Paul L. Caron

Friday, February 1, 2019

Weekly SSRN Tax Article Review And Roundup: Wallace Reviews Aprill's Enterprise Zones

This This week, Clint Wallace (South Carolina) reviews an old work (newly posted to SSRN) by Ellen Aprill (Loyola-L.A.), Caution: Enterprise Zones (66 S. Cal. L. Rev. 1341 (1993).

Wallace (2019)Twenty five years ago we stood at the dawn of the age of “targeted tax cuts.” President Clinton introduced that terminology to the political lexicon, and his administration added all variety of politically appealing tax breaks to the Code, seeking to expand access to college, help make healthcare more affordable, and promote home ownership, among other goals. One version of political-rally-friendly tax policy that the Clinton administration promoted with particular enthusiasm was geographically targeted tax breaks.  In 1993, Prof. Aprill published an article (new to SSRN this week) critiquing and offering guidance on how to effectively design this kind of tax incentive.

Today, that article is especially relevant because the 2017 tax act added §§ 1400Z-1 and 1400Z-2 to the Code, establishing Opportunity Zones (or “O-Zones” depending on how unselfconscious you are about your nerd-dom).  Geographically targeted tax breaks continue to make for good political talking points: the provisions were included in the 2017 tax act as part of the Republican Party’s “opportunity agenda,” which is meant to “encourage economic growth and job creation in economically distressed communities.”  President Trump has echoed that motivation, explaining that O-Zones encourage “investing in distressed communities to create more jobs for those who have too often been left behind.”

The basic framework of O-Zones allows deferral of existing capital gains (through something like a § 1031 exchange for investments in O-Zone businesses or property), a discount of 10% or 15% on those existing gains (if the O-Zone investment is maintained for 5 or 7 years), and total exclusion of new gains on O-Zone investments if the investment is maintained for 10 years or more.  The details of the O-Zone scheme are starting to take shape right now. The IRS issued proposed regulations in October, has scheduled a hearing on the those proposed regulations for February 14, and has promised more proposed O-Zone regulations in the near future.

Prof. Aprill’s article critiques President George H.W. Bush’s “enterprise zone” proposal, which was a response to the Los Angeles riots.  The idea—then as now—was to use tax breaks to promote investment and provide opportunities in urban areas. (In contrast, O-Zones designations can apply to urban and rural areas.) Prof. Aprill urged caution in relying on geographically targeted capital incentives to promote urban renewal, presciently analyzing the potential flaws of the Bush proposal and, as it turns out, O-Zones. 

She argued, labor incentives are necessary (though perhaps still not sufficient) to actually spur the sort of economic benefits that enterprise zone proponents touted. Citing a CRS report from around the same time written by Jane Gravelle, Prof. Aprill concludes that capital incentives are not the right kind of targeting. Rather, “a capital subsidy will encourage capital intensive firms to locate to the enterprise zones and encourage all firms, including those already in the zone, to use relatively less labor and more capital.”  The best possibility for geographically targeted tax breaks that fulfill the political promises they followed is tax incentives that are “tied to the primary purpose of creating jobs.”  She essentially predicted that, because the incentives appeared to be misaligned, the results of enterprise zones in the real world would be disappointing.

Consistent with the substance of Prof. Aprill’s critique of the Bush proposal, the Clinton administration’s version of geographically targeted tax breaks actually did target employment. Their first go—a part of the late-1993 legislation that increased the top marginal tax rate, among other things—established two types of zones: Enterprise Communities (ECs) and Empowerment Zones (EZs).  ECs were a designation that allowed for tax exempt financing in an area designated by local authorities and approved by the federal government—a capital subsidy.  But the greater emphasis in the Clinton program—in terms of dollars committed, at least—was on EZs. These were essentially ECs on labor-incentive steroids: in addition to the tax exempt financing, EZ status qualified employers within the zone for a wage credit worth 20% of wages paid to residents of the zone (up to a maximum credit of $3,000 per employee). It also included another capital subsidy, in the form of immediate expensing for certain EZ property. These provisions were renewed and expanded in 1997 and again in 1999, and more were added as well: District of Columbia Enterprise Zone (DCEZ – 1997), Renewal Communities (RCs – 2000), and, under the second Bush administration, the New York Liberty Zone (NYLZ – 2002) and Gulf Opportunity Zones (GOZones – 2005).  Yeesh! 

So, have these ECs and EZs and RCs and GOZones and the other versions of geographically targeted tax incentives actually worked? And, 25 years on, what does our experience with these zones tell us about O-Zones?  The record is mixed.  Despite the focus on employment incentives, EZs were found to have “no statistically significant effect on income, unemployment or poverty” in designated areas. The employment incentives may not have done much, suggesting a need for stronger medicine.  

What about the capital incentives?  There is less information on the effects of the tax exempt financing, although one study found that renters in EZs were potentially worse off because rents in EZs rose faster than wages—not a surprising outcome, and one that may be even more pronounced in areas where there are capital incentives without any labor incentives. There is evidence of underwhelming results from the states as well, in terms of both business investment and employment outcomes. One study (from the early 1990s) suggested that enterprise zone incentives were particularly ill-suited to prompting positive outcomes in “the most distressed areas.” In short, 25 years of tax zones has left us without much to show.

Thus, re-reading Prof. Aprill’s critique of enterprise zones today re-confirms that the Opportunity Zone provisions leave much to be desired.  Further, basic economic principles tell us that if we want to promote the sort of economic development that broadly benefits a community—jobs for people in the community—then the tax incentives need to directly target jobs. My Tax Practicum students at the University of South Carolina offered some proposals in the first O-Zone notice and comment process for shoehorning employment incentives into the regulatory scheme. But as yet there is no indication that Treasury and IRS regulation writers will take this approach, notwithstanding plenty of rhetoric focused on job creation.  So we may be left with a subsidy to capital with the vague hope of indirect employment effects, which is precisely what Prof. Aprill warned against 1993. 

From the vantage point of 2019, Prof. Aprill’s article raises another important issue as well: wouldn’t it be nice if Treasury could do some careful analysis of where capital is deployed under the O-Zone regime, and what effect it has on O-Zone communities?  O-Zones are expected to cost the fisc $1.6 billion in the first 10 years, and much more after that (as O-Zone gains are excluded).  Will the results be worth the price—and will we be able to tell, or are we doomed to rinse and repeat in another few decades?

Here’s the rest of this week’s SSRN Tax Roundup:

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