A fiscal impact analysis will identify costs and benefits over a period of time accruing to a city or county from an economic development project. Since the timing of the individual costs and benefits is important, the analysis should take into account the time value of money. The way to account for the time value of money is to discount the flow of revenues and costs and evaluate them based on their present value. The present value is a way of expressing dollars to be paid or received in the future, in today’s dollars. A dollar today is worth more than a dollar a year from now, since an invested dollar would yield a rate of return or interest over the year.

Discount Rate
The connection between future dollars and today’s dollars is the discount rate. The discount rate represents the decision maker’s patience – the lower the discount rate the more patient one is, the higher the discount rate the more impatient. We recently evaluated energy efficiency investments which included significant upfront costs and incremental savings each year during the 20-year life of the efficiency measure. Only with a discount rate below 1% would the present value of benefits exceed the present value of costs. In this case the organization would have to be extremely patient.

So what is the right discount rate?
Theory suggests the discount rate should be the opportunity cost of the project relative to other investments. Since a city or county may invest in other projects or capital investments, municipal bond rates are a good measure of this opportunity cost. Right now, 10-year municipal bond rates are about 2.06% to 2.37% based on credit rating (AAA to A). The project’s opportunity cost may also be considered against other private investments. In this case, the 10-year corporate bond rates are 2.49% to 3.15%.

Currently, these bond rates are extremely low as a result of the overall interest rate environment in the economy. Remember, a low discount rate means the organization is very patient. We believe using a discount rate in the 2% to 3% range may distort the city or county’s decision-making process. Recently, we’ve recommended economic development organizations use a discount rate of 4% to 5%.

Ultimately, the discount rate should be evaluated regularly based on interest rate conditions and the city or county should feel comfortable with the rate. The city or county may already use a standard discount rate, in which case you may choose to use this rate to evaluate economic development projects.

Although critics may view the use of economic development incentives as corporate welfare, local governments can improve the social welfare by supporting private economic activity. It is important that economic development organizations implement a consistent, objective process to evaluate economic development deals, using clear evaluation criteria to ensure the organization is using scarce economic development funds wisely.

The decision to offer incentives can really be thought of as a two step process.

Step 1: Should an incentive be offered to this firm?
Step 2: What is the appropriate value of the incentive?

Click on the links above to learn how economic development organizations can use incentives wisely.

• Target Industries: Incentives should be used to to advance the strategic vision of the community and economic development organization. Therefore the organization should limit the use of incentives to projects in specific target industries.
• Generate New Economic Activity: Economic development incentives should be limited to businesses that will support new economic activity in the area, rather than reshuffle existing economic activity.
• Jobs for Current Residents: In addition, the organization should consider the employment impacts of the project. Will the business employ current residents or require in-migration? Will the business result in net new income for residents?

Collecting information from the prospect firm and preparing an economic and fiscal impact analysis will go a long way in answering these questions.

If the EDO has determined that a firm or project is worthy of an incentive, the question becomes: What is the appropriate level of the incentive?

Once an economic development organization has determined that the business or project is worthy of an incentive offer, the organization must determine the appropriate value of the incentive. An appropriate incentive can only be determined once the economic and fiscal impact of the business or project has been estimated. Our website addresses the components of a comprehensive economic and fiscal impact analysis.

The firm or project will generate taxes and other revenues for the community and impose costs on various taxing authorities. The fiscal impact analysis will itemize the benefits, costs for each local taxing authority over a period of time. Assuming the project will result in positive net benefits, the incentive-granting organization should base the incentive offer on the net benefits to be received as a result of the project.

Incentives in the form of job grants can be viewed as an investment in the project. The flow of net benefits represent the return on this investment. Within this framework, an average annual rate of return can be calculated for a given incentive level. In addition, the length of the payback period can be estimated. The payback period is the number of years before the taxing authority is paid back.

Communities should only consider incentives with a rate of return greater than 10 years and a payback period of fewer than 10 years. Given the level of uncertainty surrounding economic development projects, communities may impose specific limits such as requiring a rate of return greater than 20% or a payback period shorter than the firm’s initial lease length.

Continue to follow our blog as we address proper discounting, uncertainty and evaluating other types of incentives or contact us to learn more about our Local Economic Development Incentive Training Course or to discover how one of our customized impact models will help you protect public funds by using economic development incentives wisely.