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V. The policy and public choice implications of enterprise zone tax abatement shifting

The preceding analysis has implications for the intended incentive effects of enterprise zone programs. Moreover, the analysis suggests a potential motivation other than the community or public interest for landowners and public officials to endorse and pursue the establishment of enterprise zones.

The potential impact of capitalization on the incentive effects of enterprise zones

The model implies that development incentives like tax abatements that subsidize the purchase of variable production inputs increase the amount of the inputs employed by recipient businesses. If the tax abatement is granted only to businesses operating in enterprise zones, it will increase the amount of the targeted inputs employed in production within the zones. This is represented by the change in the profit-maximizing amount of v (from v* to v**) employed by the enterprise zone business. Consequently, the enterprise zone serves to increase the productive use of variable inputs like capital or labor above the level that would otherwise have arisen. This result is consistent with the general findings of the literature evaluating the effectiveness of enterprise zone programs (reviewed above in section II), where enterprise zones are found to have a positive impact on employment and capital investment, however variable the impact may be. What's more, the model reveals that besides the potential for resource transfers from recipient businesses to local landowners, the enterprise zone also leads to an increase in resource transfers from recipient businesses to the local workforce or to local suppliers of other variable inputs.

The model also suggests that businesses in pursuit of sites in the enterprise zone, and the accompanying tax abatements, will bid up zone land values. By and large, this result is consistent with the property tax and public service capitalization literature (reviewed above in section III). Fiscal differentials, in this case created via tax abatements granted to businesses operating within enterprise zones, are reflected in the value of business sites within the zones. However, capitalization of enterprise zone tax abatements would presumably vary depending upon the elasticity of supply of enterprise zone business sites, and depending upon the elasticity of demand for business sites.

If the supply of enterprise zone business sites is inelastic, land rents will be bid up by an amount equal to the producer's surplus (denoted by the shaded rectangle in Figure 2), provided the demand for business sites within the community containing the enterprise zone is relatively elastic. This proposition has important implications for the implementation of enterprise zone policy. In economically depressed communities the supply of business sites is probably rather elastic (even in the short run because of an over-abundance of idle resources) and the demand for business sites is probably rather inelastic. As a result, little or no capitalization of tax abatements will probably arise in enterprise zones in economically depressed communities. On the one hand this result is good since it suggests that businesses receiving tax abatements within these zones will retain those resources. Thus, the decrease in cost and increase in profit for businesses operating in such zones will be maintained. On the other hand, this result also may suggest that the inducements provided by enterprise zones only minimally increase development of land in those depressed communities relative to the land available for development.

Conversely, in more prosperous communities that nevertheless have enterprise zones, the supply of business sites may well be inelastic in the short run and the demand for sites elastic. Under such circumstances, the results of the model would hold. That is, the value of enterprise zone land would be subject to an upward adjustment offsetting (potentially in full) the decrease in the net price of the variable input due to the tax abatement. This implies that given a tight market and sizeable demand for business sites, tax abatement dollars secured by enterprise zone businesses may not be retained entirely by those entities. Rather, the tax abatement dollars may be transferred to owners of enterprise zone land. The monetary amount of the transfer would approach the monetary amount of the producer's surplus (denoted by the shaded rectangle in Figure 2) as the supply of enterprise zone sites is restricted and the elasticity of demand increases.

The discussion above also highlights an important facet in the competition among communities. In a competitive metropolitan setting, more prosperous communities may be able to readily bid potential investment away from the enterprise zones in depressed communities. Given the divergence in the elasticity of demand for business sites in the two types of communities, more prosperous communities may be able to bid investment away from depressed communities by making only marginal fiscal improvements through tax abatements, other incentives, or service enhancements. This suggests that enterprise zones should be limited only to depressed communities. Even with such a limitation, this suggests that competition for development from more prosperous communities will reduce the effectiveness of depressed community zones. Fiscal improvements made at a minimum of cost by more prosperous communities potentially will require depressed communities to offer increasingly costly tax abatements and other incentives with the hope of remaining competitive.

Ultimately, and most importantly, capitalization potentially may drive profits of zone businesses to zero, the same profit margin the businesses would earn outside the enterprise zone. Capitalization of the unit subsidy into enterprise zone land prices serves to diminish the presumed incentive effects of the enterprise zone. That is, the incentive of reduced production cost and increased profit margin that the enterprise zone is intended to offer to businesses is diminished, if not eliminated, by the capitalization effect. As a consequence, the more prosperous the community in which an enterprise zone is situated, the lesser the incentive effect the zone will create as any potential increase in profit margin via the tax abatements is extracted by local landowners. Under these circumstances, enterprise zones appear to be of little use as a tool for providing any competitive advantage in terms of cost or profit to the business receiving zone tax abatements. Alternatively, substantial capitalization should be absent in enterprise zones located in extremely depressed communities. Therefore, the incentive effect of the enterprise zones would be preserved as the tax abatement resources are retained by recipient businesses.

Does the empirical literature confirm the results of the model?

Three studies of the capitalization effects of enterprise zones suggest that resource shifting from enterprise zone businesses to landowners does occur (Erickson & Syms, 1985; Landers, 1999; Engberg & Greenbaum, 1999). In addition, one of the studies (Engberg & Greenbaum, 1999) suggests that the capitalization effects of enterprise zones are influenced by supply conditions.

Empirically, Erickson and Syms (1985) examined capitalization of tax abatements within British enterprise zones. Time trends of rental rates for industrial properties before and after enterprise zone establishment implied that the zones created a dual property market. Within this dual property market industrial properties just outside the periphery of the enterprise zones experienced a sharp decline in real rental rates. In addition, Erickson and Syms found that tax abatements led to a significant increase in rental rates within the enterprise zones. The empirical estimates suggested that almost two-thirds of the value of the tax abatements provided to land and fixed capital in the enterprise zones were capitalized into the rental rates charged by landlords for property within the zones.

Employing sales price and other realty information for 1,732 commercial and industrial parcels sold between 1984 and 1993, Landers (1999) estimated the relationship between parcel sales price and parcel location within an enterprise zone controlling for a variety of structural and spatial pricing variables. Parcels located within and outside of eight enterprise zones in the Cleveland (Ohio) metropolitan area were utilized to estimate the capitalization effects. The regression estimates suggested an inconsistent pattern of enterprise zone price effects. On average, enterprise zone parcels were sold for a price that was 0.195% higher than non-zone parcels. However, this result was not statistically significant at a standard level of significance (6). Six of the eight enterprise zones exhibited positive price effects. However, only two of these enterprise zones exhibited statistically significant price effects. On average, parcels in those two enterprise zones sold for a price approximately 0.6% higher than other zone and non-zone parcels.

Engberg and Greenbaum (1999) examined the impact of enterprise zones on the growth in housing values in 4,107 cities with populations between 5,000 and 50,000, 303 of which had enterprise zones (7). They found that the impact of enterprise zones on growth in housing values was moderated by the supply of housing within particular cities. On average enterprise zones didn't increase the value of housing, but did have a positive impact on housing values when the existing vacancy rate for housing was lower than average. The empirical results suggest that in a community with a housing vacancy rate one standard deviation below the average, an enterprise zone will cause housing values to grow at a rate one percent higher than otherwise. Conversely, in communities with higher-than-average vacancy rates, the price effect of the enterprise zone is negative. Thus, the price effect of increased demand for land within the enterprise zone varies depending upon the elasticity of supply for land. When supply is inelastic (low vacancy rate) a positive price effect arises. When supply is elastic (high vacancy rate) the positive price effect does not arise, but vacancy rates decline.

As to the impact of capitalization on the incentive effects of enterprise zones, two empirical findings suggest that the supply of enterprise zone sites influences the investment and employment effects of the zones. The conceptual discussion and empirical capitalization results suggest that resource shifting from enterprise zone businesses to zone landowners varies inversely to the supply of zone business sites. Moreover, the conceptual discussion implies that the incentive effect of enterprise zones (the additional profit resulting from the zone tax abatements) diminishes as capitalization increases.

Consistent with these conclusions, Erickson and Friedman (1991) found that size of enterprise zones had a substantial impact on zone performance. Specifically, the number of businesses investing in zone establishments, and the number of jobs created or saved by firms investing in zone establishments, was found to be increasing in enterprise zone size. The employment effect was statistically significant. Albeit not statistically significant, Elling and Sheldon (1991) also found that enterprise zone size influenced zone performance relative to relocating firms. They found that enterprise zone area was positively related to the number of relocating firms qualifying for enterprise zone benefits.

Differences in the size of enterprise zones would be expected to create variation in the absolute level of business activity among enterprise zones. However, a more elastic supply of enterprise zone business sites (via larger zone size) should minimize capitalization and the corresponding drag on the incentive effect of the enterprise zones. The tax abatements provided when the supply of enterprise zone sites is elastic will be retained by recipient businesses and not as readily shifted to owners of enterprise zone land through capitalization. Thus, it appears that enterprise zone policies are most effective when the supply of enterprise zone sites is elastic.

Given the potential for an elastic supply of enterprise zone business sites to forestall incentive and tax abatement shifting and lead to enterprise zone effectiveness, it appears that state policies authorizing enterprise zones should do so liberally. The criteria for establishing enterprise zones should have a broad impact, allowing zones in a substantial number of communities. Moreover, the legal and governmental process under which enterprise zones may be established or altered should consume a minimum of time and resources. The liberal establishment and alteration policies would ensure a large and elastic supply of enterprise zone business sites. For this reason, expansive policies would diminish the capitalization of zone incentives and tax abatements into zone land values.

Expansive enterprise zone policies, however, belie the fundamental purpose of enterprise zones, which is to target development incentives and tax abatements to economically depressed areas. On this point, Anderson and Wassmer (2000) have found that the efficacy of development incentive programs diminishes over time and as a result of intensified use of the incentives by more prosperous communities located on the periphery of urban areas. Their empirical findings suggest that periphery communities are more likely to employ incentives (relative to economically depressed core communities) the longer the incentive program is in existence (Anderson & Wassmer, 2000, 166-67). In so doing, the periphery communities are able to bid development away from the core communities within which blighted and depressed areas tend to dominate. The shifting model presented in this paper implies that prosperous periphery communities would be able to do so with only marginal changes in incentives because of the substantial differences in supply and demand elasticities for business sites that exist between periphery and depressed core communities.

Ultimately, Anderson and Wassmer (2000, 163) found that the increasing use of incentives by periphery communities diminished the efficacy of the incentive programs overall. In particular, they found that as periphery communities intensified their use of incentive programs, the programs were less effective in depressed core communities as measured by growth in population, employment, and commercial and manufacturing property base. Consequently, Anderson and Wassmer recommend strict targeting of incentives only to economically depressed communities. Interestingly enough, the shifting model suggests that capitalization would not occur (or would be severely constrained) in economically depressed communities where the supply of business sites is relatively elastic and the demand for sites is relatively inelastic. Thus, targeting enterprise zones, as opposed to allowing for significant expansion in the number and size of zones, may serve to minimize capitalization while providing for effective incentive programming in economically depressed communities.

Capitalization and the potential for local landowners to act as rent seekers

While the potential impact of enterprise zones on land prices has substantial implications for the efficacy of these programs, it also provides a basis upon which landowners may become advocates for the establishment of enterprise zones. The monetary windfall that local landowners may be able to extract as a result of the establishment of an enterprise zone becomes the political motivation for advocating their establishment and operation. As Bartik (1991, p. 113) suggests with regard to all development incentive policies, enterprise zones may represent "a modern version of 'honest graft,' a way for persons of influence to use government to increase property values." Thus, the "public interest" may serve as the apparent justification for the establishment and operation of enterprise zones only in so far as it obfuscates the rent-seeking behavior of local landowners.

On this point, tests of the monopoly-zoning hypothesis may illustrate the potential for enterprise zones to be utilized to contrive rents for local landowners. The monopoly-zoning hypothesis suggests that communities can increase the value of new housing by artificially restricting its supply through local zoning policies. By creating a small and inelastic supply of land available for financially lucrative development, local authorities may assist such development in obtaining a premium price. Consequently, a substantial portion of the interurban variation in housing values can be attributed to variation in the natural supply of urban land available for development (Rose, 1989; Thorson, 1996).

In particular, monopoly zoning encompasses an assessment regarding the monopoly power of each community to control the use and development of land within its boundaries. The hypothesis suggests that a community's monopoly zoning power declines as the supply of land available for development increases in neighboring communities. Thus, land rents created through zoning restrictions employed by any particular community will vary inversely with the number of autonomous surrounding communities and the supply of land available for development within those communities (Fischel, 1980; Thorson, 1996).

The empirical findings on monopoly zoning are quite consistent with the conceptual shifting model. The monopoly zoning literature suggests that local public officials may be able to manipulate local land prices by severely restricting the supply of land available for location of profitable enterprises, provided there is little or no competition for development from other communities. Likewise, the conceptual shifting model coupled with the empirical analyses of the capitalization effects of enterprise zones suggests that local public officials could manipulate land prices by establishing enterprise zones. In so doing, local public officials could establish a restricted supply of land (the enterprise zone) that firms must occupy to obtain tax abatements. The price effect would provide a rationale for local landowners to pursue enterprise zone establishment through the local public policy process. In particular, landowners in communities where the demand for business sites is relatively elastic may find this strategy most effective because capitalization of tax abatements and other incentives under such supply and demand conditions would be maximized.

As under monopoly zoning, however, the price effects of the enterprise zone would depend on the supply of enterprise zone business sites in surrounding communities. The effect of competing enterprise zones may provide the basis for local landowners and local public officials to obstruct enterprise zone efforts in neighboring communities by pursuing public policies that place overall limitations on enterprise zone establishment. While the analytical results illustrate the potential price effects of enterprise zones, they don't suggest that public officials or landowners are, in fact, using the zones to inflate property values. Rather, the analytical results only suggest that the basis for such activity is present.

The potential for rent seeking by local landowners has implications for criteria and oversight efforts relating to the establishment of enterprise zones. Stringent oversight of enterprise zone establishment may preclude misuse of the enterprise zones to enrich local landowners. However, more stringent reporting requirements and more invasive oversight could interfere with the efficient and effective implementation of enterprise zones by communities. In response communities in need of these policies may reject enterprise zones as a development tool. A better course of action may be to limit enterprise zones only to economically depressed communities where capitalization is expected to be at a minimum. If capitalization related to enterprise zone establishment is zero or close to zero, rent-seeking behavior by local landowners would have little or no basis. Thus, targeting enterprise zones to depressed communities appears to represent a rather effective check against strategies aimed merely at contriving land rents through the establishment of zones.

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