Tax incentive

A tax incentive is an aspect of the tax code designed to incentivize, or encourage a particular economic activity.

Disambiguation

There are very few provisions in the tax code that constitute incentives. The term is a frequent misnomer.

For the most part so-called “tax incentives” simply remove part or all the burden of the tax from whatever market transaction is taking place. This is because almost all taxes impose what economists call an excess burden or a deadweight loss Deadweight loss is the difference between the amount of economic productivity that would occur absent the tax and that which occurs with the tax imposed.

This is illustrated by the following examples. If savings are taxed, people save less than they otherwise would. Taxing goods and people buy less. Taxing wages and people work less. And taxing activities like entertainment and travel reduces their consumption as well. Sometimes the goal is to reduce such market activity as in the case of taxing cigarettes. But reducing activity is most often not a goal because greater market activity is considered desirable.

When a tax incentive is spoken of, it usually means removing the tax (or a portion thereof) and thereby lessening the burden, really removing a disincentive. To understand how removing a tax increases the level of market exchange by removing the excess burden. A comparable analogy might be with the use of carrots and sticks. Carrots are incentives; sticks are not. If one reduces blows with a stick from ten to five, one hardly thinks of this as increasing incentives. Yet doing so is an apt comparison with most taxes. Most all taxes are sticks.

Regardless of this, the term "tax incentive" is incorrectly used in common parlance to refer to any change in behavior caused by a tax or a relative decrease in the tax.

Inelastic Supply

In only one case does removing a tax constitute an actual incentive to market activity. This is when a tax is levied on any item or base with an inelastic supply.

A supply is inelastic when it can be represented graphically by a completely vertical supply line, parallel to the Y axis. As supply and demand curves are usually presented, the X axis is used to represent quantity and the Y axis shows price. Most market items with a completely vertical supply are natural resources--land, air, water, the electromagnetic spectrum, airport time slots, and so on.

Fossil fuels, minerals, and precious stones often also fall into this category, because the supply is roughly fixed at any given time, even though in due course more can be made available to the market. Their limited supply means that their bid-curve escalates sharply with demand. Mark Twain, and later Will Rogers, were known to have said, "Buy land; they ain't makin' it any more." Another category of items with a fixed supply are what are often called "collectibles"--art objects, antiques, autographs of notable people, and so on.

The reason why aggressively taxing items and bases with fix supply constitutes a market incentive is because levying a tax does not dampen transactions at all; rather it stimulates them. The higher the tax levied on such bases, the more their titleholders are pressed to get a return on their carrying costs. Rather than being vehicles of speculative investment, their idle possession then imposes a price. Whatever market price such items might by themselves have, their cost is due more to what economists call rent. Their market value is due not to anything owners might have done, but is due rather to the demand of the total market community taken together.

When the market value of items with an inelastic supply is transformed into rent, it becomes a flow, which, when captured by a tax, is shifted into the active economy. Rather than being effectively "frozen" and removed from the market, this wealth, otherwise hidden and lost, is restored to the market's circular flow. This enriches the community's general wealth flow and thereby constitutes an incentive to common enterprise. In this way, a tax on items with an inelastic supply are an incentive not just to individual titleholders but to the community and society taken in toto.

Land Value Taxation

Land Value Taxation is effectively a user fee for the private ownership of land in the form of a rate levied on its value.

A land value tax is different from a property tax in that the property tax is levied on land and improvements (e.g. buildings), whereas a land value tax is levied upon land value only.

As a model of how Land Value Taxation affects incentives, take for example a vacant lot in the center of a vibrant and growing city. Any landowner that must pay a tax for such a lot will perceive holding it vacant as a financial liability instead of an investment that passively rises in value.

A Land Value Tax does not increase the purchasing price of land.Tax incidence rests completely upon landlords. This is to say that landlords can not collectively raise the overall market price of land as a result of the tax.

A tax upon ground-rents would not raise the rents of houses. It would fall altogether upon the owner of the ground-rent, who acts always as a monopolist, and exacts the greatest rent which can be got for the use of his ground....The more the inhabitant was obliged to pay for the tax, the less he would incline to pay for the ground; so that the final payment of the tax would fall altogether upon the owner of the ground-rent.

— Adam Smith , The Wealth of Nations, Book V, Chapter 2, Article I: Taxes upon the Rent of Houses

One reason is that buyers will not pay for the anticipated appreciation of land since such appreciation is taxed away. From the seller's perspective, land costs more to continuously maintain ownership of. Thus, Land Value Taxation gives buyers increased leverage over sellers.

Similarly, the selling price of anything that is fixed in supply will not increase if it is taxed. Since there is, for all intents and purposes, a fixed supply of land, a land value tax is paid by the seller only. See tax incidence.

Furthermore, unlike taxing goods that carry higher purchasing prices as a result of higher production costs, land does not increase in price when taxed. This is because land simply exists. It is not produced by individual land owners.

For these same reasons, a land value tax is also not passed on to tenants as higher rent. Landlords are impelled to make land available to tenants as a means of generating the funds required to pay the Land Value Tax. Relatively speaking, landlords compete with other landlords for tenants instead of tenants competing with each other for space.

Land Value Taxation creates an impetus to either use a site for an income generating purpose, such as apartments, store fronts, office space, etc. or to sell part or all of the site. Of course, anyone who purchases the land will be faced with the same incentive, which is to use it or lose it.

The Land Value Tax paid per surface area is high in locations with high land values, especially cities. In vibrant cities, under use of land in the form of buildings which are underused, short, or even derelict are generally speaking converted to more intensive uses. Of course vacant or ground-level parking lots are also generally converted to building space and parking structures.

Such incentives result in an increase in the supply of space for living, working, recreation, etc. Assuming constant demand, an increase in supply of constructed space, i.e. substitutes for land, decrease the rent paid for such space.

This is especially relevant since land value taxes are often used to replace taxes on buildings, among other taxes. Of course, taxes on buildings restrict the supply of building space. A revenue neutral shift from buildings to land increases the supply of building space more than a land value tax alone. The incentive is strongest in urban areas and other locations in which there is a high demand for land.

Removing taxes on property, i.e. land and buildings, constitutes an incentive affecting land use. However, removing taxes from buildings simply removes the burden of taxation placed on buildings. Lowering a building tax is not a true incentive; it is just a relative decrease in excess burden.

Pseudo Tax Incentives

Regardless of the fact that an incentive spurs economic activity. Again, many use the term to refer to any relative change in taxation that changes economic behavior. Such pseudo-incentives include tax holidays, tax deductions, or tax abatement. These "Tax incentives" are targeted at both individuals and corporations.

Individual Incentives

Individual tax incentives are most prominent in the federal income tax code in the United States, and include deductions, exemptions, and credits. Specific examples include the mortgage interest deduction, individual retirement account, and hybrid tax credit.

Corporate Tax Incentives

Corporate tax "incentives" more typically include federal, state, and local governments. The federal tax code provides a wide range of incentives for corporations, totaling $109 billion in 2011 according to a Tax Foundation Study.

The Tax Foundation categorizes federal tax incentives into four main categories, listed below:

• Tax exclusions for local bonds valued at $12.4 billion.
• Preferences aimed at advancing social policy, valued at $9 billion.
• Preferences that directly benefit specific industries, valued at $17.4 billion.
• Preferences broadly available to most corporate taxpayers, valued at $68.7 billion.

Corporate tax incentives provided by state and local governments are also included in the tax code, but many times are directed at individual companies involved in a corporate site selection project. Site selection consultants negotiate these incentives, which are typically specific to the corporate project the state is recruiting, rather than applicable to a broader industry. Examples include:

• Corporate income tax credit
• Property tax abatement
• Sales tax exemption
• Payroll tax refund

See also

• Tax Exemption
• Tax Competition