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Does Tax Increment Financing (TIF) generate economic development?

by Adam Millsap on June 20, 2016

in City Life, Economic Growth, Infrastructure, Public Finance, Taxes

Tax increment financing, or TIF, is a method of financing economic development projects first used in California in 1952. Since then, 48 other states have enacted TIF legislation with Arizona being the lone holdout. It was originally conceived as a method for combating urban blight, but over time it has become the go-to tool for local politicians pushing economic development in general. For example, Baltimore is considering using TIF to raise $535 million to help Under Armor founder Kevin Plank develop Port Covington.

So how does TIF work? Though the particulars can vary by state, the basic mechanism is usually similar. First, an area is designated as a TIF district. TIF districts are mostly industrial or commercial areas rather than residential areas since the goal is to encourage economic development.

Usually, in an effort to ensure that TIF is used appropriately, the municipal government that designates the area as a TIF has to assert that economic development would not take place absent the TIF designation and subsequent investment. This is known as the ‘but-for’ test, since the argument is that development would not occur but for the TIF. Though the ‘but-for’ test is still applied, some argue that it is largely pro forma.

Once an area has been designated as a TIF district, the property values in the area are assessed in order to create a baseline value. The current property tax rate is applied to the baseline assessed value to determine the amount of revenue that is used for the provision of local government goods and services (roads, police, fire, water etc.). This value will then be frozen for a set period of time (e.g. up to 30 years in North Carolina), and any increase in assessed property values that occurs after this time and the subsequent revenue generated will be used to pay for the economic development project(s) in the TIF district.

The key idea is that municipalities can borrow against the projected property value increases in order to pay for current economic development projects. A simple numerical example will help clarify how TIF works.

In the table below there are five years. In year 1 the assessed value of the property in the TIF district is $20 million and it is determined that it takes $1 million per year to provide the government goods and services needed in the area (road maintenance, sewage lines, police/fire protection, etc.). A tax rate of 5% is applied to the $20 million of assessed value to raise the necessary $1 million (Tax revenue column).

TIF example table

The municipality issues bonds totaling $1 million to invest in an economic development project in the TIF district. As an example, let’s say the project is renovating an old business park in order to make it more attractive to 21st century startups. The plan is that improving the business park will make the area more desirable and increase the property values in the TIF district. As the assessed value increases the extra tax revenue raised by applying the 5% rate to the incremental value of the property will be used to pay off the bonds (incremental revenue column).

Meanwhile, the $1 million required for providing the government goods and services will remain intact, since only the incremental increase in assessed value is used to pay for the business park improvements. Hence the term Tax Increment Financing.

As shown in the table, if the assessed value of the property increases by $2 million per year for 4 years the municipality will recoup the $1 million required to amortize the bond (I’m omitting interest to keep it simple). Each $1 million dollars of increased value increase tax revenue by $50,000 without increasing the tax rate, which is what allows the municipality to pay for the economic development without raising property tax rates. For many city officials this is an attractive feature since property owners usually don’t like tax rate increases.

City officials may also prefer TIF to the issuance of general obligation bonds since the latter often require voter approval while TIF does not. This is the case in North Carolina. TIF supporters claim that this gives city officials more flexibility in dealing with the particular needs of development projects. However, it also allows influential individuals to push TIF through for projects that a majority of voters may not support.

While TIF can be used for traditional government goods like roads, sewer systems, water systems, and public transportation, it can also be used for private goods like business parks and sports facilities. The former arguably provide direct benefits to all firms in the TIF district since better roads, streetscapes and water systems can be used by any firm in the area. The latter projects, though they may provide indirect benefits to nearby firms in the form of more attractive surroundings and increased property values, mostly benefit the owners of entity receiving the development funding. Like other development incentives, TIF can be used to subsidize private businesses with taxpayer dollars.

Projects that use TIF are often described as ‘self-financing’ since the project itself is supposedly what creates the higher property values that pay for it. Additionally, TIF is often sold to voters as a way to create jobs or spur additional private investment in blighted areas. But there is no guarantee that the development project will lead to increased private sector investment, more jobs or higher property values. Researchers at the UNC School of Government explain the risks of TIF in a 2008 Economic Bulletin:

“Tax increment financing is not a silver bullet solution to development problems. There is no guarantee that the initial public investment will spur sufficient private investment, over time, that creates enough increment to pay back the bonds. Moreover, even if the investment succeeds on paper, it may do so by “capturing” growth that would have occurred even without the investment. Successful TIF districts can place an additional strain on existing public resources like schools and parks, whose funding is frozen at base valuation levels while growth in the district increases demand for their services.”

The researchers also note that it’s often larger corporations that municipalities are trying to attract with TIF dollars, and any subsidies via TIF that the municipality provides to the larger firm gives it an advantage over its already-established, local competitors. This is even more unfair when the local competitor is a small, mom-and-pop business that already faces a difficult challenge due to economies of scale.

There is also little evidence that TIF regularly provides the job or private sector investment that its supporters promise. Chicago is one of the largest users of TIF for economic development and its program has been one of the most widely studied. Research on Chicago’s TIF program found that “Overall, TIF failed to produce the promise of jobs, business development or real estate activity at the neighborhood level beyond what would have occurred without TIF.”

If economic development projects that rely on TIF do not generate additional development above and beyond what would have occurred anyway, then the additional tax revenue due to the higher assessed values is used to pay for an economic development project that didn’t really add anything. Without TIF, that revenue could have been used for providing other government goods and services such as infrastructure or better police and fire protection. Once TIF is used, the additional revenue must be used to pay for the economic development project: it cannot be spent on other services that residents might prefer.

Another study, also looking at the Chicago metro area, found that cities that adopt TIF experience slower property value growth than those that do not. The authors suggest that this is due to a reallocation of resources to TIF districts from other areas of the city. The result is that the TIF districts grow at the expense of the municipality as a whole. This is an example of the TIF working on paper, but only because it is pilfering growth that would have occurred in other areas of the city.

Local politicians often like tax increment financing because it is relatively flexible and enables them to be entrepreneurial in some sense: local officials as venture capitalists. It’s also an easier sell than a tax rate increase or general obligation bonds that require a voter referendum.

But politicians tend to make bad venture capitalists for several reasons. First, it’s usually not their area of expertise and it’s hard: even the professionals occasionally lose money. Second, as Milton Friedman pointed out, people tend to be more careless when spending other people’s money. Local officials aren’t investing their own money in these projects, and when people invest or spend other people’s money they tend to emphasize the positive outcomes and downplay the negative ones since they aren’t directly affected. Third, pecuniary factors don’t always drive the decision. Different politicians like different industries and businesses – green energy, biotech, advanced manufacturing, etc. – for various reasons and their subjective, non-pecuniary preferences may cause them to ignore the underlying financials of a project and support a bad investment.

If TIF is going to be used it should be used on things like public infrastructure – roads, sewer/water lines, sidewalks – rather than specific private businesses. This makes it harder to get distracted by non-pecuniary factors and does a better – though not perfect – job of directly helping development in general rather than a specific company or private developer. But taxpayers should be aware of the dangers of TIF and politicians and developers should not tout it as a panacea for jump-starting an area’s economy.

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