By Tim Bartik/ W.E. Upjohn Institute for Employment Research
Louise Story, an investigative reporter for The New York Times, recently wrote a three-part series on state business incentives. The series was accompanied by a new database, which reports annual dollar figures for business incentives for each state. This database reports that Michigan’s business incentives total $6.65 billion annually.
This figure immediately seemed large to me. I have calculated in previous work that Michigan’s business incentives total about $1 billion per year, which is certainly large, but nowhere near $6.65 billion. Why are the New York Times figures so large?
It turns out that $4.83 billion of Michigan’s business incentives in the NYT database are sales tax relief. In turn, $4.8 billion comes from just two aspects of Michigan’s tax law.
First, the database reports that Michigan businesses save $3.88 billion annually because they do not pay sales tax on business services that they purchase. This is because Michigan’s sales tax does not require anyone, business or consumers, to pay sales tax on most purchases of services.
Second, the database reports that Michigan manufacturers save $920 million annually because they do not pay sales tax on goods used or consumed in industrial processing.
Should this $4.8 billion in reduced sales tax because of these two provisions be regarded as a business incentive? This depends on how we want to define an incentive.
However, regardless of whether sales tax relief for business inputs is an incentive or not, most public finance economists would argue that the sales tax should not be applied to business purchases of business inputs, regardless of whether those business inputs are goods or services. If business inputs are subject to the sales tax, then the sales tax pyramids as businesses buy inputs from suppliers, who in turn buy inputs from other suppliers.
This pyramiding has several adverse consequences, the most serious of which is that businesses can avoid this pyramiding by “vertically integrating” — that is by bringing their supply activities in-house or buying their suppliers. This vertical integration is easier for large businesses to do, and it also encourages businesses to get larger by buying their suppliers, and reduces the number of small supplier businesses. It is unclear why government would have any reasonable public policy reason for encouraging vertical integration.
For example, if the sales tax was applied to business purchase of accounting services, this encourages businesses to bring their accounting services in-house. Furthermore, such a sales tax would advantage businesses that are large enough that bringing accounting services in-house is feasible. Both these effects would in turn decrease market demand for the services of small, independent accounting businesses. But there is no good reason for policy-makers to want to bias how accounting services are delivered to businesses in our economy.
Therefore, more than two-thirds, in dollar volume, of the business incentives identified by the New York Times for Michigan are incentives that a sensible state and local public finance system would want to continue.
Regardless of what one thinks of property tax abatements, or customized job training, to mention just two other business incentives, state laws that provide sales tax relief for business purchases of inputs can be reasonably justified.