The Effects of Location Taxes on Location Decisions and Urban Economic Growth - Literature review Example

THE EFFECTS OF LOCATION TAXES ON LOCATION DECISIONS AND URBAN ECONOMIC GROWTH Introduction With the rapid development in globalization, interests with regard to international capital flow of income from capital and capital between countries are increasing. Apparently, policy makers have been concerned on the impact of such flows on economic welfare as well as the constraints that may be realized from the mobility of capital on their capabilities of taxing the income that arise from such capital. A considerable number of studies have been conducted for the last decade in determining the capital flow as well as the flow of income from capital. In particular, these studies have focused on the impact of taxation on these flows (Blomström, 2009, 15) In recent perspectives, capital has become increasingly mobile between states. Owing to this aspect, multinational corporations do face a choice regarding where to locate their production facilities. As a response to this mobility, many governments are pressured to attract and maintain capital that flows to their jurisdictions. In doing so, they have employed various strategies to achieve this goal. Some of these strategies include establishing a flexible labor market, investing in good infrastructure, offering tax reductions and incentives and so on. Understanding the effect of taxes on the location of capital is definitely a crucial step in evaluating these issues (Karkinsky, and Riedel 2012. 116). It is because of this that we decide to study the impact, which location taxes have on business location decisions. In particular, the role of taxation with regard to investment allocation has been a subject of immense empirical and theoretical scrutiny. Although there are several other factors, that influence the location decisions, the tax issue has appeared to be prominent in the recent past. Earlier studies have pointed that with high taxes, the flow of FDI is negatively affected. However, there are also studies and findings which have refuted this assumption (Lynch, 2004, 76). This paper will evaluate the effect of location taxes on decisions regarding investment locations as well as the urban economic growth. Discussion The Impact of Location Taxes on Location Decisions This section discusses the insights gained from studies on the effect of taxation on cross border flow for economic policy. In locating businesses, organizations occasionally encounter a number of heterogeneous sites. When business corporations contemplate a major relocation or expansion of facility, it is normal for them to ask themselves: where is the best place to locate this business or facility? In their assessment of the various alternative locations or jurisdictions for their businesses, or property, there are a number of factors that need to be considered by these firms before making the final decision. The main factors in this respect are those that affect production, sales, costs, access to suppliers or markets, energy costs, transportation costs, access to a labor pool, support of business services, the rate of taxes, and incentives among others (Lynch, 2004, 115) In particular, the role of taxation with regard to investment allocation has been a subject of immense empirical and theoretical scrutiny. Although there are several other factors, that influence the location decisions, the tax issue has appeared to be prominent in the recent past. Earlier studies have pointed that with high taxes, the flow of FDI is negatively affected. An example can be derived from the U.S export tax regulations, and differences between the countries, and the rates in foreign countries. This in most cases, has created an incentive for business organizations in U.S to use exports instead of foreign production in serving their foreign markets (Cassou, 1997). The tax factor has been regarded as one of the crucial factors that influence the location decisions of many businesses. In addition, it has been suggested that a state can employ a tax -cut as a strategy to boost the economy and still generate tax revenue in the process. Once they have located their businesses in a particular jurisdiction, there is a high probability that local economic and tax conditions could have an impact on decisions that regard productions (Blomström, 2009). In the structure of homogenous capital, and when taxation or other distortions are absent, the combined capital stock in a given country will be determined by equalization of the trivial product of capital, and the rate of return in the global business sector. In a case when the marginal product becomes higher than the rate of return on the global businesses, it will certainly trigger higher investment in the particular country or region. Apparently, if it was lower, capital could flow to other regions and vice versa. There are various types of taxes that are paid by organizations. The kind of tax paid by these entities is determined by various other factors that are based on the nature of the business, and the physical location. In order to avoid taxation in more than one jurisdiction, many entities conduct a careful analysis on tax, with consideration of taxation systems in various other nations (Cassou, 1997). A firm’s income tax and its perception towards risks are among the major factors that influence the firm’s decision-making. This is because; either of these may affect the firm’s investment negatively since its potential returns may decline. Corporate taxation is quite a significant factor in a firm’s decision-making process with regard to location. This is attributed to the fact that a lower tax rate will enable a company to lower price and subsequently generate higher revenue from the increased sales. A lower tax burden could increase the net income of a particular company (Wildasin, 1991, 34). As Kemsley (1998) notes, local and state taxes presents a significant business cost for many firms. He goes on to claim that in most cases, tax rates do affect the net operating margins of many firms. Consequently, the decisions regarding the location of company facilities, headquarters, or even facilities are in most cases influenced by the evaluation of relative tax burdens across a number of states. Owing to this aspect, Kemsley advises that policymakers should consider setting up policies that are aimed at improving the competitiveness of businesses in their respective jurisdictions. They should take into consideration that the rates of income tax are just as crucial to business operations as the corporate rate. Various proposals that are aimed at raising tax rates through such means as increasing the marginal rates, limiting deduction, closing “loopholes” or implementing a minimum tax would greatly impact the operations of corporate businesses. Further, he continues to argue that raising of taxes will hamper the hiring capabilities, and investment programs of these particular entities, further curtailing economic growth. It should however, be considered that there are various other factors, that may affect the stability of the economy; this is why the economy is not always at the same equilibrium. In the case of an open economy, taxation of capital income that is source based subsequently raises the pre- tax rate of return. This however, leaves the post rate of return to be unaffected. In most cases, this process necessitates a reduction in the stock of capital (Wildasin, 1991,393). It is therefore, imperative to understand the sensitivity in the impact of the effective tax rate on the combined capital stock. For some reason, the economy might not be at an equilibrium position, as in the case of limitations on accessible funds in financing the investments. These limitations may also a rise from a number of reasons. In essence, it is agreeable that taxes do affect the behavior of an economy. Earlier research evidence suggests that taxes, specifically corporate income taxes including indirect ones do affect FDI in a number of ways. For example, a 10% increase in the rate of corporate tax has been related to approximately 8% decrease in the level of foreign investments. Additionally, all types of financing decisions, including where these organizations use debt in states, how they would choose to support the issue of the first order are also sensitive factors that relate to tax issue (Klassen, and Laplante, 2012a). Cassou, (1997) articulates that the manner in which organizations organize themselves globally is a sensitive issue with regard to tax factor. Apparently, a number of firms occasionally view tax havens suspiciously. This assumption is backed by research that has noted that the idea of tax havens is not particularly right for a number of reasons. In particular, the presence of tax havens in a particular country has tended to trigger organization to invest elsewhere, where tax havens are not present. Stated differently, many organizations would tend to invest in countries or jurisdiction where tax havens are not present. Scholars have documented various reactions of firms with regard to tax incentives by shifting income, and capital across jurisdictions for their business stability and growth. In essence, the consolidated tax burden becomes low when the income, and capital is shifted from a jurisdiction that harbors high tax to that with low tax system. This increasing shift leads to low investment, and subsequently a decline of the tax base on the firm’s host country. Therefore, policy makers especially in countries with high and unfavorable tax rates have been increasingly concerned on the potential losses of tax revenue that have been generated from the shifting of income, and capital to other jurisdiction (Klassen and Laplante, 2012b). Previous studies with regard to the effect of accounting decisions on capital and income shifting have largely focused on location of property and businesses, transfer of prices and financing structures. With regard to the location of business and property, since this is the focus of this paper, it is apparent that the context of multinational corporations in specific, realizes high savings in their investments in regions that experience low tax rates. This situation may different case with their subsidiaries, or other firms that operate in jurisdictions with high tax rates (Karkinsky, and Riedel 2012, 432). This is a clear indication that the differences in the rate of taxes in different jurisdictions do influence organizations to locate their businesses or property in particular jurisdictions. In this case, jurisdictions in low tax rates are more favored in comparison to those with high tax rates. Klassen and Laplante, (2012) explains that when the rate of tax vary over time, organizations tend to react by transferring their capital, income, investment and personnel to other facilities in jurisdictions with low tax rates. In addition, this impact tends to increase as time goes on. On the perspective of the weighted cost of capital, a lower rate of tax will subsequently lead to low cost of debt for an entity (24) Dissenting on these views, Devereux et al (2007) observes that, firms are much sensitive on the local fiscal incentives. Apparently, this aspect influences decisions regarding business locations. This author has also noted that the role of government grants in attracting firms in particular jurisdictions is quite insignificant. Additionally, most of these firms are not responsive to subsidies especially in areas that have few plants existing in the particular industry. Other more important factors that are considered by firms in location decisions include economic stability of the host country, political stability, the rate of depreciation, concession cost, potential uncertainty and risk. Devereux et al (2007) emphasizes that local, and state taxes constitute only a small portion of doing business, hence it is not a very important factor concerning decisions on business location and other decisions on investments in comparison to other factors that have already been mentioned. What many businesses require are customers, and a tax incentive does not address such a need. Even if a particular jurisdiction has low tax incentives but few or no customers, this may not make much sense to the respective business. There is a common assumption which articulates that corporations will migrate to specific jurisdictions for the aim of reducing costs. According to this assumption, lower costs will subsequently lead to increased profit for business entrepreneurs. However, it should be considered that a combination of local and state taxes only constitute a small share of all the related business costs, and reduce profits to a small extent. In essence, the cost relating to taxes are just small when compared to other costs, and factors associates with location. Such costs include but not limited to proximity to clients, qualified workers, and quality public services. These factors are usually more critical in comparison to taxes. The availability of these essential location factors largely depends on the commitment of the local and state authorities to public investment and there capabilities in paying for it. Public investment plays a significant role in lowering operating costs for organizations (Klassen, and Laplante, 2012). Overall, the evidence in the power of low taxation or tax incentives in attracting or retaining business and job creation depends on how corporations respond to them. On this perspective, such evidence fails to support the assumption that spurring the economy necessitates reducing taxes and shrinking the public sector. Specifically, there is very few evidence to suggest that a cut on local or state tax at the expense of reducing public service will stimulate an economic growth or create more jobs. Evidence is however rife that increasing taxes especially when employed to improve the quality and quantity of public service could enhance economic development and employment opportunities. Urban Growth An understanding on the decisions regarding business locations is crucial especially for the state, federal or local authorities wishing to encourage economic growth in the specific areas. This understanding is also significant when determining the reasons for the shifts in economic or business activity from specific jurisdictions to the author. It should be noted that market forces in the development of urban areas are related on how the decision on location of corporations, and households results into the development of these areas. The behavior and nature of markets largely depends on where they are located. This translates that the physical geography is one of the factors for effective market performance. Many firms would be carefully not to locate themselves in a geographically isolated place, since their performance will be lower in comparison to their counterparts in concentrated regions. The location decision of entities and households may result into cities that are different in economic structure and size. A city that harbors a cluster of industries will have a distinct economy (Wildasin, 1998, 67). Literatures on fiscal competition have developed an assumption that local jurisdictions in most cases tend to compete with their neighbors in attracting investments and business. For example, Wildasin (1998) expresses that neighboring jurisdictions tend to aim at optimizing their tax incomes in a non-collaborative game. Taxes generated from the local jurisdictions are usually employed for the public good. A decline in the rate of taxes will subsequently lead to a reduction of the jurisdictions income. However, it might as well lead to an improvement in the jurisdictions tax rate. This owes to the fact that many organizations will get attracted to low tax incentive in that particular jurisdiction. Among the top priorities for most local and state authorities are improving the economy and creating jobs. In achieving these objectives, these authorities employ strategies and instruments that may not always be very effective. Offering tax incentives and lowering of taxes are the chief instruments used by these authorities to grow the economy. However, a review of relevant studies have failed to adequately support the assumption that tax incentives, and lowering of taxes especially when taken out of the expense of the public investment as being the best in spurring economic growth or expanding employment opportunities (Sillard and Roland, 2011). Other research findings have refuted the assumption that a cut on business taxes do encourage investment in the local area or jurisdiction. For instance, Sillard and Roland (2011) articulate that such an increase if (any) is insignificant to the economy of the particular area. According to the authors, when neighboring councils engage in competition in attracting investors by decreasing the rate of their taxes, the specific jurisdiction would not be productive and normal operations will be costly to run. In essence, urban growth in the particular jurisdiction will be minimal if any. Further, these opponents of low tax are also of the opinion that taxes on local business may not be the best strategy to boost the economy of a particular region. This is because tax rates are not the only factor influencing the decision of firms with regard to location. Rather, these firms consider also other factors such as sales, costs, access to suppliers or markets, energy costs, transportation costs, access to a labor pool, support of business services among others. This points on why areas that harbor many firms tend to attract higher taxes than those with few. This supports the assumption that lowering tax on business may not necessarily attract new businesses in an area. In addition, low taxes charged on these firms may hinder development or economic urban growth in the specific jurisdictions. A decision for urban authorities to cut down corporate income or capital tax as a means of revitalizing urban growth will have an insignificant impact in relation to such an objective. Further, major operations such as running of schools, provision of essential public services, transportation services and other things will be negatively affected (Roland and Sillard, 2011, 234). In another perspective, some of the benefits gained from the cut in state or local tax reduction may be transferred to shareholders. Some of these shareholders may be living elsewhere hence; such benefits from tax cuts will be utilized where they live. It would therefore, be imperative for respective authorities to consider an investment in health, education, transportation, and other constituents of a strong economy instead of cutting down taxes on corporations. This is because an income tax cut has a likelihood of draining such resources, and priorities(Wildasin, 1991, 415). Since the authorities on the particular regions are expeted to balance their budget on a yearly basis, a reduction in the corporate income or capital cut would necessitate a corresponding tax increase in other areas or a reduction in the cost of providing particular aspects of public service to cover such a reduction. This will subsequently lead to a decline in economic operations. This is the exact opposite of what is anticipated by leaders in the particular jurisdictions (Lynch, 2004). A deterioration of transportation, infrastructure, public safety and other services may lead to a backfiring of the business tax cuts. On the other hand, an increase in tax rates may lead to more jobs being created and improve the public services to the particular businesses. The decline revenues will lead to reduced funding in important sectors in urban development such as education, infrastructure, and so on (Kemsley, 1998, 55). A cue could be taken from Missouri State where tax reduction on corporations led to an increase in the cost of education among high schools and college students. Further, the low quality of services provided subsequently made the jurisdiction to be less attractive for potential investors. This is because for businesses to thrive, they apparently require a good education systems for quality employees as well as an efficient infrastructural systems to conduct their businesses. A reduction in corporate taxes will only lead to increased investments by companies if there is a subsequent increase in demand of the particular products produced by specific entities. If demand for the particular products is absent at current or in future, firms will simply keep a tax cut instead of spending it (Roland and Sillard, 2011, 333). These companies may end up spending more from other related costs such as training of their workers, poor infrastructure and so on. Conclusion This essay has examined the main aspects associated with the impact of location taxes on decisions regarding locations as well as the urban economic growth. It should be considered that there are various factors that may affect the stability of the economy; this is why the economy is not always at the same equilibrium. Among these factors is the issue of taxation itself. In the case of an open economy, taxation of capital income that is source based subsequently raises the pre tax rate of return. This however, leaves the post rate of return to be unaffected. In most cases, this process necessitates a reduction in the stock of capital. It is therefore, imperative to understand the sensitivity in the impact of the effective tax rate on the combined capital stock. The manner in which organizations organize themselves globally is a sensitive issue with regard to tax factor. Apparently, a number of firms occasionally view tax havens suspiciously. This assumption is backed by earlier research that has noted that the idea of tax havens is not particularly right for a number of reasons. In particular, the presence of tax havens in a particular country has tended to trigger organization to invest elsewhere, where tax havens are not present. It is clear that differences in the rate of taxes in different jurisdictions do influence organizations to locate their businesses or property in particular jurisdictions. In this case, jurisdictions in low tax rates are more favored by some firms in comparison to those with high tax rates. All in all, the evidence in the power of low taxation or tax incentives in attracting or retaining business, and job creation depends on how corporations respond to them. On this perspective, such evidence fails to support the assumption that spurring the economy necessitates reducing taxes and shrinking the public sector. Specifically, there is very few evidence to suggest that a cut on local or state tax at the expense of reducing public service will stimulate an economic growth or create more jobs. Evidence is however, rife that increasing taxes especially when employed to improve the quality and quantity of public service could enhance economic development and employment opportunities. Literatures on fiscal competition have developed an assumption that local jurisdictions in most cases tend to compete with their neighbors in attracting investments and business. For example, Wildasin (1998) expresses that neighboring jurisdictions tend to aim at optimizing their tax incomes in a non-collaborative game. Tax generated from the local jurisdictions is usually employed for the public good. A decline in the rate of taxes will subsequently lead to a reduction of the jurisdictions income. However, it might as well lead to an improvement in the jurisdictions tax rate. This owes to the fact that many organizations will get attracted to low tax incentive in that particular jurisdiction. However, other recent research findings have refuted the assumption that a cut on business taxes do encourage investment in the local area or jurisdiction. For instance, Sillard and Roland articulate that such increase if (any) is insignificant to the economy of the particular area. According to the authors, when neighboring councils engage in competition in attracting investors by decreased the rate of their taxes, the specific jurisdiction would not be productive and normal operations and service provisions will be costly. In essence, urban growth in the particular jurisdiction will be minimal if any. Further, these opponents of low tax are also of the opinion that taxes on local business may not be the best strategy to boost the economy of a particular region. This owes to the fact that taxes cannot be the only factor influencing the decision of firms with regard to location. Rather, there are also other factors, which these firms take into consideration such as sales, costs, access to suppliers or markets, energy costs, transportation costs, access to a labor pool, support of business services among others. These points on why regions that harbor many firms tend to attract higher taxes than those with few firms. This also supports the assumption that lowering tax on business may not necessarily attract new businesses in an area. In addition, low taxes charged on these firms may hinder development or economic urban growth in the specific jurisdictions. This paper therefore concludes that though tax cut influences the decision making of firms in regard to location, this influence is to a small extend in comparison to other factors such as infrastructure, cost of operation, customer base, cost of labor and so on. On the other hand, tax reduction will negatively affect the economic development of urban regions. This is because the respective authorities will realize lower revenue from the reduced taxes and therefore hamper service provision accordingly. References Blomström, M. (1989), Foreign Investment and Spillovers: A Study of Technology Transfer to Mexico , Routledge, London. Cassou, S.P. (1997), The link between tax rates and foreign direct investment, Applied Economics 29, 1295-1301. Kemsley, D (1998), The Effect of location taxes on Production Location, Journal of Accounting Research, Vol 36, No 2. Klassen, K. J. and Laplante, K.S (2012a), Are U.S. Multinational Corporations Becom-ing More Aggressive Income Shifters? Journal of Accounting Research 50(5): S. 1245 -1285 Karkinsky, Tom and Nadine Riedel (2012), Corporate Taxation and the Choice of Patent Location within Multinational Firms. Journal of International Economics 88(1): S. 176- 185 Lynch, R (2004),“Rethinking Growth Strategies ” Economic Policy Institute Roland R and Sillard, P (2011), Local Corporate Taxes Have Only Weak Effects On Business Location Decisions French National Institute for Statistics and Economic Studies (INSEE). Wildasin, D. E. (1991), Some rudimentary ‘‘duopolity’’ theory, Regional Science and Urban Economics , vol. 21, pp. 393–421 Read More