New Business July 1, 2009, 7:54PM EST

Will Tax Breaks Boost Jobs?

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Tennessee points to tax subsidies as a crucial factor in Volkswagen's (VLKAY) decision to build a plant in Chattanooga in 2008. "Incentives are a win-win proposition," says Matthew H. Kisber, Tennessee's head of economic and community development.

The job gains, however, may prove fleeting. In 2002, Ohio lawmakers shelled out $1.7 million in tax incentives to Wal-Mart Stores (WMT) to build an eyeglass manufacturing plant in the state. Wal-Mart shuttered the operation in April, citing the worsening economy, and paid back the money. "It's a net-loss game for state and local governments," says LeRoy. "The only winners are the companies playing the tax game."

Last year, Caterpillar (CAT) got $10 million in subsidies from Texas to construct an assembly plant that would create an estimated 1,400 jobs. Days after breaking ground in the small town of Seguin, the company announced plans to lay off 20,000 employees worldwide. That has raised fears among state officials that all the local jobs won't materialize. Says Caterpillar spokesman Jim Dugan: "The new facility in Texas represents a strategic long-term priority for Caterpillar."

Meanwhile, states often use tax breaks to poach jobs from each other. In March, Pepsi Bottling Group (PBG) began threatening to move its headquarters from Somers, N.Y., if local lawmakers didn't pass favorable tax and other policies. Now both New Jersey and Connecticut are using a slew of tax incentives to lure Pepsi Bottling to their states.

Such warring is creating a conundrum for the Obama Administration. The states are an integral part of the U.S. recovery and job-creation plan. Some economists say the only remedy is a congressionally mandated cease-fire; they're suggesting the U.S. withhold federal funds unless the states stop using tax incentives to grab jobs from other states. Says Rolnick of the Minneapolis Fed: "It's time for Congress to act."

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Slashing Services

Amid record budget shortfalls, state lawmakers are tightening their belts, according to a report from the Center on Budget & Policy Priorities, a think tank. Already, more than 20 states have cut programs for the elderly and disabled. Education also is on the chopping block: Some 24 states have reduced funding for K-12 education while more than 30 have pulled back on spending for higher education. As medical costs soar, health care is another vulnerable area, with 21 states reducing services.

To read the full report, go to http://bx.businessweek.com/us-economy/reference/.

Silver-Greenberg is a reporter for BusinessWeek.com.