919805

research-article2020
EDQXXX10.1177/0891242420919805Economic Development QuarterlyMeurers and Moenius

Research and Practice

Economic Development Quarterly

Market Potential and Fiscal Incentives

2020, Vol. 34(2) 126­–139
© The Author(s) 2020
Article reuse guidelines:
Influence Firms’ Location Decisions: sagepub.com/journals-permissions
DOI: 10.1177/0891242420919805
https://doi.org/10.1177/0891242420919805

Evidence From U.S. Counties journals.sagepub.com/home/edq

Martin Meurers1 and Johannes Moenius2

Abstract
How important are market potential and fiscal incentives for firms’ location decisions? We estimate the influence of subsidies
and tax breaks on the decisions of firms to relocate or to remain in a certain U.S. county using a structural economic
geography model developed in Meurers and Moenius (2018). In a panel data set from 1990 to 2016 for almost 3,000 U.S.
counties, the authors find a strong and robust impact of economic geography on firms’ location decisions: The closer a county
is to market demand and to the supply of inputs, the more firms locate there. As the model predicts, public investment
attracts firms while the local tax burden disincentivizes economic activity, although to a lesser extent. Furthermore, in
counties that are closer to economic centers, firms respond less to public investment and tax changes than firms in counties
far away from centers. These data, therefore, confirm the predictions of the model regarding the potential effectiveness of
regional development policies, in particular for investment tax credits, job creation, and training.

Keywords
regional economic policy, fiscal incentives, market potential

Economic theory suggests that firms choose their location to
maximize profits. This requires them to locate close to mar-
ket demand, to factors of production, or to inputs. The eco-
nomic geography literature measures proximity to market
demand as the distance-discounted sum of (real) economic
activity in neighboring regions (see, e.g., Harris, 1954;
Krugman, 1991). As transport costs fall, the distance to mar-
kets becomes relatively less important, and other factors
such as local fiscal incentives increase in importance. In this
article, we study this trade-off between access to markets and
fiscal incentives, which can take the form of tax exemptions
or a high-quality provision of public infrastructure (e.g., road
transport or broadband connections).
Previous work has focused on the empirical role of either of
these two factors. Our own prior work establishes the impor-
tance of localized pecuniary spillovers that may lead to equi-
librium levels of investment in public infrastructure near
economic centers that are below the social optimum.
Henceforth, we will label this phenomenon as underinvest-
ment in the periphery. Our model is static in nature and
assumes instantaneous adjustment. As such, it cannot capture
the rich, dynamic adjustment processes that are ongoing on a
region’s path toward such an equilibrium. However, it delivers
some inherently interesting insights, as well as testable hypoth-
eses, that deliver answers to questions of local public policy
relevance. First, if underinvestment is an equilibrium outcome
in which pecuniary spillovers create attractiveness for firms
that compensate for lower public investment in the periphery,
underinvestment can likely persist for a long time or repeat-
edly occur. As such, it should be measurable in the data.
Second, underinvestment does not imply no public investment
at all. It only indicates lower investment than in the centers in
the amount that positive spillovers from neighbors can com-
pensate for lower public investment that allows regions to
enjoy lower taxation at the same time. Third, differences in
fiscal policies across regions matter for attracting firms.
Therefore, we investigate how market potential, localized
incentives, and potential underinvestment in infrastructure
jointly determine firm location within the United States over
time. The rich U.S. data infrastructure, specifically at the
county level with its sizeable public investment and measur-
able spillover effects, lends itself to this kind of analysis.
We use the general equilibrium framework developed in
Meurers and Moenius (2018) to guide our empirical analy-
sis as we identify the relative importance of economic geog-
raphy and fiscal incentives. We study the effect of local
public investment and taxation on the net number of firms in
1
Federal Ministry for Economic Affairs and Energy, Berlin, Germany
2
University of Redlands, Redlands, CA, USA
Corresponding Author:
Martin Meurers, Federal Ministry for Economic Affairs and Energy, Alt-
Moabit 101d, Berlin 11019, Germany.
Email: martin.meurers@bmwi.bund.de
Meurers and Moenius 127
manufacturing. This number includes the founding of new
firms net of firm deaths, the firms that persist and stay, and
net migration of firms. Our dependent variable is the pro-
portion of total manufacturing firms in a county and we con-
trol for the firm size distribution in most of our specifications.
Our independent variables capture local fiscal incentives,
taxation, and variables that reflect economic geography,
such as how much the distance from centers affects relative
prices. We control for local factors that are or can be viewed
as constant over time with county-specific fixed effects. We
control for influences that affect all locations in a similar
manner over time with time fixed effects. We expect fiscal
incentives to increase the number of firms and taxes to
decrease the number of firms. Our theoretical model also
predicts that positive spillovers from centers into the sur-
rounding areas leads to an increase in the number of firms in
those surrounding areas.
Our panel regressions show that both economic geography
and fiscal variables exhibit significant influence on the devel-
opment of the number of firms at the county level in the
expected way. Most notably, our economic geography vari-
ables consistently appear large and significant in our results:
For firms, it pays to be close to a center and counties can afford
to underinvest in public infrastructure there without fending off
firms. The detailed available data, moreover, allow us to iden-
tify the most effective forms of tax incentives to attract firms:
investment tax credits, job creation tax credits, and job training
grants. These results have some important consequences for
public policy: (1) Both public investment and lower taxes help
increase the number of firms; (2) Both types of fiscal incentives
are more effective in attracting firms and supporting firm
growth in remote places, as there is less leakage through posi-
tive spillover effects to competing firms in neighboring coun-
ties; and (3) While fiscal incentives seem to be effective to
promote firm location and growth, their efficiency is less clear.
The magnitude of our estimated effects is rather moderate, such
that we do not obtain convincing evidence that such policies
might pay off from a taxpayer’s perspective.
Our most pervasive empirical results come from estimat-
ing the effect of fiscal policy on the number of firms in cen-
ters with high market potential versus the periphery with low
market potential. For given market potential differentials
between centers and the periphery, fiscal policy is almost
meaningless in centers but highly effective to keep or attract
manufacturing firms in regions far from centers. As the mar-
ket potential of a region depends on distance-weighted eco-
nomic activity in all other regions, the effectiveness of such
policies can change over time, namely when transportation
costs fall. Therefore, locations that see changes in their mar-
ket potential need to adjust their fiscal policies accordingly.
Our results, however, suggest that economic development
support, be it through tax credits or public investment, should
be focused on areas distant from the centers, as it has the
strongest effect in areas with low market potential.
The article begins with a brief review of the literature and
discusses previous empirical findings on the role of market
potential and fiscal incentives on firm location. The next sec-
tion derives the estimation equation from the model in
Meurers and Moenius (2018), followed by a description of
the data and the calculation of market potential and the
adjusted number of firms. We then present the results and
conclude with a discussion of policy implications.
Literature Review
Since there is a vast literature on the determinants of firm
location, we focus only on the part of the literature most
closely related to our work. Brülhart (1998) categorized the
factors that affect location choice into two main groups. The
first, neoclassical factors such as natural endowments, trans-
portation costs, and technologies are exogenous to the firm at
any point in time. The other group comprises endogenous
factors, which include spillovers between firms and markets.
For the United States, Ellison and Glaeser (1999) provided
evidence on the relevance of spillover effects. They attrib-
uted at least one fifth, but no more than one half, of industry
location choice in the United States to observable cost-deter-
mining natural advantages. They conjectured that the remain-
ing—larger—share must be explained by endogenous
factors, such as localized intraindustry spillovers, and con-
firm this in Ellison et al. (2010).
Already Marshall (1890) recognized spillovers resulting
from firms at the same location (e.g., through technology
sharing or leakages, knowledge transfer, labor pooling, and
intermediate input linkages). These are frequently referred
to as agglomeration economies. Spillovers, however, can
also result from changes in the structure of markets with
imperfect competition and increasing returns to scale.
Location of firms then heavily depends on the proximity to
market demand and to supply factors of production (see
Fujita et al., 2001; Krugman, 1991). Identifying the central
role of the location of production, its agglomeration in
space as evidenced by cities as economic centers as well as
the resulting market environment, shapes the foundation of
the new economic geography. If production and consump-
tion are concentrated, access to those markets becomes key,
with producers and consumers located more closely to an
economic center assumed to have less costly access.
Economic geography models capture proximity to the rel-
evant market environment with a variable, labeled “struc-
tural market access.” This variable closely resembles the
concept of market potential by Harris (1954). Typically,
indicators of local economic activity, such as local nominal
wages and the size of the industrial sector, are positively
related to market potential. Firm location is a discrete
choice: A firm either locates in a particular location or else-
where. McFadden (1973) developed a discrete choice mod-
eling strategy for empirical analysis in which individual
128 Economic Development Quarterly 34(2)
cases of firm location are observed over a certain time span.
Crozet et al. (2004) used this approach to investigate the
location choice of foreign investors in France. They found
that foreign firms in sectors like computers, car parts,
machine tools, and office machinery prefer existing
agglomerations of competitors. Over time, however, exist-
ing firm clusters lose their relevance and the impact of mar-
ket potential becomes larger. Interestingly, they did not find
any impact of French or European regional policies on the
location choice of foreign firms.
Head and Mayer (2004) investigated whether Japanese
affiliates in Europe chose locations that offer market access à
la Krugman or access to an industry cluster of firms within
the same industry. They found that both market potential and
industry-specific agglomeration of firms, measured by the
share of domestic firms in the sector within a region, helped
to explain why firms locate in a specific region.
The evidence therefore suggests that agglomeration posi-
tively affects firm location through two different channels: a
direct spillover effect between neighboring firms in the same
sector and a market-size effect. We add to these two main
pillars of this literature in two distinct ways. First, we explic-
itly capture the channel of the market-size effect; namely,
through the effect on relative prices for both consumers and
producers who require intermediates for production. Second,
we revisit the largely understudied area of fiscal incentives
and public policy in the context of location choice.
There is a substantial literature on the economic effects of
fiscal policies at the state and local levels. Earlier studies for
the United States are surveyed in Bartik (1991). This strand
of research empirically assesses how fiscal variables influ-
ence local economic outcomes, such as output and employ-
ment. Since the importance of market potential has been only
recently established by the economic geography literature,
these studies use control variables that do not include market
potential. In contrast, empirical studies of location choice
rarely analyze fiscal incentives. An exception are papers
along the lines of Holmes (1998), or Chirinko and Wilson
(2008). These studies viewed relatively easy firm relocation
between neighboring counties on both sides of a state border
as the source that allowed them to identify the effects of dif-
ferences in fiscal policies on firm location choices. In these
studies, policy differences are typically measured at the state
level, while firm location choice is recorded at the county
level, which gives the policy variables a more exogenous
character. However, Peltzman (2016) highlighted that the
moderate fiscal policy impact regularly obtained from the
difference estimation for border counties might be blurred by
demand spillovers resulting from state policies on the other
side of the border. Taking these into account, he showed that
the true policy impact might be larger than previously
recorded. For example, fiscal expansions on both sides of the
border diminishes the relative importance of firm-level
incentives and thus reduces their effect on firm location
choice. Many of the earlier studies on fiscal incentives strug-
gled with problems of multicollinearity of fiscal variables
that lead to insignificant results. Specifically, revenues and
expenditures are not orthogonal, but depend on each other
through budget constraints. Including both types of variables
in the same regression generates multicollinearity. As a solu-
tion, Helms (1985) suggested to omit expenditure categories
from the set of explanatory variables and then interpret the
coefficient on the tax variable as the impact of the omitted
expenditures on growth as those taxes were raised to finance
them. A recent comprehensive survey by Rickman and Wang
(2018) noted that despite all advances in econometric tech-
niques (e.g., accounting for multicollinearity, nonlinearity,
spatial spillovers, and endogeneity, and despite much better
data availability), there is still no clear answer, as the results
still vary across studies and strongly depend on individual
circumstances in time and space. In particular, Rickman and
Wang (2018) argued that there is still no convincing evidence
that local tax burden is a major driver of local economic per-
formance in either direction. In contrast, public expenditure
particularly expenditure on education and transport seem to
have a positive impact on economic growth.
Our article fills the gap between the studies of agglomera-
tion and market potential on firm-specific location decisions
and studies that assess the impact of fiscal incentives.
Following the model developed in Meurers and Moenius
(2018), we investigate how market potential and fiscal incen-
tives jointly determine firms’ location decisions. To do so,
instead of individual firm’s location choice, we model the
aggregate outcome of individual location choices. This
encompasses firm continuation, relocation of firms, and the
birth and death of firms.
Theoretical Background
In Meurers and Moenius (2018), a new economic geography
model was developed based on the previous works of Fujita
et al. (2001), Krugman (1991), and Redding (2016). Instead
of land, Meurers and Moenius used immobile labor as a
locally fixed factor of production. Immobile labor has insuf-
ficient incentives to move (e.g., potential real wage increases
from moving cannot compensate for total moving costs,
which not only includes physical transportation and cost of
living adjustments, but also social adjustment costs such as
building new social networks or being separated from family
and friends). Furthermore, the authors assumed that both
mobile and immobile workers are needed for the production
of manufactured goods. Finally, fiscal variables are intro-
duced into the model as local public investment expenditure
raises total factor productivity of manufacturing firms. It is
financed by a proportional local payroll tax such that the
local fiscal budget is always balanced.
The equilibrium in the model is determined by spatial
real-wage arbitrage of mobile workers. Equation (1) states
Meurers and Moenius 129
the equilibrium condition of the model, requiring that mobile
workers’ real wage is equal in all regions. Then, the share of
total national mobile workers ( λ i ) locating in each region is
determined by an index of economic fundamentals in each
region relative to an index of fundamentals aggregated across
all regions R. These economic fundamentals are the relative
endowment with immobile workers ( θi ), the relative total
factor productivity fi, which depends positively on the local
public investment ratio to gross domestic product (GDP;
gi = Gi / Yi ), the relative tax rate ( taxi ), and the relative
terms of trade ( PX / PM ).
i i
γ work with county-specific fixed effects, which capture local
1
 PX  1− αγ
θi (1 − taxi ) 1− αγ
 i
fi ( gi )
 PM 
λi =
i
1
 PX
∑ ( )
R
θ j (1 − tax j )1− αγ  fj gj 
j
j =1
 PM j

The parameter α captures the wage share of mobile workers
in the total regional wage bill. γ describes the share of each
worker’s income that is spent on tradable manufactures.
Both parameters increase the relevance of mobile workers
location choices for the equilibrium of the model. If there are
differences in economic fundamental (e.g., Region 1 has a
higher tax rate than Region 2 [ tax1 > tax2 ]), then the differ-
ence in mobile labor allocation between the two regions will
be more pronounced with rising α and γ .
The terms of trade capture the proximity to markets.
Redding and Venables (2004) showed that they are a linear
function of both the distance-weighted demand for final
manufacturing goods (market access) and the distance-
weighted access to the supply of intermediate inputs (sup-
plier access).
For simplicity, firms are assumed to be symmetric with
identical cost functions in every region. This implies that the
number of firms ( N i ) is a linear function of manufacturing
output ( X i ), fixed cost ( F ), and the elasticity of substitution
X national GDP ( Yt ) and the total number of firms (N t ) enter as
between manufacturing varieties ( ε) : N i = i . From an
εF
empirical perspective, we would rather allow for varying
firm-specific fixed costs that depend on the existing number
of firms. This is, for example, the case when it gets more and
more expensive to set up a new firm because of limited
space. Such increasing fixed costs would imply that every
additional firm has to produce a higher output to be profit-
∂Fi
able: dX i = ε dN i . This leads to firm heterogeneity like in
∂N i
the model of Melitz (2003). The relationship between the
number of firms and output in such a model is characterized
by a function of the form X i = F0 eφN . The parameter φ i
determines how strongly the firm-specific fixed cost rises
with additional firm entry. Based on this reasoning, we can
derive the following reduced-form equation for the number
of local firms N i :
1
logN i = c0 + logX i (2)
φ
The theoretical model does not include other factors that are
relevant for the local cost of production (e.g., the supply of
land, labor participation, qualification of labor, or climate
conditions and topography). Instead, it reduces all local char-
acteristics to local immobile labor θi , which is unobservable,
in reality. To keep our empirical analysis simple, we will
factors that do not change over time. This includes county-
specific deviations from the average impact all other right-
. (1) hand side variables may have. As a consequence, these fixed
γ
 1− αγ effects unfortunately also capture at least part of the impact
public investment has on our dependent variable. Public
investment should be county specific, as we can expect that
the marginal productivity of public investment depends on a
large set of local factors, such as the size of the local econ-
omy, quality and quantity of existing infrastructure, and local
educational attainment. To account for general trends in the
number of firms, we scale our dependent variable to each
county’s share in the total number of manufacturing firms
nationally.
After manipulation of Equations (1) and (2), and assum-
ing a log-linear production function of manufacturing pro-
duction X i depending on equilibrium mobile labor λ i ,
exogenous immobile labor θi , and productivity enhancing
public investment gi , we obtain the following reduced-form
equation for the relative number of firms in each region:1
N i ,t PX
log = β0,i + β1 gi ,t − β2 ( taxi ,t − tax∅ ,t ) + β3log i ,t
Nt PM i ,t (3)
r
−β4 logYt + β5 logN t + ξi ,t
Apart from the two fiscal variables and the terms of trade,
macro variables on the right-hand side of the equation. This
results from Equation (1) as local economic activity is deter-
mined by local fundamentals relative to the aggregate eco-
nomic activity in the country. Hence, all else equal, a rise in
aggregate economic activity and/or the total number of firms
reduces the relative attractiveness of a region, as this implies
the region falls behind and other regions attract mobile labor.
Data
Our sample comprises annual data from 1990 to 2016 (T = 27).
All variables refer to the county administrative borders char-
acterized at the five-digit level of the Federal Information
Processing Standard Publication Code. For each year, we
130 Economic Development Quarterly 34(2)

Table 1.  Variables and Descriptions.

Symbol Variable Unit Source

Y Personal income US$ thousands BEA, local GDP data
G Public investment, sum over Items F and G US$ thousands U.S. Census, annual survey of state and local
(construction and other capital outlays), sum government finances
over all units 1-5a
Tax Tax revenues, sum over Items T (Taxes), and US$ thousands U.S. Census, annual survey of state and local
over all units government finances
PX/PM Terms of trade index Author calculations based on Y
N No. of establishments, for manufacturing count U.S. Census, county business patterns
(NAICS 31-33) and SIC 20-39 before 1998

Note. BEA = Bureau of Economic Analysis; GDP = gross domestic product; NAICS = North American Industry Classification System; SIC = Standard
Industry Code.
a
The local government units in the data set with a geographical area encompass the county, cities, townships, special districts, and independent school
districts, or educational service agencies.

Figure 1.  Adjustment of the number of firms by employment size to the national firm-size distribution.

have raw observations for R = 3,088 counties. The data
sources are summarized in Table 1.
Number of Firms
Our dependent variable is the number of firms in the manu-
facturing sector in a specific county, i relative to the total
number of manufacturing firms in the United States N i / N .
Since the average firm size increases with local production,
the estimated impact of policies on firm location might be
biased in favor of smaller local economies. To compensate
for this potential issue, we adjust the number of firms for
firm-size differences as follows: We use the firm size catego-
ries by employment in the County Business Patterns to com-
pute a national average distribution of county employment
across firm sizes. Then, we allocate the total manufacturing
employment in each county to the different firm-size catego-
ries according to the average national distribution. We finally
add up this allocation of firms across all firm-size categories
for each county.
Figure 1 demonstrates the procedure to obtain the adjusted
number of firms for Los Angeles County in 2016. A larger
share of Los Angeles County’s 338,448 manufacturing work-
ers work in smaller firms as compared with the national aver-
age. Thus, after adjusting the distribution of employment
across firm sizes in Los Angeles County to match the national
distribution (Figure 1) and reallocating Los Angeles County
total employment to the firm size categories, Los Angeles
County has fewer small firms than before adjustment. This
leads to a reduction from 12,105 firms before adjustment to
8,569 firms after adjustment. Unless noted otherwise, we use
the adjusted values throughout for our analysis.
Meurers and Moenius 131
The County Business Patterns industry classification
switched from Standard Industry Code (SIC) to the North
American Industry Classification System (NAICS) in 1998.
This change in classification leads to small, but measurable,
structural shifts in the number of firms. In our empirical anal-
ysis, we therefore preemptively account for these structural
shifts by including a dummy variable SIC that takes the
value 1 before 1998 and 0 thereafter.
Public Investment and Taxes
Local public investment and tax revenues are taken from the
U.S. Census of Governments (see Randall et al., 2018, for a
detailed description). Our fiscal variables of interest are
aggregate taxation and investment expenditures (construc-
tion and other capital outlays) at the county level. We aggre-
gate the data at the county level across all five types of county
governments: the county itself, the embedded cities, town-
ships, special districts, and the independent school districts.
Aggregate tax revenues at the county level contribute roughly
40% of total county revenues. Expenditures on construction
and other capital outlays constitute 12% of total county
expenditure. The significant residual in the budget allows us
to interpret the coefficient on the tax variable as the impact of
raising taxes for purposes other than investment. We can also
think of the coefficient on public investment to be partially
independent from local taxes, as they are at least partially
financed through earmarked transfers from the state and the
federal levels. The correlation coefficient between our tax
and investment variable amounts to 0.52 for our whole sam-
ple of 80,728 observations. Thus, we are confident to avoid
many of the typical collinearity problems.
County administrations spent about $200 billion in 2016
on construction and other capital outlays, which amounts to
about 1.1% of national GDP. The counties’ public investment
contributes to approximately 40% of total national public
investment. Roughly 80% of counties’ investment expendi-
tures is on construction. The largest investment items are
schools (28%), highways (9%), sewerage (8%), water (7%),
and public transit (6%). Independent school districts and
other special districts perform 45% of all county-level invest-
ment, followed by cities (39%) and the county administra-
tion (16%).
County tax revenues in 2016 amounted to $610 billion or
around 3.3% of national GDP. County tax revenues account
for 19% of total U.S. tax revenue. By far the largest portion
of counties’ taxes is raised through property taxes (72%).
Again, the special and school districts receive the largest
share of the tax revenues (42%), followed by cities (33%)
and the county administration (25%).
To construct expenditure and tax measures relative to
local economic activity, we calculate ratios to personal
income at the county level ( g = G / Y and tax = Tax / Y ), as
in Yu and Rickman (2013).
Upjohn Panel Database on Incentives and Taxes
Understanding the joint influence of fiscal policies and eco-
nomic geography on the number of firms helps policy mak-
ers and economic development officers understand their
county’s potential. However, from a policy maker’s point of
view, it is of particular interest which kind of tax incentives
are most promising to promote regional economic develop-
ment. We therefore test the impact of state level incentives
and taxes on firm location. We employ the Panel Database on
Incentives and Taxes (PDIT) by the W.E. Upjohn Institute
for Employment Research.2 The database provides informa-
tion on how much taxes a business would pay and incentives
it would receive if it opened a new facility in a particular
year. It includes 33 states covering over 90% of U.S. output
for each year from 1990 to 2015. It details this information
by five different types: (1) property tax abatements, (2) cus-
tomized job-training grants, (3) job-creation tax credits, (4)
investment tax credits, and (5) research and development
(R&D) tax credits. We include these types of incentives sep-
arately in our analysis. We use the tax incentives relative to
sectoral value added and aggregate overall manufacturing
industries.
Since the PDIT data are at the state level, adding the
incentive variables into Equation (3) with identical values
for all counties in a particular state is of limited value. In our
estimations, we therefore apply a variation of the “border
approach” sketched in our literature review, and test whether
differences in state incentives affect the relative growth of
the number of firms in counties in distinct states. To avoid a
complex and untraceable interaction between market poten-
tial at the county level with policies at the state level, we only
match counties in different states that have similar market
potential.
Terms of Trade
The terms of trade are computed by iteration. From the price
equations in Meurers and Moenius (2018), it follows that
PX / PM is a linear function of the ratio of market access ( MA )
to supplier access ( SA ; see also Redding & Venables, 2004):
1

∑ 
R  −1
Y j ⋅ PM ⋅ Ti , j1−
PX   MA (4)
=ϕ 
j =1 j
ToTi = i
1
=ϕ
PM SA

∑ ⋅ Ti , j1− 
R − 1−
Y j ⋅ PX
i
 j =1 j 
The factor ϕ is a combination of the parameters in the cost
function of the final goods producers and unknown, a priori.
In the model from Meurers and Moenius (2018), each year’s
price indices PX and PM —and therefore the terms of
i i
trade—only depend on variables of the same year. This
allows us to calculate them for each year separately. We start
132 Economic Development Quarterly 34(2)

Figure 2.  Simulated terms of trade for the contiguous United States, 2016.
Note. While Alaska and Hawaii are not displayed on this map, they are included in the calculations. Hawaii has the smallest terms of trade with a value of
0.39; New York has the highest with a value of 1.53.

with the first year in our sample, 1990, for which we initiate capture economic power of a location and distance to just
the iteration by setting P= iM P=
X
i
1. Iceberg transportation one city ignores the economic potential of all other locations
costs between regions i and j are calculated as within reach.
Ti , j = 1 + di , j 0.35 , where di , j is the Euclidean greater circle The terms of trade calculated in this way for all counties for
distance between the centroids of the counties’ administra- the year 2016 are displayed in Figure 2. It confirms the well-
tive borders. We follow Hummels (1999) and Anderson and known spatial distribution of economic activity in the United
van Wincoop (2004) and set the elasticity of trade costs with States with the traditional industrial heartland and large cities
respect to distance to 0.35. We compute the internal distance on the east, as well as the rising economic centers3 on the West
within a county following Head and Mayer (2000) as Coast (e.g., Los Angeles County and Silicon Valley).
di ,i = 2 / 3 Area i / π . We set the elasticity of substitution As terms of trade greater than one (ToTi > 1) imply that
between varieties of manufacturing goods to  = 3.5, which prices of goods exported from a region are higher than those
is consistent with the trade cost elasticities of Simonovska imported into a region, this is positive for local immobile
and Waugh (2014). Based on these assumptions, we compute factors that benefit from higher factor income and purchas-
MA ing power. As mobile labor locates based on real wages,
an initial value of . We obtain ϕ  from a linear regres-
SA which are the same across locations in equilibrium, there are
P MA no direct benefits for mobile labor. As the figure indicates,
sion (without constant) of X onto and compute the
PM SA New York has the highest terms of trade in the country and
new value for the terms of trade as ϕ  MA , which we then counties like Glacier County in Montana have the lowest due
SA to its remote location from any other economic activity.
can also transform into new estimates for the price indices The model in Meurers and Moenius (2018) suggests that
MA firms in counties with lower terms of trade/lower market
PX and PM . We use these new values to recalculate
i i
SA potential are more likely to respond to fiscal incentives. In
and repeat the procedure until we achieve convergence (i.e., particular, the model considers that every fiscal incentive has

∑( )
R 2
that 1 a price tag in the form of foregone alternative public expen-
ToTinew − ToTiold < 0.0015). We repeat the
R i =1
same process for all years.
Note that our terms of trade variable improves on com-
monly used measures of market potential in several ways:
Instead of any ad hoc specification, it is directly derived from
the basic specifications of production and consumption in
our model. Ad hoc measures of market potential, such as
population and population density as well as distance from
large cities, can be seen to only capture part of the market
potential, as population and population density alone do not
diture or higher taxes. Furthermore, economic activity in
centers, including the economic activity fostered by local fis-
cal policies there, creates positive spillovers for nearby loca-
tions through the access to the large market. Therefore, the
rational location choice for newly created firms and those on
the move is to locate in counties close to central market-
places where they can enjoy the spillovers from the center
while avoiding the higher equilibrium tax rate in the center.
As a result, fiscal incentives are less effective in and near
economic centers as the spillovers dominate.
Meurers and Moenius 133

Table 2.  Summary Statistics Across Time and Across Counties.

Variable Symbol Observation Mean Median SD Min Max

For averages across all counties
Public investment g.t 27 .0113 .0110 .0028 0.0064 0.0164
Tax burden tax . t 27 .0294 .0295 .0068 0.0173 0.0411
Terms of trade ToT. t 27 .9068 .9068 .0005 0.9059 0.9076
Share of local firms N. t / Nt 27 .00033 .00033 .0000 0.00033 0.00033
For averages across all periods
Public investment g i. 2,994 .0114 .0095 .0107 0.0005 0.4016
Tax burden tax i. 2,994 .0294 .0257 .0270 0.0024 1.056
Terms of trade ToTi. 3,088 .9068 .9104 .1215 0.3829 1.530
Share of local firms Ni / Ni . 3,081 .00033 .0001 .0011 0 0.0368
For all individual observations
Public investment gi,t 80,728 .0113 .0081 .0162 0 0.7557
Tax burden tax i , t 80,728 .0294 .0259 .0326 0 1.924
Terms of trade ToTi , t 83,376 .9068 .9108 .1216 0.3808 1.562
Share of local firms Ni , t / Nt 81,579 .00033 .0001 .0011 0 0.0471

Figure 3.  Time profile of public investment and tax burden (as a ratio to personal income).

In contrast, firms in remote places do not benefit as
much—if at all—from positive spillovers originating in other
counties. Therefore, fiscal incentives in remote places appear
highly effective as they predominantly—if not exclusively—
benefit local businesses. To account for this in our empirical
analysis, we estimate the impact of fiscal incentives on firm
growth for counties with high, intermediate, and low market
potential separately.
Descriptive Statistics
Total variance in our dependent and independent variables can
be decomposed into the variance across counties and the vari-
ance over time. Table 2 first displays summary statistics for
the averages across all counties over time (27 observations),
then for the averages over time for all counties (about 3,000
observations), and finally across the individual observations
both across counties and over time. The standard deviations in
Table 2 reveal that for all variables the variation across coun-
ties dominates the variation over time. The averages across all
counties of local public investment and the tax burden (as a
ratio to personal income) both fluctuate over the 27 years
without a specific time trend. Both drop to minimum values in
the years 1993 to 1996 during a period of economic recovery
(see Figure 3).
During that period, apparently the recovery of local gov-
ernment revenues and expenditure lagged relative to other
local economic aggregates. Counties with a ratio of invest-
ment to personal income close to the sample mean over the
27-year average are, for instance, Scott (Missouri), Lawrence
134 Economic Development Quarterly 34(2)

Table 3.  Panel Regression.

Dependent variable: log Ni , t / Nt

  I (unadjusted) II (all counties) III (center) IV (periphery) V (rural)

logToTi , t (terms of trade) 2.240*** (0.344) 4.227*** (0.542) 2.955* (1.748) 4.976*** (0.822) 2.082 (2.544)
tax i , t − tax ∅ , t (relative tax burden) −0.025 (0. 162) −0.478* (0.267) −0.146 (0.630) −0.355 (0.363) −0.854* (0.462)
g i , t (public investment) 0.187 (0.153) 0.915*** (0.269) 0. 384 (0 .758) 0. 732** (0.352) 1.215*** (0.451)
logNt (total firms) −0.037 (0. 039)  
logYt (national income) 0.299*** (0. 034)  
SIC-Dummy 0.118*** (0. 006) −0.093*** (0.011) − 0.095*** (0. 019) −0.105*** (0.014) 0.012 (0.035)
Constant −0.727 (3.109) −12.01*** (1.292) −11.98*** (4.087) − 8.797*** (1.742) −35.94*** (7.081)
Time trend −0.007*** (0. 002) 0.002** (0.001) 0.002 (0.002) 0.000 (0.001) 0.013*** (0.001)
R2 .097 .179 .152 .084 .106
County fixed effects yes yes yes yes yes
Time fixed effects no yes yes yes yes
Observation 66,127 15,027 40,938 10,162
Counties 2,870 594 1,741 535

Note. Robust standard errors in parenthesis.

*,**, and *** denotes significance at the 1%, 5%, and 10% levels, respectively.

(Ohio), and DeKalb (Georgia). Counties with particularly low
investment ratios (1% or even lower) are Buffalo (South
Dakota) and Lancaster and Charlotte (both Virginia). Counties
with high ratios (9% and above) are Big Stone (Minnesota),
Platte (Nebraska), and Aleutians East (Alaska). Counties with
a tax burden (local revenues as a ratio to personal income)
close to the sample average are Effingham (Georgia), St.
Clair (Michigan), Deuel (South Dakota), and Wilson (North
Carolina). Counties with a tax burden at the bottom of the
sample (0.4% and lower) are, for example, Hale (Alabama),
Chattahoochee (Georgia), Oglala Lakota (South Dakota), and
Yukon-Koyukuk (Alaska). Counties with a tax burden at the
top of the sample (22% and more) are Kennedy and King
(both Texas), Eureka (Nevada), and North Slope (Alaska).4
Results
Table 3 presents the results of our panel estimations of
Equation (3).5 We use robust standard errors throughout. In
column 1, we present our baseline regression for the raw
number of firms, including county-fixed effects only. Market
potential is highly significant and affects the number of local
firms positively as expected. Fiscal policies carry the
expected signs but are not statistically significant.
As suggested above, the impact of policies might be
blurred if the number of firms changes due to composition
effects without altering county employment. For example,
Henly and Sanchez (2009) showed that there is a long-run
trend starting in the early 1970s that workers become more
evenly distributed among establishment types and less con-
centrated in large firms. Thus, there could be shifts in the
local share of firms that are independent of policies. We
therefore think of the unadjusted number of manufacturing
establishments as measures of innovation and local product
and process differentiation, which are important aspects of
economic development but do not cover the whole range of
it. Henceforth, we therefore switch to the size-adjusted num-
ber of establishments.
After switching to the size-adjusted form of our depen-
dent variable, all variables of interest in columns 2 to 5 are of
the expected sign. As we will see, parameter values and sta-
tistical significance across columns vary in an economically
meaningful way. In column 2, we display the results for
county-fixed and time-fixed effects. Since model selection
tests (Hausman-test, likelihood-ratio for joint significance of
effects) favor a model with both county- and time-fixed
effects, we base our explanations on the results of this col-
umn. We can interpret the coefficients in column 2 as fol-
lows: A 1% increase in relative market potential as measured
by the terms of trade leads to a more than 4 percentage point
increase in a county’s share in the total number of manufac-
turing firms. Thus, holding the total number of firms con-
stant, this would also imply a rise in the absolute number of
firms in a county by 4%. A 1% increase in market potential is
equivalent to moving from a county close to the sample
mean, such as Oklahoma County to one with a 1% higher
market potential, namely, Tulsa County (also in Oklahoma).
For Oklahoma County, which had, on average, 730 firms,
such a market potential increase would lead to an increase of
about 31 manufacturing firms. An increase of market poten-
tial by 1 standard deviation (0.12) relative to the sample
mean (0.91)—comparable to a move from Oklahoma County
to Winnebago County in Wisconsin—would imply a rise in
the number of firms by 57%.
A 1 percentage point higher local tax burden, all else
equal, leads to a decrease in a county’s share of the total
Meurers and Moenius 135
number of manufacturing firms by 0.5 percentage points. For
a county at the sample mean in terms of the number of manu-
facturing firms (130), a 1 percentage point increase in local
taxes implies a decrease in the number of local manufactur-
ing firms by roughly one firm—again holding the national
number of firms constant. For the Oklahoma County exam-
ple (with, on average, 730 manufacturing firms), it would
mean a loss of four firms. A 1 standard deviation increase,
which is equivalent to a local tax hike by 2.7 percentage
points, would thus imply a loss of approximately 1.3% of
local firms, holding the total number of firms constant. Such
a hike or even stronger tax hikes occurred over the 27-year
time span in only 103 counties (tax declines of equivalent
size occurred in 134 counties).
A 1 percentage point increase in the ratio of public invest-
ment to local personal income leads to an increase in a coun-
ty’s share of the total number of manufacturing firms by 0.9
percentage points. A 1 standard deviation increase in the
ratio of public investment (by 1.07 percentage points) leads
to a roughly equivalent increase in the number of local firms.
A county at the sample mean has about 130 manufacturing
firms. For such a county, a 1% increase in the public invest-
ment to local personal income ratio implies an increase in the
number of manufacturing companies by roughly one firm
(an increase by six firms in the Oklahoma case), which is
similar to the impact of a 1 percentage point tax hike. Such
an increase or more occurred in 348 counties; an equivalent
decline in this ratio occurred in 338 counties during the 27
years of our sample.
We repeat our exercise for subsets of counties to study the
relative importance of fiscal variables at different levels of
market potential. Inspection of the spatial distribution in
Figure 2 suggests that while low market potential counties
(dark blue) extend over roughly half of the U.S. territory, they
constitute rather a minority in the total number of counties.
The same applies to economic centers (dark red). To separate
economic agglomerations from remote and intermediate dis-
tances to central markets, we therefore split the sample into a
lower 20%, an intermediate 60%, and an upper 20% quantile
with respect to the market potential variable.6 We present the
results in columns 3 through 5: Column 3 presents the results
for the top quantile of counties with the highest market poten-
tial (values for terms of trade equal to one or above), column
4 the results for the second quantile (values for terms of trade
larger or equal to 0.8 but smaller than 1), and column 5 for the
quantile of counties with the lowest market potential (values
of the terms of trade smaller than 0.8).
In counties with high market potential (3), coefficients on
fiscal policies are smaller in absolute value than in the over-
all sample and are statistically insignificant, but market
potential still has a substantial and statistically significant
effect. The opposite is true in counties with small market
potential (5). In these counties, both taxes and investment
have a larger effect than in the overall sample; market
potential has an even lower effect than in the high market
potential subsample. Interestingly, counties with intermedi-
ate market potential (column 4) show moderate, statistically
significant, effectiveness of fiscal policy. However, they
exhibit more than twice the effectiveness of market potential
on the number of firms than in the low market potential
areas. Firms in counties with intermediate market potential
appear similarly or slightly less sensitive to the overall tax
burden as compared with the total sample, but the estimates
are statistically insignificant.
In the next step, we study the effect of specific tax incen-
tives on firm location using the matching procedure described
earlier. Recall that we would like to compare similar counties
in terms of market potential that are exposed with different
policies, which requires them to reside in different states. To
select those, we first compute the average market potential of
our 2,343 counties from 1990 to 2015 for which we have
data on fiscal incentives. On average, we have 70 counties
per state, which would allow us to generate 2.6 million
matches of counties in distinct states in our sample. To ensure
that the selected counties are similar in terms of market
potential, we keep only 0.03% of the pairs, namely those
pairs with the closest market potential. To achieve this selec-
tion, we set an upper tolerance limit for between-county
deviations of market potential of 5/10,000 of the standard
deviation in average market potential (which is 0.1215). This
yields an acceptable number of 689 matching pairs of coun-
ties. Table 4 shows some examples of matched counties with
high and low terms of trade.
For these pairs, we then compute the differences in all our
variables, as well as the fiscal incentives from the PDIT for
each year in our sample.
To account for possibly countervailing effects between
the overall tax burden and tax incentives, we compute mea-
sures for tax incentives relative to the previously employed
overall tax burden relative to personal income. For exam-
ple, for investment tax credits ( Inv.TC. ), we compute our
measure for the differences between matched counties i
and j as:
( )
∆ ( Inv.TC. − tax )ij = ( Inv.TC.i − taxi ) − Inv.TC. j − tax j . (5)
The calculation shows that our measure identifies the differ-
ences in specific tax incentives relative to the compared
counties’ overall tax burdens. Employing these measures as
explanatory variables in our regression then shows how
those differences in fiscal variables influence the rate of
agglomeration of manufacturing firms across counties. We
repeat the fixed-effects regressions from Table 3, in which
we replace our fiscal variables with the newly constructed
ones on the right-hand side. We also replace county dummies
with matching county-pair dummies.
The results with respect to the PDIT fiscal incentives in
Table 5 show a differentiated picture with respect to the
136 Economic Development Quarterly 34(2)

Table 4.  Examples of Matched Counties.

High market potential Low market potential

Adjusted Adjusted Adjusted Adjusted

Terms of number of number Terms of number of number
trade County 1 firms County 2 of firms trade County 1 firms County 2 of firms
1.090 Hamilton, 1,613 Oakland, 1,769 0.797 Mohave, 78 Carson City, 80
Ohio Michigan Arizona Nevada
1.064 Columbia, 45 Fulton, 793 0.789 Eagle, 8 Sierra, 1
New York Georgia Colorado California
1.049 Hillsdale, 118 Milwaukee, 1,670 0.785 Garden, 2 Midland, 57
Michigan Wisconsin Nebraska Texas
1.026 Clark, 78 Forest, 4 0.769 La Plata, 18 Torrance, 1
Kentucky Pennsylvania Colorado New Mexico
1.024 Louisa, 23 Orange, 4,497 0.747 Sierra, New 1 Greenlee, 1
Virginia California Mexico Arizona

Note. Terms of trade and adjusted number of firms are averages over the period 1990 to 2016; adjusted noumber of firms are rounded up to the next
whole number.

likely effectiveness of these incentives. In the first column,
we repeat the equivalent exercise to column 2 in Table 3.
First, note that the fiscal variables have the expected sign,
but only the difference in tax rates is marginally significant.
In columns 2 to 7, we replace the overall tax burden with dif-
ferences in specific tax incentives, net of the overall tax bur-
den. Again, note that all incentive variables have the expected
sign, but not all are statistically significant: While overall
incentives ( Tot.Inc. ), R&D tax credits ( R & D.TC. ), and
property tax abatements ( Prp.TA. ) are not significant for dif-
ferences in firm agglomeration across states, investment tax
credits ( Inv.TC.), job creation tax credits ( JobC.TC. ) and
job training grants ( JobT .Gr. ) are significant at least at the
10% level. The coefficients on these later three fiscal incen-
tive variables (see columns 3, 6, and 7 of Table 5) are all
close to 1. This means that across otherwise comparable
counties, a 1 percentage point higher tax incentive is associ-
ated with a 1 percentage point higher firm agglomeration.
Four aspects contribute to the noteworthiness of these
results. First, across state differences in fiscal incentives are
arguably small as compared with other aspects or factors not
explicitly included in our estimation, such as quality of life,
access to research facilities, or varying transportation costs
that depend on the availability of transportation means such as
waterways versus trains. Second, certain incentives, specifi-
cally workforce-related ones, may have immediate direct
effects, while others, such as R&D incentives, may only lead
to firm growth in the longer run, which is not captured by our
specification. Third, as Figure 3 reveals, fiscal incentives are
quite volatile over time; thus, firms may not expect incentives
to persist, which may lead to responses considering only the
average differences across locations, not to variation over
time. Finally, as highlighted by Peltzman (2016), if we match
counties that share a common state border (which only occurs
unintentionally in our approach), we cannot rule out spillovers
that reduce the measured impact despite sharp policy differ-
ences. That our specification still finds significant results
shows that differences in fiscal incentives are effective in
attracting and growing firms.
Discussion and Policy Implications
In contrast to many previous empirical studies that are incon-
clusive concerning the impact of fiscal policy, we find local
investment to be effective in terms of keeping and attracting
firms. Our study differs from previous work in that we con-
sider county aggregates of fiscal variables instead of specific
tax and expenditure instruments. The effectiveness of those
instruments may depend on local circumstances, which are
hard to tease out. Considering county aggregates instead pro-
vides us with a large data set that allows controlling for gen-
eral county- and time-specific effects. We consider this as
key to obtaining our results.
The results bear substantial significance for policy makers.
In a nutshell, they indicate that low market potential counties
far away from economic centers benefit the most from local
investment to attract manufacturing firms. They also indicate
that the same policies are likely less effective in central
places—they could be even entirely ineffective there.
Moreover, differences in fiscal incentives across states matter
for firm agglomeration: Specifically, investment tax credits,
job creation tax credits, and job training grants have the poten-
tial to attract, keep, and grow manufacturing firms locally.
There are also some important caveats. This study only
focused on the manufacturing sector as it is most closely
related to the model in Meurers and Moenius (2018). Strictly
speaking, all results we obtain can therefore only be taken as
guidance for the manufacturing sector. The model also makes
 Table 5.  Panel Regression for Matched Counties ij.

Dependent variable: ∆log Nij,t

  I II III IV V VI VII
∆taxij,t (Total tax difference) −0.871* (0.500)  
∆gij,t(Difference in public investment) 0.666 (0.473) 0.577 (0.463) 0.723 (0.471) 0.626 (0.470) 0.540 (0.467) 0.700 (0.475) 0.670 (0.473)
  constant −0.014*** (0.000) −0.015*** (0.000) −0.015*** (0.000) −0.015*** (0.000) −0.015*** (0.000) −0.015*** (0.000) −0.014*** (0.000)
∆(Tot .Inc . − tax )ij , t (Difference in total 0.544 (0.439)  
incentives
∆ ( Inv .TC . − tax )ij , t (Difference in 1.061** (0.510)  
investment tax credit)
∆ ( R & D.TC . − tax )ij (Difference in 0.720 (0.494)  
R&D tax credit)
∆ ( Prp.TA. − tax )ij (Difference in 0.407 (0.487)  
property tax abatements)
∆ ( JobC .TC . − tax )ij (Difference in job 0.901* (0.483)  
creation tax credit)
∆ ( JobT .Gr . − tax )ij (Difference in job 0.889* (0.503)
training grants)
R2 .011 .012 .023 .004 .002 .015 .013
Observations 14,217
Counties 689

Note. Robust standard errors in parenthesis. A Hausman test rejects a random effects model at the 1% level.
*,**, and *** denotes significance at the 1%, 5%, and 10% levels, respectively.

137
138 Economic Development Quarterly 34(2)
predictions about the service sector and could be also applied
to other sectors if interpreted loosely. This would be specifi-
cally important to provide general guidance for policy as
manufacturing continuously decreases in importance, spe-
cifically in terms of employment, in the United States.
Another issue is that we only measure the direct effect of
fiscal policy on manufacturing firms. Due to the large geo-
graphic spillover effects present in the data, part of the effect
of fiscal policy in the center actually benefits the periphery
close to the centers. As these effects are not directly identi-
fied in our theoretical model, we also excluded them in the
empirical analysis to stay true to the model. We intend to
address some of these issues in future work.
Acknowledgments
We would like to thank our editor, Dr. Timothy Bartik, for com-
ments that substantially helped clarify our results and thus made
them more accessible for readers outside of geographical econom-
ics. We would also like to thank two anonymous referees for many
valuable suggestions that helped us improve our article. All remain-
ing errors are ours.
Declaration of Conflicting Interests
The author(s) declared no potential conflicts of interest with respect
to the research, authorship, and/or publication of this article.
Funding
The author(s) received no financial support for the research, author-
ship, and/or publication of this article.
ORCID iD
Martin Meurers https://orcid.org/0000-0001-7514-4138
Supplemental Material
Supplemental material for this article is available online.
Notes
1. A more complete derivation of this equation can be found in
the online appendix (supplemental material available online).
2. For a detailed description of the data, see Bartik (2017).
3. We use the term “economic centers” in its intuitive meaning as
places of high economic activity relative to places with aver-
age economic activity. We do not require a certain (arbitrary)
threshold (e.g., in terms of market potential, above which a
county is called an economic center). Economic centers are
often not sharply delimited, particularly if neighboring coun-
ties also have a relatively high economic activity and distances
between the geographic center points are small.
4. For descriptive statistics on the PDIT variables the reader may
refer to Bartik (2017).
5. While we are aware of possible spatial autocorrelation in
our data, we prefer to use a regular fixed-effect estimation
approach. Our market potential variable is a theory-driven
indicator that already captures the distance-discounted impact
of economic activity in space. Since we are interested in an
asymptotically correct point estimate of this theory-based vari-
able, we are reluctant to exploit the covariance structure in our
variables any further.
6. The choice of three quantiles is supported by the frequency dis-
tribution of the terms of trade, which has a global maximum at
0.9, and two minor peaks at values of 0.8 and 1.0, respectively.
The minor peaks also separate the distribution roughly into a
lower 20%, an intermediate 60%, and an upper 20% quantile.
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Author Biographies
Martin Meurers is head of the Division for Fiscal and Business
Cycle Policies at the Federal Ministry for Economic Affairs and
Energy in Berlin. His interest in spatial analysis of fiscal policy
stems from his work on the effectiveness of policies to improve
public infrastructure.
Johannes Moenius is the director of the Institute for Spatial
Economic Analysis at the University of Redlands. He holds a PhD
in economics from the University of California, San Diego. In his
research, he is interested in how domestic institutions affect interna-
tional trade as well as how geography shapes economic decision.
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