force companies to honor promises they make. One community in Oregon has even refused to grant tax breaks for a major Japanese company, and not for environmental reasons either. More often, competitive reality pits governments against each other in what might be called an ''open-arms race,'' in which, as with any arms race, unilateral disarmament is impossible.

Jeffrey Finkle, executive director of the National Council for Urban Economic Development, an organization for economic developers, offers a grim warning: ''I am convinced that in the near future city or state officials and company officers will be indicted because of the appearance of kickbacks stemming from the receipt of incentives. '' At the very least, given the current climate, he says, ''News media and politicians will look at businesses that accept incentives with a lot more scrutiny. The business community will become the new welfare cheats.''

An exaggeration? Perhaps, but excessive corporate wooing is already landing governments in hot water. Consider Rio Rancho, New Mexico, for example. Thanks mainly to aggressive business recruitment, the town's population since 1980 has quintupled to 44,000. A couple of years ago, Rio Rancho snared its biggest trophy, a $ 1 billion chip-making plant from Intel Corp., plus expansion of an existing Intel facility, by offering a $ 114 million incentives package that included a 30-year exemption from property taxes. Not the smartest move, as it turned out.

Property tax revenues pay for schools in Rio Rancho, as they do in many jurisdictions. This past spring the town made news for being unable to provide the additional classrooms its expanded population needs.

Such overhead competition among governments has led to irrational development policies and ''Makes Swiss cheese out of tax bases,'' says William Schweke, program director at the Corporation for Enterprise Development, a nonprofit economic development think tank and consulting firm. ''Ultimately it's not sustainable,'' says Schweke, who is among a growing number of critics doubting such packages are cost-effective or that governments get back sufficient public revenue to offset what they give away. ''It's really disguised public works,'' he says, ''the equivalent of building a dam.''

What especially galls critics is that incentives often pay businesses to do what they would have done anyway, and thereby raise the potential for abuse. They note that companies have many strategic reasons for choosing locations before incentives come into play. And they point out that Rio Rancho competed for Intel's new plant against communities in Arizona, California and Oregon. Embarrassingly, Intel expanded facilities or opened new plants in those three states, too. But that isn't surprising, given that all sweetened their incentives after Intel initially picked Rio Rancho.

Paradoxically, the sweeter the offer from governments, the greater is the risk to the companies being wooed. ''If this were not a common practice, businesses would make their decisions based on labor force quality, wage rates, quality of work and transportation,'' says Watts Carr, president of the North Carolina Partnership for Economic Development. ''But incentives are muddying the water and companies are making decisions colored by incentives instead of where is the best place to be located.''

Disillusionment about incentives may be on the rise. In a recent survey of senior executive from 203 manufacturing and nonmanufacturing firms conducted by KPMG Peat Marwick, nearly 73 percent of the respondents said states have become more aggressive with incentives over the past five years. Nothing new about that. But when asked about the past 12 months, 56 percent of the respondents said that the trend is beginning to slow. This was said even though nearly two-thirds of these firms had moved or expanded facilities in the past year and 52 percent had received incentives averaging $ 2 million, mostly in the form of property and income tax rebates. A sign that governments are starting to reconsider how far they're willing to go to please corporate citizens? Perhaps.

Incentives have a dark side that becomes noticeable in periods of economic softness when corporate demands rise. This is almost certain to become a bigger problem as the federal government cuts its own costs by downloading responsibilities to state and local governments, which already face cost constraints.

''One problem with state and local incentives is they can be taken away,'' says Marc Solochek, senior vice president and chief financial officer of Ashland Coal, based in Huntington, West Virginia, who speaks from experience. Ashland expanded substantially in the 1980s, developing three mines with the help of West Virginia's ''super tax credit.'' Similar to the federal investment tax credit, this incentive turns 50 percent of a company's investment into a credit against state tax liabilities over a 10-year period. Now the state is trying to renege on the deal.

Hard times, including a rise in statewide unemployment, caused West Virginia to cancel plans for future credits and reduce those that were already in place. ''It's been a constant uphill battle,'' says Solochek. ''Every year they try to chop away at the program and we have to lobby to try to preserve it.''

Increasingly states are using ''claw-backs,'' or measures that ensure they get reimbursed if a subsidized company fails to deliver on its promises. Lawyers are at work in many state development agencies seeking ways to strengthen the contracts communities make with companies. ''If you take an incentive you better be convinced you're going to be invested there for a long time,'' says NCUED's Finkle. ''We're going to make certain that businesses adhere to stricter long-term contracts.''

The hope among state officials is that they can hold companies accountable for the promises they make about creating jobs.

Says Finkle: ''In the future the legal documentation will be such that the cities will have the upper hand in negotiations.''

Call it jealousy or greed, if you will, but the more incentives governments hand out, the more handouts companies demand. Officials at cash-strapped governments say they are simply overwhelmed by the sheer increase in demand for incentives as companies get wind of the deals available to other firms, particularly those from out of state.

''The more executives see other businesses coming in and getting incentives, the more they start looking at their own situations,'' says Gary Dittrich, president of the Dittrich Group, a Fairfield, Connecticut-based relocation consulting firm. ''A 'what about me?' attitude has developed.''

And sometimes it's hard to decide whether the demands reflect excessive gall or shrewd corporate bargaining.

Listen to James Hebe, president and chief executive of Freightliner, the $ 4 billion-in-revenues manufacturer of medium and heavy-duty trucks that is a wholly owned subsidiary of Germany's Daimler-Benz. Freightliner keeps its headquarters in Portland, Oregon, but Hebe is threatening to move out if the state, noted for using property tax caps to attract computer chip makers, doesn't become more cooperative with sweetners for existing industries. He points to the deal Freightliner's sister company, Mercedes-Benz, got in Alabama: ''You can't help but say, 'Are we crazy for not looking around?'''

As Hebe is quick to remind Oregon officials, Alabama provided both up-front incentives and educational incentives. In return it is getting just one-third the number of jobs Freightliner has in Oregon. Asks Hebe rhetorically: ''Are we doing what's best for our shareholders by not looking around?''

Freightliner already has 5,000 jobs in North Carolina, where Hebe praises the state's concern for business. North Carolina gave the company $ 3 million to help build an automotive training center affiliated with one of the state-owned community colleges. Freightliner has invested another $ 1.5 million in the facility and the state has contributed an additional $ 3.6 million to develop training programs. This is the kind of relationship Hebe says he wants with Oregon, but claims he's been rebuffed because the state is overly concerned with recruiting high technology companies even when local communities may wonder if the potential burden on them is too high.

''It's unfair to suggest there's too much focus on high tech,'' huffs Dough Smith, a senior industry development officer for Oregon, who contends media attention on technology distorts what the state does for other industries. ''Freightliner is an extremely important company.''

Many states are in fact spending more to retain existing companies, and not just because they get strong-armed by big corporate residents. It also makes economic sense. ''If you look at any business, the cost of attracting new business is many times higher than building a better relationship with a current client,'' says consultant Dittrich. ''Plus, there's a psychological benefit to building on what you have, and not losing something. So the value is high in dollars and psychology.''

A study by the Corporation for Enterprise Development of state development programs concluded earlier in the decade found an increase in ''homegrown'' initiatives, or programs aimed at retaining existing business rather than recruiting new ones. Nearly half the respondents in KPMG's recent survey said they currently receive benefits on their existing facilities. And North Carolina's Carr says that 23 of the 53 grants made from his development fund in the last two years went to companies already in the state. Such programs typically go beyond tax incentives to include direct funding for research and development centers, educational reform to ensure a labor force trained in the latest skills and help for small firms trying to get access to foreign markets.

''One reason these programs make sense is because they tend not to favor one industry over another,'' says Kerstin Nemec, national director of KPMG's business incentives group. ''If there are differences among the programs, they're more likely to be based on other factors such as the number of jobs at stake and the size of the total annual payroll.'' But retention programs do tend to be made available to small businesses, which is generally not the case with recruitment incentives.

Some states are faring considerably better than others in building a reputation among business planners as top relocation targets. Sure, companies want a soft touch, but increasingly they're heeding state development officials who say the smartest course is one that improves the overall business climate.

John Lombard is director of business recruitment for the Connecticut Economic Resource Center, a private nonprofit firm that helps the state with marketing and recruiting. Connecticut, he says, is less aggressive with grant dollars than it used to be. Instead, he says, the emphasis is on ''reducing corporate taxes, workers' compensation costs and personal income taxes.'' These are across-the-board reductions rather than incentives targeted at individual companies. The idea is to improve the business climate overall through job retention, expansion and recruitment. Unfortunately, the moves may have come too late. Connecticut, along with most of its Northeastern neighbors, remains a net exporter of people and jobs, indicating that tax cuts are only part of the solution.

Even in states where migratory patterns are positive and buoyant, it's not easy to calibrate the incentives. In fact, the state legislature recently divided North Carolina into seven regions to ensure every region gets its fair share of industrial development, an effort coordinated by Carr's office. In the 50 less-developed counties, the state now offers an income tax credit tied to job creation. While North Carolina's job-creation counties are not enterprise zones, they do operate on a similar principle - one that draws praise even from critics. ''Enterprise zones are a general tax policy,'' says Finkle. ''Everyone in that area gets treated the same, whereas incentives favor one firm over another.''

One nagging question for government authorities: Will their claw-backs and other endeavors to get the upper hand work positively when measured against future corporate moves? According to the KPMG survey, 51 percent of companies plan to relocate or expand in the next 12 months; 77 percent in the next five years. But many respondents are already skeptical.

''There's still a gap between what cities and states are giving what corporate America wants,'' says KPMG's Nemec. ''There are still problems with bureaucracies. Companies are aware that there are incentives, but they don't go after them because they're too expensive.''

Or to put it another way, cheap labor counts for more.

According to Dennis Donovan, senior managing director of consulting firm Wadley-Donovan Group, ''The richest incentive packages can reduce payroll costs by 5 percent annually for up to 10 years, whereas a company picking the right location can cut its labor costs by as much as 25 percent to 30 percent annually.''

Does this mean that in the future companies will rely less on incentives? Don't bet on it. Companies are under intense pressure to keep their costs down. '' Incentives are here to stay,'' says Donovan. ''It's not a giveaway mentality, but a way to get every ounce of fat out of the budget.''

After all, when a company relocates, incentives can lessen the impact of any one-time charges against earnings.

Still the pendulum is moving. As the Corporation for Enterprise Development's Schweke says, ''There are enough questions about these things or the size of the packages that people are starting to react against them.''

Maybe, in the future, more firms will heed Ashland Coal's Solochek as he imparts advice born of bitter experience. ''You really can't rely on government subsidies or incentives to create an economic project,'' he says. ''You have to have a sound project to start with. Incentives should provide a safety net to guard against the risks you're taking.''

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Copyright ©1995, Corporate Finance Magazine.

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