Arkansas' business tax environment has been improved this General Assembly session thanks to the work of Sen. Lance Eads and Rep. Andy Davis. Senator Eads and Representative Davis sponsored legislation that will phase out Arkansas' InvestArk tax credit as well as the sales tax on the partial repair and replacement of manufacturing machinery.
By signing SB362 into law on March 14, Gov. Asa Hutchinson put the finishing touches on a piece of legislation that will make Arkansas a more attractive place to do business.
InvestArk is not just one of Arkansas' many targeted economic development incentives aimed at retaining businesses within the state. It is the largest incentive on the books, accounting for roughly half of all tax-incentive costs. From 2011 through 2015, InvestArk cost the state nearly $172 million. That is $103.4 million more than the cost of the state's next-largest tax incentive.
At the Arkansas Center for Research in Economics, we have consistently recommended reforms such as the InvestArk repeal. In our publication "The Roadmap to Tax Reform," Dr. Jeremy Horpedahl and co-authors at the Tax Foundation, an independent tax policy organization based in Washington D.C., suggested exactly this kind of tax "swap" by simultaneously eliminating InvestArk and repealing the sales tax on machinery.
But to many, it may not be clear as to why this tax swap is good policy. After all, it may appear that the state is simply trading one incentive for another. However, phasing out both InvestArk and this sales tax is good tax policy for several reasons.
First, InvestArk is inherently biased against smaller, newer firms. To receive tax credits from InvestArk, a company must have been established in Arkansas for at least two years and make an investment of at least $5 million. Clearly, this does not fit the description of every company looking to do business in Arkansas. It is biased against companies that do not already have a presence in Arkansas but are looking to start one, against startup companies, and against companies that are looking to make smaller investments. This legislation, though, removes that bias and opens up the benefits of better tax policy to all firms, regardless of age and size.
Second, InvestArk is merely treating the symptoms of poor tax policy. InvestArk is largely sought after by companies because Arkansas is one of the few states that places a sales tax on the partial repair and replacement of manufacturing machinery. But taxing the partial repair and replacement of manufacturing machinery is poor tax policy, as economists across the political spectrum agree that business inputs should not be in the sales-tax base.
Taxing business inputs, such as these partial repairs and replacements, creates what economists call tax pyramiding. This is when the cost of taxing business inputs at every step of the production process gets embedded into the final cost of the product to consumers. Naturally, this increases the cost of goods to consumers and disproportionately harms businesses that have longer production chains. Taxing business inputs may even cause some firms to vertically integrate their production process, increasing their power over the market, as nothing more than a reaction to the poor tax policy.
Finally, InvestArk, like any other targeted economic development incentive, leads to unintended consequences that do harm. For instance, the use of tax credits can lead to higher taxes for firms and individuals that do not receive these special favors in order to make up for lost revenue. Tax credits may also lead to unnecessary costs to the state government's budget if they are given to firms that would have remained in Arkansas regardless of whether they received incentives. Moreover, tax credits encourage special-interest lobbying, which is a generally unproductive activity from an economic standpoint.
Senator Eads and Representative Davis have done Arkansas a favor by successfully passing legislation that phases out both InvestArk and the sales tax on the partial repair and replacement of manufacturing machinery. While it is certainly a step toward making Arkansas a more attractive place to do business, there is much more work to be done.
Nevertheless, this reform provides a model for future reform: Special privileges can be removed at the same time as bad tax policy, without significantly affecting state tax revenue. The formation of the Tax Reform Task Force provides hope that Arkansans will see substantial tax reform in the 2019 session.
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Jacob Bundrick is a policy analyst with the Arkansas Center for Research in Economics (ACRE) at the University of Central Arkansas.
Editorial on 04/03/2017