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Washington Wire: Better by Design: Tax Credits’ Structure Provides Superior Results

Published by Michael J. Novogradac on Monday, September 1, 2014

Journal cover September 2014   Download PDF

Despite their proven track records promoting capital investment in affordable housing, community development, historic preservation and renewable energy, some tax credit critics continue to suggest capital grants may be a better alternative. For example, in response to criticism of the new markets tax credit (NMTC), the U.S. Government Accountability Office (GAO) in 2010 recommended a pilot capital grant program to compare with the NMTC. Similar suggestions have been made regarding the solar investment tax credit (ITC) and the low-income housing tax credit (LIHTC).

Capital grants do have some attractive features that make them the appropriate to incentivize certain kinds of activity. But many arguments in favor of capital grants in place of tax credits for the creation of affordable rental housing, community development in low-income communities, rehabilitating historic property or developing renewable energy facilities — where long term low-cost capital is crucial — either understate or fail to account for other factors that offset those attractive features to the point of rendering them moot.

For the purposes of providing enduring investment in affordable housing, community development, historic preservation and renewable energy, and ensuring actual benefits for the nation’s citizens and communities, tax credits have been successful because of the many structural features they boast that are not offered by capital grants.

Transaction Costs
One of the most common assertions in favor of capital grants is that they don’t entail the transaction costs that tax credits do, and as such can more directly provide economic benefit to end users. It’s true that some tax credit subsidy is consumed by third parties via administrative costs, but capital grant programs involve up-front and ongoing administrative costs as well. It is also important to note that tax credits do not have a separate stream of funding for administrative costs, while many capital grant programs, such as the U.S. Department of Housing and Urban Development’s (HUD’s) Community Development Block Grants (CDBG), do.

To administer a hypothetical capital grant program to encourage the development of low-income rental housing, an entity would be required to initially underwrite the development and dispense the capital grant during development. Not to mention the ongoing oversight required to monitor and enforce income, rent and other restrictions for the resulting properties. A Harvard Kennedy School of Government study, “Investable Tax Credits: The Case of the Low-Income Housing Tax Credit,” found that that shifting from tax credits to capital grants would “entail greater complexity and potentially higher costs when these programs are reconstituted as direct spending programs.” What is sometimes misunderstood about the design of tax credit programs like the LIHTC, is that they leverage market-based incentives and delegated monitoring to shift the administrative burden from government officials to the private sector, reducing the cost to taxpayers while providing important safeguards.

Actual Cost and Realization of Planned Benefits
Unlike tax credit programs, capital grant programs are limited in their abilities to enforce a correlation between actual government costs and realization of planned benefits. When designing and funding programs to incentivize activity such as historic preservation or community development, it is important to measure more than just the direct cost to the government against the amount of subsidy received by the intended recipient. A key consideration must be a measure of the direct cost to the government against the realized benefit.

A crucial aspect of tax credit programs’ design is the ability to terminate future tax credits and recapture some or all of tax credits already claimed if the subsidized goals aren’t attained. This integral “pay for performance” feature of tax credits is a key component to long-term success. Once deployed to actual developments, the funds provided through existing capital grant programs are difficult to recapture and often the only recoverable asset is the property funded by the capital grant. And in the case of affordable rental housing funded with such a grant, recovering a capital grant from a property that had been completed and placed in service would put at risk the low-income residents, the very population the grant was meant to help.

But if you look at the track records of the LIHTC, NTMC, historic tax credit (HTC) and ITC, the benefits they’ve created for the economy and communities across the United States are a testament to the effectiveness of the power of tax credits’ design to effect real results.

Low-Income Housing Tax Credit
The LIHTC has incentivized the construction, rehabilitation and/or preservation of more than 2.6 million affordable housing units between 1986 and 2012, according to the National Council of State Housing Agencies. The GAO and New York University report that this housing has helped some of this country’s most vulnerable citizens. Surveys indicate that approximately three quarters of households living in LIHTC properties have incomes below 50 percent of the area’s median. What’s more, LIHTC properties have an extremely low rate of failure and recapture. According to a report, Low-Income Housing Tax Credit Assessment of Program Performance and Comparison to Other Federal Affordable Housing Subsidies,” authored by Novogradac & Company on behalf of the Housing Advisory Group, between 1991 and 2006, LIHTC properties experienced foreclosure at roughly 30 percent the rate of all multifamily rental non-LIHTC properties. And that rate was well below that of single family housing and many other types of real estate.

New Markets Tax Credit
Between 2003 and 2007, the NMTC created or retained 135,970 permanent jobs and 151,304 construction jobs according to a 2013 evaluation of the program by the Urban Institute. The same report found that 80 percent of NMTC funded projects contributed to some form of increased city or county tax revenues. The flexibility of the NMTC means it has supported the creation of businesses including shopping centers, youth clubs, community centers, charter schools, food processing plants, lumber mills and neighborhood centers in low-income communities where this kind of development would not be possible without a program like the NMTC.

Historic Tax Credit
The HTC program has led to the rehabilitation of more than 39,600 properties and generated more than $69 billion worth of rehabilitation activity, according to the National Park Service (NPS). The program is also credited by the NPS with creating the 2.4 million jobs and generating $106 billion in private investment as of 2012. Perhaps one of the HTC program’s most remarkable accomplishments is that it does all this at a very low cost. If fact, the HTC has generated $26 billion in federal taxes by creating jobs and spurring on economic activity, while reducing revenues by $20.5 billion, effectively more than paying for itself.

Solar Investment Tax Credit
The solar ITC has assisted in increasing annual solar installations by more than 3,000 percent since its inception, according to survey results from the Solar Foundation. Meanwhile, the ITC is also supporting a growing industry; according to the Solar Energy Industry Association, the solar industry has expanded from approximately 15,000 employees in 2005 to almost 143,000 today. Moreover, the solar ITC is also highly cost effective. The U.S. Partnership for Renewable Finance found that when the increased tax revenues from ITC-incentivized business activity was compared to the costs of the tax credits, government earned a 10 percent nominal internal rate of return on its investment.

Tax Credits’ True Cost
The true cost of tax credits is often overstated in comparison to the costs of capital grants. Converting many tax credit programs to capital grants would actually decrease government revenues. Furthermore, to the extent that tax credits reduce basis, they make certain tax credits a partially or fully “taxable credit.”

Tax issues aside, cost comparisons between tax credits and capital grants tend to ignore that alternative capital grants would be provided upfront at full cost to the government, while tax credits are deferred over a period of time. As noted in the Novogradac special report, “Low-Income Housing Tax Credit Assessment of Program Performance and Comparison to Other Federal Affordable Rental Housing Subsidies,” using a 3.5 percent discount rate (to represent the government’s long term cost of borrowing) puts the cost of providing $1 million worth of tax credits for 10 years every year at $7.5 million.

Tax Credits’ Structural Advantages
Perhaps because they are complex, and complexity can breed distrust, tax credits’ many structural advantages are often misunderstood or overlooked.

For example, private investors assume the risks not only during the compliance period but also during the development phase, which is generally the riskiest phase of an investment. Under many tax credit programs, the government isn’t subject to construction or lease-up risk, because the tax credits usually only begin to accrue when the property is placed in service. Thus the government finances only properties that have been successfully developed.

In addition, private markets provide ongoing oversight. The combination of collectible recapture over time and delayed claiming of tax credits provide a strong incentive to remain compliant and as such investors provide intense oversight. Capital grant programs remove this extra layer of investor due diligence that is embedded in tax credit programs.

Also, upfront third party financing means government only pays for performance. Where many government capital grant programs have high failure rates with little ability to recover the grant, tax credit programs’ recapture allows the federal government to limit its losses by terminating future credits and collecting at least a portion of previously claimed tax credits via recapture.

Another strength of tax credits is their ability to introduce other sources of capital into low-income areas. Tax credits such as the LIHTC or NMTC often introduce investors with access to and debt and other equity capital to communities and low-income populations they would not otherwise be involved in, and pave the way for future collaborations and investments.

Finally, private competition produces efficiency. Government agencies aren’t subject to the competitive incentive that private companies are to limit administration and compliance monitoring costs while still adhering to property performance.

Reform Rather than Replace
Because tax credit programs for affordable housing, community development, historic preservation, and renewable energy have been effective, it would be much wiser for policymakers to work together to reform tax credits rather than attempting to replace them with less efficient tools such as capital grants.

There are modifications that would make each of the LIHTC, NMTC, HTC and ITC even more effective. For example, providing a 9 percent floor for the LIHTC rate would ensure a more predictable and stable market, thus reducing the premium paid to investors for uncertainty. Allowing for gradual recapture of the NMTC would reduce the risk of the investment, raising the price of credits and increasing efficiency. The HTC and ITC would each be more effective if casualty recapture rules were altered in a manner to better allow project owners to rebuild after disasters.

When it comes to encouraging lasting capital investment and ensuring measurable benefits for the nation’s citizens and communities, tax credits are the better tool. Research has borne this out repeatedly, as discussed in much greater detail in Rel. 66 of the University of Southern California’s journal, Major Tax Planning.

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