With bids due tomorrow, I made the case in yesterday’s blog that submitting an expression of interest should be a ‘no-brainer’. IZs offer big tax breaks, funded by central government, in exchange for planning relaxations that are yet to be defined. At this first stage places are being asked to show how they will “avoid deadweight, negative displacement, transfers, substitution, and leakage”. With the lack of details, I suspect most places will have given generic answers to these questions with the hard thinking to come as negotiations proceed. In this post, I outline what existing theory and evidence have to say on deadweight and displacement – two of core issues that will need careful consideration as places start to negotiate with central government.
What is deadweight?
Deadweight occurs when a policy costs money but doesn’t change behaviour. For IZs, deadweight will happen if firms benefit from the various tax incentives but do exactly what they would have done if the IZ hadn’t been in place. Nothing changes for the economy despite the tax foregone. For example, one of the proposed incentives is a zero rate of NICs on salaries of any new employee working at least 60% of their time in the IZ, up to an earnings limit. But we know that around 9% of people change jobs each year so some of this incentive will go to firms currently located in the zone that change nothing in the way they operate.
Other types of deadweight will be harder to detect, particularly when firms are changing behaviour, but in a way that was already planned and thus unaffected by the incentives. If firms were already planning to expand the number of jobs, they will get the NIC incentive as they fill those new jobs and may also get some additional business rate relief. If firms were already planning to invest, then they will benefit from reduced tax because of additional capital allowances (IZ proposals include 100% first year allowances on qualifying expenditure on plant and machinery assets). If firms were already planning to move to the zone, they will now be able to do so with the bonus of getting business rate relief for as long as 10 years.
Unfortunately, avoiding deadweight is difficult (even if we had more policy detail). IZs generate new economic activity by reducing the tax burden on firms, making previously unviable investments and expansions, viable. All else equal, the larger the tax incentive, the bigger the impact on new activity. But the larger the tax incentive, the more costly is deadweight because firms get larger incentives for doing things they would have done anyhow. Thus ‘avoiding deadweight’ is likely impossible – the key question is how to get a high ratio of new activity to deadweight.
One important dimension of this for local areas is where they locate their IZ. The total amount of deadweight will tend to be smaller for zones located in struggling areas with a small initial business base and not much employment. But deadweight as a percentage of overall benefits could be high even in these areas if the incentives aren’t sufficient to grow the business base and employment. Evidence from French ‘Zones Franches Urbanise’ (ZFUs) – which offer a similar package of incentives to that proposed for IZs – suggests that targeting worse performing areas could be a real concern: ZFU policy is less efficient when targeted at areas facing a very high degree of economic difficulties compared to the rest of the municipality.
One way to avoid deadweight is to work with firms to establish what they’re planning to do in the absence of the policy. This might sound a little odd, but the UK Regional Selective Assistance (RSA) programme did this to quite good effect by requiring firms to demonstrate in bids that continued activity or new investment relied on the incentive. This can help avoid deadweight, assuming bids can be carefully assessed. That’s much harder to do for IZs because, unlike for RSA, incentives apply to all firms in the zone. When developing their proposals, local areas may be able to do something along these lines, if they have good local information, for example, on what’s going on in larger firms located in the zone.
At the other extreme, in thriving local areas there is lots of scope for deadweight costs to be high – because businesses may be looking to expand anyhow. The crucial issue here will be to ensure that the planning parts of the IZ policy package are used to address planning constraints that are stopping these firms from growing. Setting aside the political constraints, this is ‘easy’ to do if you are a thriving local area – a good example is the way that Canary Wharf helped address land supply problems for the financial services industry – but much harder if the local economy is struggling. Looking at price signals might help – will the IZ expand the supply of commercial premises in a part of the local economy where commercial rents are relatively high? If not, then planning reforms may not deliver much growth.
Do we need to worry about deadweight?
Deadweight should be a big concern for national government which is presumably why places are being asked how they will avoid it. That said, it’s hard to predict what role it will play in bid assessment. Some ministers appear to be convinced that the impact of additional investments will far outweigh concerns over deadweight, others less so. The evidence – discussed in my earlier blog – is far from encouraging and urges caution in downplaying the importance of deadweight.
Much of the cost of deadweight won’t be felt locally, because local areas are not funding the tax relief, so it’s not such a big issue for local areas. That said, caution is needed depending on what areas will be asked to give up in terms of local control on land use in exchange for these fiscal incentives. As discussed in my earlier blog, this balance is hard to assess given the lack of detail on the planning side, so is probably an issue best returned to later.
What is displacement?
All policies carry the risk of deadweight. Spatially targeted policies must also address the possibility of displacement. Displacement occurs when firms change their location, but nothing else, in response to policy. Good for the zone, bad for the places that lose out on investment and employment. The spatial scale at which displacement occurs will determine whether what’s good for the zone is good for the wider local economy. If firms are moving from neighbouring areas to the zone, then the overall impact on the local economy will be limited. If firms are moving from other areas further away, then the overall impact on the local economy will be larger (even if this leaves open the question of what the national impact will be).
Unfortunately, the evidence on local displacement isn’t particularly encouraging: our 2016 evidence review on Enterprise Zones reports that most of the studies of past schemes which attempt to measure displacement find evidence of it.
As with deadweight, one important consideration for local areas is the location of the zone, because the initial attractiveness of the zone will matter for displacement. For zones in struggling areas the key challenge is to demonstrate that the incentives are large enough to attract business from outside the local area. If not, then displacement is likely to be mainly local because large fiscal incentives will be attractive to firms that are already located near to the zone. Again, the limited evidence that we have isn’t very reassuring – French IZ-type schemes that offered similarly generous incentives appear to have created a lot of local displacement.
For zones in areas that are doing relatively well, the key consideration will again be the interaction with the planning element of the zone. Displacement into the zone from other parts of the local economy still delivers local benefits if the sites these firms vacate are attractive to other business. As for deadweight, looking at price signals might help – will the IZ expand the supply of commercial premises in a part of the local economy where commercial rents are relatively high?
Do we need to worry about displacement?
At a national level, there’s not much to distinguish between deadweight and displacement – ‘shuffling’ around jobs within a local area is deadweight from a national perspective. And, as with deadweight, some ministers appear to downplay the importance of displacement so it’s hard to know how this will be assessed.
In contrast to deadweight, local areas will want to worry about local displacement because it means generating jobs and investment in the zone comes at a cost of lower investment and employment for neighbouring areas. This should be a first order consideration. There can be benefits to concentrating employment in local areas – for example it can help with the provision of other public services such as high-speed broadband and public transport. But if this comes at the cost of lower employment and vacant properties elsewhere in the area, then the overall effects need thinking through carefully.
The questions of how to avoid deadweight and displacement, and how much we should worry about them, are tricky ones to answer, and the answers may differ for national and local government. Given the uncertainty over the evidence, making strong assumptions about additionality relative to deadweight and displacement seems risky. The best advice I can offer to areas is to take these issues seriously in developing bids and think carefully about what planning and regulatory reforms would be acceptable in exchange for getting a zone. More on other things to consider tomorrow, in the last of this blog series.