Amid Deficit-Closing Cutbacks, States Consider Cutting Community Development Tax Credits

Published by Michael Novogradac on Wednesday, July 1, 2020
Journal Cover Thumb July 2020

The National Bureau of Economic Research publicly proclaimed June 8 what everyone already knew, that the economic fallout from the COVID-19 pandemic drove the United States into a recession, one that officially began in February.

As explained in more detail below, nearly every state is required to have a balanced budget (unlike the federal government). That means states are seeking and will continue to seek ways to comply with their balanced-budget rules, which can lead states to consider short-term cuts in taxpayers’ ability to claim and/or use state tax credits. These considerations put state community development tax credits at risk; a strategy that history tells us is shortsighted.

This issue of the Novogradac Journal of Tax Credits coincides with the July 1 start of the fiscal year for 46 of the 50 states. As this issue went to press, most states already had their fiscal year 2021 (FY 21) budgets in place, but the need to address the state-budget-deficit-causing impact of COVID-19 will continue into FY 22 and likely beyond.

As budget challenges persist, so too will the importance of preserving state community development tax credits and the ability to use them. 

Budget Matters
According to the National Conference of State Legislatures, 46 states begin their fiscal year July 1. The exceptions are New York, Texas, Alabama and Michigan.

By June 15, 34 states had enacted budgets for FY 21: 15 annual budgets and 19 biennial budgets (16 of which passed in 2019). The rest, except Michigan, faced a July 1 deadline.

All states except Vermont require a balanced budget, although the definition of “balanced budget” varies. In some states, a budget must be balanced when introduced, in others when the legislature passes the budget, in others when the governor signs it. Some states require the budget be rebalanced when it falls out of balance, others don’t.

Regardless of that definition, every state will face revenue shortfalls due to the COVID-19 pandemic and recession. States will be forced to find ways to increase revenues, decrease spending or both.

During the Great Recession of 2007-2009, some states temporarily limited or eliminated the use of community development tax credits to help balance their budgets. The results were instructive.

Great Recession Scramble
The Great Recession caused states to scramble to balance budgets. A 2012 report by the Brookings Institute research group documents that state tax revenue fell dramatically during the Great Recession: By the second quarter of 2009, state taxes were 17 percent lower than a year earlier. The same report showed that state and local “own-source receipts,” which includes all income sources except federal grants, fell by $100 billion from 2007 to 2009.

There was a steep drop in revenue for state budgets. States also saw increased spending in some areas, particularly in unemployment insurance and their responsibility for Medicaid. The combination of less revenue and more spending created or expanded deficits.

The National Conference of State Legislatures reported that in 2007, the combined budgets of the 50 states had equal revenue and expenditures. By 2010–after the Great Recession officially ended, but before the recovery was in full swing–there was a gap of nearly $180 billion between state revenue and expenditures (despite state budgets being “balanced,” according to the various definitions).

Forty states raised taxes between 2008 and 2011 and most cut spending: According to the Center on Budget and Policy Priorities, 34 states cut public school funding, 31 lowered health care spending and 44 reduced employee compensation.

Some reduced or eliminated the ability to use state tax credits.

California LIHTC Reduction
Facing a budget deficit, the California Legislature passed a 2008 bill that included mandatory furloughs for state employees and other reductions, including a limitation to the applicable amount of business tax credits that could be used against state income tax. Taxpayers could use credits, including low-income housing tax credits (LIHTCs), against up to 50 percent of their tax liability for taxable years beginning Jan. 1, 2008, through Jan. 1, 2010.

The change had an effect on affordable housing in California. The additional limits on the ability to use state tax credits reduced credit equity pricing, which meant less aggregate equity investment in affordable housing.  After the limitation expired, it took time for equity pricing to recover.  The California Tax Credit Allocation Committee reported that the average price per state LIHTC in 2010 was 57.4 cents. In 2011, that average price went to 65.7 cents. In 2012, it was 67.3 cents.  For the 2018 allocation round, state LIHTC pricing was in the range of 70 cents to $1.02, with an average price of 81.9 cents.

Limiting the ability to use the state credit in California resulted in fewer affordable homes being built or preserved. That happened during a period when the state needed development to spur the broader economy.

New York Reduction
New York joined California in limiting the ability to use tax credits during the Great Recession, albeit two years later. The 2010 New York budget included a provision requiring taxpayers to defer until 2013 the use and refund of certain tax credits beyond $2 million. Those credits included the state historic tax credit (HTC), LIHTC and solar equipment tax credit.

The adverse effects on economic activity of New York reducing the ability to use state credits is readily observed in the drop in renovation of HTC properties during the restricted-use period.

From 2009 to 2012, the number of Part 1 applications for HTC properties in New York–filed with the National Park Service (NPS) before a developer begins renovation work–dropped 27 percent. That decrease compared to a nationwide drop of 4 percent over the same period. Part 1 submissions then more than doubled in subsequent years, when New York taxpayers were not restricted in using the credits, increasing from 64 in 2012 to 130 in 2015. Over this same period, nationally, Part 1 applications (excluding New York) increased 28 percent.

The number of applications for NPS Part 3 approvals, required for a taxpayer to claim the credit, dropped 54 percent from 2009 through 2011 for New York properties, and then rebounded when the limitation on using credits ended. The number of New York HTC properties that requested Part 3 approval was 72 percent higher in 2013 than 2012, compared to a 3 percent increase in all states excluding New York. 

In short, New York saw a reduction in HTC property renovation activity when the credits were limited–a time when development was needed to spur the economy.

Oklahoma, Kansas Credits
Legislation to limit the ability to use state tax credits during that period wasn’t limited to the coasts. 

Oklahoma in 2010 limited several credits and suspended the state HTC until July 2012. NPS Part 1 applications dropped by 67 percent until rebounding in 2013.

Kansas imposed a limit on the state HTC for 2010 and suspended the credit in 2011. Part 3 approvals in Kansas dropped in 2010 and 2011, before rebounding in 2012 when the credit returned.

Like in California and New York, reducing the ability to use state tax credits resulted in less economic activity during a period when the states were seeking development to spur the economy.

Moves to limit the ability to use credits against state income tax didn’t succeed everywhere during the Great Recession. A 2010 Hawaii bill that would have suspended until 2013 the ability to use a high-technology tax credit passed the Legislature before it was vetoed by Gov. Linda Lingle. That credit had pumped more than $1 billion of private investment into the state and Lingle correctly reasoned that eliminating it would hurt Hawaii more than it would help.

Lingle understood what leaders in California, New York, Oklahoma and Kansas missed: that state-level community development tax incentives drive development. Reducing or eliminating those tax credits unintentionally limits the recovery during periods when states need development.

California: Risking a Repeat
More than a decade after the Great Recession, states face similar choices. One high-profile state has already considered a repeat.

Facing a budgetary shortfall due to COVID-19, California Gov. Gavin Newsom issued a FY 21 budget plan in May that would have limited all business tax credits to $5 million per taxpayer, per year, for 2020, 2021 and 2022–similar to New York’s 2010 strategy. There was immediate concern in the affordable housing community, particularly because the California Tax Credit Allocation Committee reported that 16 investors used the state LIHTC in 2018 and California had agreed to spend $500 million on state credits this year. Limiting the ability to use the credit would severely dampen investor interest in the state credit.

At the time of this writing, the state Legislature had passed a budget to exempt the state LIHTC from the $5 million restriction. As this issue went to press, it was expected that Newsom would sign the legislation and allow the state LIHTC to be used per usual. However, that was no guarantee and the limitation would still affect other credits. 

Importance of Education, Advocacy
California isn’t likely the only state that will consider limiting the use of state tax credits during the COVID-19 recession, but as seen from the Great Recession, limiting the ability to use community development credits restricts development in the years that the states most need economic activity. 

Community development tax credits are poised to play an outsized role in helping the nation recover from the COVID-19 recession due to their ability to create housing, businesses and jobs in the areas of greatest need. State credits are crucial for their role in gap financing. As seen in the Great Recession, limiting the ability to use those credits will mean fewer properties will be built or renovated with the same federal tax credit allocation.

While it’s understandable that state leadership will consider cutting tax credits as a way to balance budgets, doing so is shortsighted. Not only should state incentives such as the LIHTC, new markets tax credit, HTC and renewable energy tax credits be protected to help with the recovery, states should encourage their expansion to fuel a faster recovery and ultimately more state tax revenue.

Advocates for affordable housing, community development, historic preservation and renewable energy must make their voices heard at statehouses and must educate decision-makers on the importance of state tax credits. Here’s the message: When it comes to reducing the ability to use state tax credits, short-term limitations may end up costing states more than they save.