One way to classify tax incentives is by the component in the basic tax equation (tax base × tax rate = tax liability) that is initially targeted by the incentive. Ultimately, all incentives are intended to influence tax liability, but they differ in what component is targeted. The following typology profiles tax incentives by whether they initially alter the tax base, tax rate, or tax liability.
For example, a tax exemption excludes
a portion or all of the value of a category of property, sales, or income from the tax base. A split tax roll, by contrast, creates a multitiered rate structure that levies a lower tax rate on preferred types of property, sales, or income—for example, the two-tiered property tax rate used by Michigan for public education (discussed in Chap-ter 3). A tax credit, on the other hand, is a dollar-for-dollar reduction in tax liability.
Tax base Tax rate Tax liability
Tax abatement Tax exemption
Tax increment financing Tax base sharing
Split tax roll Tax rate freeze
Tax credit Tax rebate
Tax abatements were originally used for property taxes. More recently, local govern-ments have abated sales taxes, or at least a portion of them, for new retail developgovern-ments such as big-box retailers. In this case, the abatement typically takes the form of a tax credit. The retailer retains a portion of the sales taxes collected rather than remitting the full amount to the local or state government.
According to state and federal reports, thirty-seven states now sanction the use of tax abatements by local governments.4 These states may also provide for the partial abate-ment of state taxes. Although states and their local governabate-ments usually pursue their economic development initiatives independently of each other, states that permit local tax abatements typically require that local governments adopt policies to guide their use of abatements. These policies specify the qualifications for an abatement, the approval process, and the terms of the abatement agreement.
Qualifying businesses Most states allow a broad range of industries to participate, especially if the abatements are targeted to blighted areas. Some states or local policies may restrict abatements to predetermined reinvestment zones where business investment is targeted to stimulate economic growth. Iowa and Illinois restrict their abatements to new firms moving into a local jurisdiction from another state or country or to an exist-ing firm expandexist-ing its production capacity by addexist-ing to an existexist-ing facility.
In stipulating the qualifications for a partial or full abatement of property or sales taxes, the local policy may specify a minimum investment that must be made in new construction or renovation, which may include new equipment; the number of new jobs to be created by the proposed investment; and the economic life of the proposed project (i.e., the number of years the facility is expected to be operational). Some poli-cies may impose even more specific criteria, especially where a municipality or county has already well-established agglomeration economies. Even if a business qualifies for an abatement, however, local governments typically have the discretion to grant such benefits on a case-by-case basis.
Approval process States typically give their municipalities or counties responsibility for approving abatements. But other overlapping local governments, such as schools and special districts, also levy property or sales taxes. Thus, for its benefits to be max-imized, the abatement should be extended to these other jurisdictions—an issue that has become the focus of considerable disagreement and litigation. Those on one side of the issue say that all local jurisdictions, including school districts, should participate in encouraging redevelopment of an area because all will enjoy the future revenue benefits from the increased property value. Those on the other side contend that maintaining or improving the urban environment is the responsibility of a municipality, not a school district. Not surprisingly, overlapping jurisdictions resist the loss of tax revenue, and states often give them the choice to participate in an abatement.
Louisiana is the only state in which the state commerce department may exempt new or expanding firms from local property taxes without the approval of the local govern-ments affected by the decision. At the other extreme, to the extent that funds are appro-priated by the state legislature, Maryland compensates local governments for up to half the lost revenue from property tax credits approved for firms locating in enterprise zones.
Terms of abatement agreements Once an abatement is approved, local governments usually enter into contractual agreements that specify the improvements or restorations that both government and business are to make as a condition for abatement. These agreements, which are typically made with the developer of the property, should specify
the amount of exemption and the method of calculating it; the improvements to be made and the time line for completion; any documentation that the property owner must provide to demonstrate compliance with the agreement; the number and types of new jobs, if any, that must be added by the project; the provisions for access and inspec-tion by city personnel; and the terms for recovering lost property tax revenue should the owner fail to honor the contract’s terms.
Tax exemptions Tax exemptions permanently exclude from the tax base particular types of transactions or property. For example, building materials used in construc-tion may be exempted from a local-opconstruc-tion sales tax. A common form of property tax exemption—a freeport exemption—extends to inventory items, both raw materials and finished goods, that move across state borders for fabrication or sale. By targeting exemptions to businesses with inventories, local governments can stimulate significant agglomeration economies. For example, a community that serves as a transportation hub—either by highway, railroad, or airline—may use its competitive advantage to be-come a center for warehousing. Most states now extend some sort of partial exemption for goods in transit, but the parameters vary.
In Texas, for example, the freeport exemption is a local option for cities, counties, and school districts. One, two, or all three overlapping local governments may extend an exemption, which is available on all inventories brought into the state for “fabrication, assembling, manufacture, storage or processing” and then exported outside the state within 175 days. If the local governing body adopts the exemption by ordinance, Texas law provides that the exemption can never be revoked.
Of the four types of tax incentives, exemptions are the most powerful at stimulating growth. At the same time, they are the least amenable for targeting economic devel-opment efforts because they almost always exist as a blanket provision (covering all inventory or all sales of a particular type) in state law. Moreover, they deprive a local government of the discretion to target its tax incentives to industries that will provide the greatest benefits to its economic development goals. Businesses, however, generally prefer tax exemptions because those businesses that meet the provisions of state law qualify for the exemption, and the exemption, once approved, is virtually impossible to repeal.
Tax increment financing TIF is authorized in forty-eight states; only Arizona does not authorize TIF and California has terminated its use.5 Although California was the first to adopt TIF in 1952, the state disbanded all 400-plus redevelopment agencies in 2012 after a report prepared by the Legislative Analyst’s Office concluded that they had not been effective at attracting business development to California.6
Purpose and design Unlike tax abatements, which are typically awarded to busi-nesses on a case-by-case basis, TIF targets local tax incentives to an area that has lagged in development; this area is thus designated a TIF district. The design of TIF is basically the same across all states: the increased property tax revenue resulting from redevelop-ment in the TIF district is dedicated to financing the developredevelop-ment-related costs in that district. TIF divides that tax revenue into two categories. Taxes on the predevelopment value of the tax base (the tax increment base) are kept by each taxing body, while taxes from the increased value of property after redevelopment (the tax increment) are de-posited by each jurisdiction into a tax increment fund, which is usually maintained by the city. Property owners in the TIF district incur the same property tax rate as owners outside the district. Preferential treatment is granted only in that tax revenues from the district are dedicated to financing public improvements in the district.
Typically, tax-exempt TIF bonds are sold up front to provide financing for the pur-chase and preparation of the land, including preparation for industrial, commercial, or residential development and for the installation of public infrastructure, such as streets, lights, water and sewer lines, curbs, gutters, and landscaping. Once prepared, the land is sold to developers at a price that is often below the local government’s cost of preparing the site, a technique known as a land write-down. The predevelopment costs, includ-ing write-downs, are recouped through the tax increment fund over the life of the project, and the money in the fund is usually used to repay TIF bonds.
The underlying assumptions of the TIF approach to economic development are that locally financed improvements will draw private investment into the TIF district, and that without those improvements, private investment would not occur. Whereas a tax abatement draws business investment by lowering the property (or sales) tax burden, TIF lures such investment by providing a ready-made site for construction, usually at a sub-sidized price. The up-front financing for site preparation is repaid by developers, whose property taxes on the incremental increase in property values are earmarked to repay the bonds as they mature over several years.
Responsibility for costs Although TIF is more complex and costly to administer than tax abatements, private firms generally prefer it. With TIF, the local government shares the financial risk of the TIF district’s failure with developers who invest in the district.
But should the increment in property tax revenues be insufficient to meet the annual debt service costs, the city is responsible for repayment of the outstanding debt—in which case it must find some other source of funds to prevent a bond default. Local governments also use TIF to stimulate agglomeration economies in and adjacent to the redevelopment district, a strategy essential to building a sustainable local economy.7
State laws vary on whether overlapping local jurisdictions, such as counties and school districts, that levy property taxes on the TIF district must share in the cost of redevelopment by forgoing the tax revenue captured by the district. Without TIF, cities bear the full cost of redevelopment while overlapping jurisdictions reap revenue wind-falls from increased property values. Opposition to TIF comes primarily from those overlapping jurisdictions that are required to share in the costs.
Effectiveness in stimulating economic growth A number of studies have examined the effectiveness of TIF at increasing taxable property values in the TIF district as well as throughout the city or county. Unlike the mixed results of earlier studies, findings from more recent studies show increasingly consistent results. For example, one of the more rigorous analyses found that, among Illinois municipalities, increases in commercial property investment within a TIF district came at the expense of reduced investment in commercial property outside the district.8 This result was not found for industrial devel-opment, however; property values in TIF districts dedicated to industrial development were lower than they otherwise would have been in the absence of TIF. The researchers attribute this to lower demand for industrial-only TIF districts as opposed to districts where investors have more discretion in how the land is developed.
Another study, which focused on Wisconsin cities, found that while TIF stimulated the growth of property values within the TIF district, it did not change the aggregate property values for the host city.9 One explanation could be that TIF causes development to move from one part of the city to another, resulting in no net gain in total property values.10 The Wisconsin study also found evidence that, unlike commercial development, residential and manufacturing TIF districts provide no net gain in property values.