How Evaluators Should Approach Discretionary Versus Nondiscretionary Incentives

In this column, originally published by The Pew Charitable Trusts in May 2024, Jim Landers, professional practice associate professor, Enarson Fellow, and director of graduate/professional studies at John Glenn College of Public Affairs at The Ohio State University, examines the differences between discretionary and nondiscretionary incentives and the implications of these differences for evaluators.

Evaluation perspectives

Evaluating Discretionary and Nondiscretionary Incentives

Jim Landers
Professional Practice Associate Professor, Enarson Fellow, Director of Graduate/Professional Studies
John Glenn College of Public Affairs
The Ohio State University

Introduction

Economic development incentives employed by state and local governments vary in myriad ways. A good typology of these incentives could be based on many different features, including whether the program offers:

• A tax incentive or a direct financial subsidy.
• A tax exemption, deduction, or credit.
• A preference claimed against income, sales, or other tax.
• Low-cost loans or loan guarantees.

These are all key features, but probably the overriding feature of an incentive program is whether it is nondiscretionary (by right) or discretionary (negotiated).

Evaluative implications of nondiscretionary tax incentives

Nondiscretionary tax incentives are granted automatically to businesses that meet conditions prescribed by statute, such as the specific economic activity (e.g., investment, employment) for which the incentive is targeted, minimum required levels of the incentivized activity, taxes the incentive may be claimed against, and requirements for claiming the incentive.

One common and important feature of nondiscretionary incentives is that they are typically managed by tax administration agencies. This has several implications for incentive evaluators. Nondiscretionary incentives usually have no formal application review process. Rather,  business taxpayers simply claim the incentive when filing their tax returns. The tax return probably has a specific line where a business reports the amount of the incentive to be claimed and may be required to file supporting documentation.

There are pros and cons to using nondiscretionary incentives. Program implementation is streamlined, and businesses may prefer this system because of the lower level of effort needed to obtain incentives, which may be a salient feature for small businesses or governments with limited capacity. Additionally, when we speak of targeting incentives, nondiscretionary incentives can work reasonably well targeting incentive dollars to certain industries or businesses as well as certain economic activities. 

However, nondiscretionary incentives lack a process for examining whether incentive dollars are targeted only to economic activity that would not otherwise occur. While statutes may outline basic requirements for claiming the tax incentive, there is no consequential review to determine whether the incentive led to any of the economic activity for which it is being claimed. This may lead to unwarranted incentive claims that fail the “but for” test—that is, whether the incentives are required for the project to proceed and/or lead to additional economic activity such as proposed capital investment and/or employment. 

There are two implications here for evaluators. First, administrative processes may need to be scrutinized not because they hinder utilization of an incentive, but because they allow the incentive to be utilized too freely. Second, the administrative process could have a negative impact on the overall effectiveness of the incentive because it allows incentive dollars to be obtained when the incentive claims fail the “but for” test. Consequently, evaluators should exert considerable efforts to estimate the economic activity initiated by nondiscretionary incentives.

Another challenge for incentive evaluators is that nondiscretionary incentive programs typically yield minimal administrative data because of the limited nature of the review process. Data from nondiscretionary incentive programs generally consists of standard taxpayer information. This could include the income and tax liability of the business taxpayer (e.g., taxable income), amounts claimed under other tax preferences, and the tax incentive amount claimed. Thus, evaluators may find it challenging to do more than report about the utilization of the tax incentive, the total incentive dollars claimed, or statistics relating tax incentive claims to income or tax liabilities. Evaluating effectiveness would therefore require evaluators to access other secondary data sources and employ other analytical approaches.

Evaluative implications of discretionary tax incentives

Discretionary tax incentives, by contrast, are granted through a negotiated process between the business seeking the incentive and the government entity that administers the tax incentive program (e.g., state or local department or board of economic development). The entity administering the program bases its decisions on statutory requirements prescribed for the incentive program and operating regulations it has adopted. Most of these programs require business taxpayers seeking to obtain the incentive to file a formal application.

Every state has its own system, but typically the administering entity reviews applications, conducts due diligence on the business and proposed economic development project, and may make a formal determination whether the project passes the “but for” test.

Discretionary incentives are often performance-based, meaning that a business receives incentive dollars in relation to its capital investment in a project or the number of jobs the project creates. As a result, a business awarded an incentive will often sign a performance agreement outlining the employment, investment, or compliance milestones it must meet as a condition of receiving the incentive. Under these performance agreements, a government may “claw back” incentive dollars paid to a business that fails to meet employment or investment milestones. In addition, a government may allocate job creation incentive dollars as a business pays income tax withholdings for new employees, preventing the need for claw-back procedures. One downside of discretionary incentives is that they can be complex to administer for governments. The application processes and compliance can also be complex for businesses, which could prevent many smaller businesses from participating in the incentive program. 

Discretionary incentives have crucial implications for incentive evaluators, including:

• The administrative burden of the program.
• The need for program statutes and rules to create transparent, objective, and predictable review and approval processes.
• Potential impacts of the program’s administrative processes on program outcomes.
• the success of the program in targeting incentive dollars to projects that pass the “but for” test.
• The administrative data that these programs yield.

As outlined above, many discretionary tax incentive programs come with extensive administrative processes, post-award reporting, and oversight to ensure that businesses receiving incentives comply with investment, employment, or other requirements. Furthermore, tax administration agencies are likely to incur some administrative burden ensuring that business taxpayers claiming incentives have met all requirements. Finally, businesses will expend resources to monitor their progress in meeting milestones and to maintain required documentation. Thus, evaluators should consider how the administrative burden of a program could extend beyond application processing and award determinations for both government and private sector stakeholders.

In addition, administrative processes can themselves reduce program performance. For instance, substandard marketing and outreach activities could limit an incentive program’s effectiveness as businesses with viable economic development projects may not know about the incentive program and, thus, invest elsewhere. Inefficient review and approval processes could likewise deter potential applicants. And sloppy, ineffective processes could lead to erroneous approvals or disapprovals or unexpected costs for businesses. Hence, rigorous process analysis by evaluators could uncover administrative challenges that have significant implications for the performance of an incentive program.

Compared with nondiscretionary incentives, the administrative processes of discretionary incentive programs can yield rich data describing the businesses applying for incentives, those approved and not approved, incentive amounts, the time frame the incentives will be allocated, and the jobs, investment, and other economic activity conducted by the businesses receiving the incentives. Still, the depth and utility of the administrative data from discretionary incentive programs depends on the capacity of the administering agency to identify and collect data that is key to conducting incentive evaluations and in a usable format for evaluators.

Additional considerations for evaluators

While evaluating the extent to which programs are effective in producing additional economic activity, investment, or employment, these programs should also be evaluated on how their benefits are distributed in the economy, and the extent to which the programs are transparent and provide consistent and predictable results.

Recent research by Slattery and Zidar (2020) examines the distribution of firms receiving state and local business tax incentives by firm employment, profits, revenue, value of capital stock, industry sector, and location. The research includes nondiscretionary tax incentives (referred to as general tax credits) and discretionary tax incentives (referred to as firm-specific incentives). The authors find that large, profitable firms are more likely to receive discretionary, firm-specific tax incentives. High-value-added firms with significant agglomeration effects that increase demand for labor and services are predominant recipients of discretionary incentives. Industries that benefit most from these types of incentives are manufacturing, technology, and high-skilled services. The authors also find that most distressed locations are rarely able to attract firms with incentives, even though these areas would enjoy larger welfare gains from the additional economic activity. Thus, smaller businesses and more distressed communities appear to be left out much of the time. These are distributional issues that could be ripe for evaluation in just about any state.

Evaluators should also start thinking about transparency of incentive programs, especially where administrator discretion needs to be coupled with accountability. Transparency goes beyond just reporting the utilization and revenue cost of these programs. Zee, Stotsky, and Ley (2002) weigh in on transparency and tax incentives, particularly as it applies to discretionary incentive programs. They suggest that there are three dimensions in granting tax incentives: (1) legal and regulatory, (2) economic, and (3) administrative dimensions. The legal and regulatory dimension requires that “all tax incentives should have a statutory basis in the relevant tax laws, and changes to such incentives should require amendments to these laws.” The economic dimension “involves making explicit the rationale for granting any tax incentives on the basis of well-thought-out economic arguments; estimating the economic impact and revenue costs of granting the incentives based on clearly stated assumptions and methodologies; and subjecting the estimated revenue costs to public scrutiny in the budgetary process as tax expenditures.” Finally, the administrative dimension “involves formulating qualifying criteria for tax incentives that are simple, specific, and objective to minimize the need for subjective interpretation and application by the administering officials of the incentive system, as well as to ease monitoring and enforcement responsibilities on the part of tax administrators.”

As is fundamental to all tax policies, tax incentives need to be predictable. Statutes authorizing incentives should prescribe eligibility criteria and requirements for the implementation of the incentive programs. Any operating rules adopted by the agency administering the incentive program should be consistent with statute. Laws and rules, especially for discretionary programs, should provide for an objective and consistent process of reviewing and approving incentives such that different firms with the same project get the same result. Anything less would probably negatively impact the performance of the incentive program.