DC: A Capjitalist City?, Martin A. Sullivan, October 1997

A Preliminary Analysis of the New Federal Tax Incentives for the District of Columbia

Prepared for the District of Columbia Tax Revision Commission by Martin A. Sullivan

Martin A. Sullivan earned his B.A. in economics from Harvard University and his doctorate in Economics from Northwestern University. He has served as an economist at the Office of Tax Analysis of the U.S. Treasury Department and at the Joint Committee on Taxation of the U.S. Congress. He has also worked in the private sector as a Principal at Arthur Andersen. He is now an economist for Tax Analysts of Arlington, Virginia and is a regular contributor to Tax Notes magazine. With the AICPA, he has authored two books on tax reform called America's Tax Revolution and Changing America's Tax System. These were published in 1996 by John Wiley & Sons.

All views expressed in this report are those of the author. These views are not necessarily shared by the staff or members of the District of Columbia Tax Revision or by Tax Analysts.

A Preliminary Analysis of the New Federal Tax Incentives for the District of Columbia

On August 5, 1997 President Clinton signed into law the Taxpayer Relief Act of 1997. The Act provides a net tax cut estimated to be $275 billion over ten years--the first significant tax cut since 1981. One component of this tax reduction package was a set of tax incentives uniquely available to District of Columbia residents and businesses operating in certain impoverished areas of the District. According to official estimates, the Act provides the District total federal tax relief of approximately $1.2 billion over the ten-year period from 1998-2007.⁽¹⁾

(1) Wage credit. A tax credit of up to $3,000 per employee will be available for wages paid to any District residents by businesses operating in areas of the District with poverty rates of 20 percent or more. Wages paid during calendar years 1998 through 2002 are eligible.

(2) Tax-exempt financing. The District of Columbia will have the authority to issue enterprise zone facility bonds for businesses operating in areas of the District with poverty rates of 20 percent or more. These tax-exempt financing bonds can be issued during the period after December 31, 1997, and before January 1, 2003.

(3) Faster write-offs. Small businesses operating in areas of the District with poverty rates of 20 percent or more will have an additional $20,000 of first-year deductions for expenditures on capital equipment. The additional first-year deductions will be available for qualified taxpayers with taxable years beginning after December 31, 1997, and ending before January 1, 2003.

(4) Zero-percent capital gains rate. A zero-percent capital gains rate will be available to investors who have owned for at least five years business property used in areas of the District with poverty rates of 10 percent or more, or who have owned a business operating primarily in areas of the District with poverty rates of 10 percent or more. To qualify for the zero rate an investment must be paid for in cash after December 31, 1997 and before January 1, 2003.

(5) Homebuyer credit. Since August 5, 1997, a tax credit of up to $5,000 has been available for couples with incomes below $130,000 (and singles with incomes below $90,000) making their first purchase of a home anywhere in the District of Columbia. (An eligible taxpayer may currently own a home as long as it is not in the District.) This credit expires on December 31, 2000.

In addition, two tax benefits will become available to District businesses as a result of the District's new status as an empowerment zone:

(6) "Brownfields." Businesses operating in areas of the District with poverty rates of 20 percent or more will be able to deduct environmental clean-up expenses in the year these expenses are incurred. Under current law, these expenses often could not be deducted at all. (Urban sites contaminated with hazardous substances are commonly referred to as "brownfields.") These special deductions are available for expenditures incurred in the years 1997 through 2000.

(7) Work opportunity tax credit. District employers can earn a tax credit of up to 40 percent on wages paid to high-risk youths (ages 18 through 24) and qualified summer youth employees (ages 16 and 17) as long as these employees reside in areas of the District with poverty rates of 20 percent or more. In general, the credit is available for the first $6,000 of wages paid to each employee. This credit is available only in the District during the first six months of 1998.

Under the 1997 Act, the census tracts⁽²⁾ of the District with poverty rates of 20 percent of more are collectively referred to as the "District of Columbia Enterprise Zone." As the name suggests, there are a lot of similarities between the new federal tax incentives for the District of Columbia and the tax incentives available under current law in federal empowerment zones and enterprise communities around the country. But there are significant differences as well. There are more types of tax incentives available in the DC zone than in empowerment zones generally. Moreover, some of the tax incentives are available in an expanded version of the zone (i.e., in census tracts with poverty areas of 10 percent or more), and some are available in the entire District of Columbia.

Of all the new tax incentives for District of Columbia, only the first-time homebuyer tax credit is available in all parts of the District.⁽³⁾ The availability of the other new tax incentives for the District of Columbia varies across neighborhoods.

The availability of tax incentives in any particular part of the District depends upon the level of poverty in that area. As with all major cities in the United States, the Census Bureau has divided the District of Columbia into small, neighborhood size areas called census tracts. A census tract generally has a population between 2,500 and 8,000 residents. The new federal legislation in effect creates three classes of census tracts: (1) census tracts with poverty rates between zero and 10 percent, (2) census tracts with poverty rates between 10 and 20 percent, and (3) census tracts with poverty rates of 20 percent or more. In general, the census tracts with the most poverty get the most tax incentives.

Only in the census tracts in the District of Columbia with poverty rates⁽⁴⁾ at least 20 percent are all the new tax incentives (including the "brownfields" provisions and additional work opportunity tax credits) available. In census tracts with poverty rates of 10 percent or more, only the zero-percent capital gains rate and the first-time homebuyer credit is available. The availability of various tax incentives by census tract poverty level is summarized in Figure 1.

Figures 2A, 2B, and 2C together show a map of the entire District of Columbia and indicate the general level of poverty in each census tract. As anybody generally familiar with the District might expect, the maps indicate that many of northern and northwestern parts of the city have low levels of poverty. Of the all the new tax benefits for the District of Columbia, the one with the most direct impact in these areas is the homebuyer credit. And among these census tracts, the wealthier areas get relatively less from the homebuyer credit for two reasons. First, the flat credit amount is smaller percentage of the price of a house for more expensive homes (i.e., the $5,000 homebuyer credit does not play as large a role in the purchase of a $500,000 as it does in a $100,000 home). Second, by statute the homebuyer credit is not available to families with high incomes (i.e., the credit phases out between $110,000 and $130,000).

And, as one generally familiar with city might expect, much of the southeast and eastern portions of the city have significant levels of poverty, and accordingly, much of this area qualifies for all the new tax incentives. A new business in a 20-percent poverty area could get wage credits, additional first-year write-offs, and tax-exempt financing; and after five years the owners can sell their stock and pay no capital gains taxes.

But there are exceptions to these generalizations about poverty in the District. For example, a significant portion of the Georgetown area is eligible for the zero percent capital gains rate, and in some parts of Georgetown all the new DC tax incentives are available. Conversely, there are big pieces of the southwestern and southeastern District--particularly around Capitol Hill--that do not qualify for anything but the homebuyer credit.

But probably the most difficult area for deciphering the geography of tax benefits is the downtown business district and the areas immediately north of that. In the downtown area it is only the matter of a few minutes walking to move through areas with three different sets of tax rules. In these areas, there is often is no readily apparent reason (e.g., natural barrier, neighborhood identity) for having different tax rules on one block but not on the next. For example, just a few blocks west of the White House, restaurants on one side of the Pennsylvania Avenue are eligible for wage credits while restaurants on the other side are not.

Although the spottiness of tax regimes is particularly concentrated in the downtown areas, there is likely to be quite a lot of confusion for businesses and residents throughout the city. These new and unmarked (and mostly unknown) borders between census tracts with different tax regimes are many dozens of miles in length. There are more than half a dozen intersections in the District of Columbia where all three types of census tracts form a common border.

PART II. ECONOMIC IMPACTS OF THE TAX INCENTIVES

Even though Congress has devoted an estimated $1.2 billion of tax benefits to the District of Columbia, there are no assurances that the intended objectives can be met. Unfortunately, nobody--inside Congress or out--has any reliable evidence on the efficacy of tax incentives that will soon be available in the District of Columbia. This is not to say economist have not tried. Many economic studies have attempted to measure the effects of local tax incentives on economic development. But the results of these studies are sufficiently uncertain that they can provide little guidance to legislators. Like preliminary tests of an experimental drug, these studies are really only useful to other researchers trying to learn more. Inconclusive research is a poor guide for practical implementation.

One way to show the degree of uncertainty that surrounds the effectiveness of the new tax incentives is by comparison to the state of economic knowledge on issues that have received far more attention from economists. Over the last forty years, hundreds of empirical studies have attempted to measure the effect of federal tax incentives like the investment tax credit and accelerated depreciation on total private investment in the United States. Despite this tremendous effort by the finest minds in economics, there is little consensus even today about the magnitude of investment's response to tax incentives. Economists simply do not have the data and statistical methods that allow then to sort out which movements in investment are due to taxes and which are due to other factors.

The number of empirical economic studies on the effects of local tax incentives on local economic development is only a small fraction of the resources devoted to study tax incentives on investment for the overall U.S. economy. Although a significant amount of research has been done, it is unlikely economists will soon reach a consensus. This is reflected in the following passages excerpted from two recent reviews of the statistical evidence on the effectiveness of enterprise zones:

In summary, there are several policy lessons to be learned from interregional and intra-regional econometric studies. First, many studies find that the level of taxes matters--i.e., that tax variables are statistically significant determinants of economic activity--but many others do not, casting doubt on how the literature would answer the simple question posed at the beginning of this section [i.e., "Do taxes matter?"]. Even when taxes do matter, the magnitude of the effect is small, and other factors are more important in explaining differences in economic activity across space. Finally, in creating an environment conducive to economic development, how governments spend their tax revenues may be more important than the level of taxes. Our overarching conclusion is that cutting taxes is not a panacea for a poorly performing regional economy. As McGuire (1992) stated in her review of Bartik (1991), the "message to policy makers is that the effects of state and local tax policy are so uncertain that concern over this issue [of economic development] should not be a driving force in general fiscal policy decisions."⁽¹⁾ [emphasis added]

[O]nly a limited amount of the research specific to enterprise zones has employed a methodology that would allow identification of the unique contribution of the enterprise zone to the investment or employment growth observed in the zone. Most of the research is merely suggestive, and rather contradictory. Part of the problem lies in the measurement problems discussed above and in the use of inappropriate methodologies. Another part of the problem lies in the very diverse nature of enterprise zones, in terms of the severity of the inherent economic disadvantages confronting the zone at its inception, the range and value of the incentives offered, the underlying tax systems and quality of public services, and the economic performance after zone designation. It is difficult to generalize other than to say that, given the similarity of enterprise zone incentives to the kinds of incentives and tax differences that have been the subject of most research, it is likely that the incentives offered will, in some zones, produce measurable gains in investment or employment.⁽²⁾ [emphasis added]

Even if more conclusive results were available from these studies about other local tax incentives and enterprise zone programs, the conclusions might not necessarily apply to the special features of the DC enterprise zone. First, the DC enterprise zone's geographic layout is unique. As noted on Section I, the benefits available vary dramatically from neighborhood to neighborhood--and in some case from block to block--throughout the city. And both highly-developed and undeveloped areas are eligible for incentives. Second, a geographically targeted zero-percent federal capital gains rate is only available to the DC enterprise zone.

Although economics may not be able to provide cut-and-dry quantitative impacts of how local tax incentives affect the local economy, economic reasoning can provide some useful insights. One of these is that it is easier to get targeted tax incentives to change behavior than it is to get broad-based incentives to work. For example, it is easier to increase employment in a small area than it is to increase employment in a large area. This is because in order to increase employment in a large area, there generally must be new job creation. Creating employment for a more targeted area can be achieved by either job creation of by moving employment from surrounding areas into the targeted areas.

Economics can also provide some insight into whether incentives are well targeted toward achieving their objectives. For example, as shall be discussed further below, the homebuyer credit does provide an incentive for a "stable residential base" in the District in two ways: it encourages current middle-class DC residents who are renting apartments to buy and it encourages middle-class non-residents to move into the District and buy homes. The credit does not, however, encourage current DC homeowner to stay in the District. It does not provide incentive for most low-income and most high-income families to buy a home in the District. And the credit does not encourage immigration of families and individuals who may want to rent instead of buy.

Economics can also provide some warnings about possible unintended side effects of some of the incentives. For example, as discussed below, the empowerment zone wage credit provides incentives for employers to use more temporary workers and to substitute low-wage workers for high-wage workers. The credit will also encourage District employers to favor hiring DC residents over non-residents. As stressed in the prior paragraphs, the economic consequences of the new tax incentives for the District are highly uncertain. So it is not known if these hypothesized side effects will actually materialize. It can be said from the outset, however, that targeted economic incentives like the wage credit--to the extent they affect economic behavior at all--are more likely to change the composition of economic aggregates rather than the total amounts. For example, it is much more likely that the wage credit will induce shifts in employment patterns in the regional economy than increase overall employment. Many of these possible shifts in the composition of the labor force may not be particularly helpful to the area economy.

The wage credit can reduce a business's cost of employing qualified employees by up to 20 percent .⁽³⁾ The credit is as available to employers for wages paid to any resident of the District of Columbia that performs substantially all of his or her services in the District of Columbia enterprise zone (i.e., in census tracts of the District with poverty rates of 20 percent or more). Because the credit applies to only the first $15,000 of wages paid by an employer to each employee each year, employers of low-wage employee are favored over employers of high-wage employees. Figure 3 shows how the credit as a percentage of wages declines as wages paid by an employer increases.

The availability of the wage credit in some areas of the District could increase land values and rents in those areas relative to other parts of the District that are not eligible for the wage credit. The fact that so many employees qualify and relatively few areas of the District are eligible for the credit make this a likely possibility.

For example, suppose an office building on the south side of Pennsylvania Avenue (call it property Z) is in the DC enterprise zone while a comparable office building on the north side of the Pennsylvania Avenue is outside of the zone (property N). If it is expected that the facility has space for 100 employees of which 75 percent are expected to be DC residents, the credit could be worth $225,000 (in pre-tax dollars) per year to a business that intends to lease that property. The capitalized value of the tax incentives over a five-year period is more than $1 million.

This is a significant value relative to the total value of the lease. If in the prior example the total size of the space being leased was 18,500 sq. ft. and the annual rental rate was $25 per square foot, the total annual rental cost would be $462,500. If the entire, $225,000 of expected annual tax benefits can be captured by the property owner, there would be a 49 percent increase in rent.⁽⁴⁾ The potential percentage increase in value would be greater for properties with lower rental costs per employee (i.e., for firms that pay lower rent per square foot or that put more employees in the same space).⁽⁵⁾

Whether or not the property owner can extract an extra the full value of the tax benefits depends on market conditions. If there are several other private companies seeking to rent the same property (i.e., it's a "sellers' market"), and other properties with comparable characteristics are not available in the DC enterprise zone, the property owner may prevail in raising the rent. If, however, all the other potential lessors of that property cannot use the credit (i.e., they are not-for-profit entities, or most of their employees are non-residents), it is unlikely that the property owner will be able to significantly raise the rent.

The value of the tax benefits will vary depending on the degree of labor intensity of the tenant, on the wages paid, on the permanency of the employees, and on the residence of the employees. In order to maximize their rents, property owners in DC enterprise zone areas may wish to seek out employers of low-wage, high turnover, labor-intensive businesses. For the next five years for which the zone designation is in effect, there may evolve a natural "sorting out" of tenants as governments and non-profit organizations move out of DC enterprise zone areas to make room for private business that can take advantage of the wage credits inside the zone areas.

Any increase in property value is a windfall to existing property owners in the DC enterprise zones, i.e., relatively well-off DC residents and non-residents get a benefit for having done nothing more than they would have done otherwise. This runs counter to the intent of any "targeted" tax benefit. Targeted tax benefits try to encourage new economic activity that is consistent with policy objectives (in the case, increase economic development in the District). To the extent that the owners are not residents of the District, the direct benefit for the District from higher property values will be limited to increases in property tax revenues. To the extent the owners of the property are residents of the District of Columbia, the increased rents and capital gains should increase DC income taxes. There may be some indirect benefits if the extra income generated by the higher land values (whether for District or non-resident owners) is spent on products and services generated in the District.

The extent to which the wage credit induces any increase in property value in the DC enterprise zone is an indicator of the credit's effectiveness in reducing unemployment. Higher real estate price signal that the benefits of the credits are accruing to property owners and not to employers (who might boost employment by increasing the demand for labor) or employees (who might boost employment by increasing labor supply). If the wage credit increases real estate values, there may be positive indirect effects on employment, but these are likely to be small. For example, higher real estate values could increase property taxes and higher taxes might increase government employment. Higher real estate prices could mean higher incomes for owners of real estate, but this is unlikely to increase employment because it is often the case that owners do not reside in the District and in any case are unlikely to spend a significant amount of their gain in the District. Higher real estate prices could induce more building in the District and this would increase employment in the District, but because increase in property value are probably temporary--given the five-year life of the zone--any increase in construction related employment seems unlikely. In the extreme case, if all of the value of the wage credit is reflected in higher property values and rents, the direct incentive for businesses to relocate to the District or to expand existing employment are entirely eliminated.

There is a wide variety of effects that the wage credit can have on the labor market in and around the District of Columbia. For expository purposes, this section divides the economic effects of the wage credit into two categories. First, there are the impacts of the wage credit on total level of employment in the District and the surrounding area. Second, there are the impacts of the credit on the composition of employment in the District and the surrounding area.

In order for area employment to increase, there must be an increase in the total demand for labor and an increase in total supply of labor. There are basically two reasons for total labor demand to increase: (1) an increase in business activity and (2) a switch toward labor and away from other inputs.

Employment might increase if the lower after-tax labor costs due to credit allowed District businesses to lower their prices and, in turn, these price reductions induced an increase in the demand for the employers' products. Because the relative effect of the wage credit is larger for employers who pay low wages, this type of response is more likely for a firm using low-skilled labor. It is also more likely for a labor-intensive firm where labor costs are a greater percentage of total costs. Finally, it also more likely in a highly competitive market where a small change in price is more likely to have a major impact in product demand. Thus, wage credits are most likely to increase employment in low paying, labor-intensive industries operating in highly competitive markets.

To increase the overall level of employment in the DC area, it is important that these products are "exported" out of the DC area (i.e., they do not take away market share from other DC area businesses). Low-tech manufacturing and telephone marketing are types of businesses in which the wage credit has a lot of potential to increase overall area employment. These business are highly competitive. They pay relatively low wages. Their market is national not local. And in the case of the telemarketing, their business is labor-intensive.

But there are also many types of businesses where increases in regional employment are not likely. Retailers may pay low wages and be in a competitive market, but a retail business in a DC enterprise zone that is able to increase its product sales through lower prices made possible by the wage credit is primarily going to reduce market share of other DC area retailers.

ii. Increase in Labor Demand--Substitution of Labor for Other Inputs (Capital, Materials, Imported Services)

Even without an increase in demand for employers' products, it is still possible for the wage credit to increase the demand for labor if businesses substitute labor for other production inputs. The wage credit has this potential because it reduces the price of labor relative to other inputs declines.

Much economic research has been devoted to measuring how much labor and capital may substitute for each other. Although some economists believe that labor and capital have a fair degree of substitutability, most economists do not. The majority view is that the proportion of capital and labor inputs remains fairly constant in the face of any changes in the relative costs of labor and capital---whether or not those changes are due to taxes. This is particularly true over shorter time horizons. Even if a change in the production mix makes sense, it usually takes time to recognize the need and then more time to implement that change. Because the DC enterprise zone has only a five-year life span, the ability to substitute capital for labor is particularly limited. Given all this, it does not seem likely that there will be any significant increase in employment because labor is being substituted for capital. To the extent there is any impact on the mix of capital and labor, it is more likely to occur in the case where the credit delays the adoption of labor-saving technologies.

Lower labor costs might cause a business to rethink other operational issues besides its capital intensity. For example, a District business may now be contracting with a foreign company to perform its data entry or its computer programming. A wage credit for local labor could cause the business to reconsider foreign outsourcing. But the limited time the credit is available becomes an issue. Because the wage credit is only available for five years, any decision to reduce outsourcing might have to be revisited in the near future.

Economists divide unemployment into two categories: voluntary and involuntary. A person is voluntarily unemployed when jobs are available but the employee is unwilling to work at the going wage rate. To non-economists the notion of voluntary unemployment often seems strange. This is because they think of the labor market as having a fixed supply of labor: people must work to live, and they try to get the highest paying job that is available to them. In such a world there is no such thing as involuntary unemployment. This is, in fact, a fair description of primary earners of middle-class households. In general, the only time these workers are unemployed is during the transition between jobs.

But for many individuals working is not a necessity. The amount of work they are willing to perform depends on prevailing wage rates. This is often the case that second (or third) earners in a household, senior citizens, and students. For these individuals, there is a thin line between working and not working. For example, a married woman considering re-entering the labor market after maternity leave may not find working economically viable given the high costs of day care. A college student can take out more student loans instead of working. A senior citizen with pension income can simply reduce consumption rather than work. For unemployment among these types of individuals, it is not the lack of available jobs that is the problem. For employment to increase among these individuals, it is necessary for the wage credit to increase wages.

One type of involuntary unemployment deserves special mention. In high-poverty urban areas where crime is prevalent, employment in illegal activities is frequently an option to employment in the legitimate labor market. Many believe that low wages deter residents of high-crime areas from entering the labor market.⁽⁶⁾ If the wage credit is successful in raising wages, it may not only increase employment but may also help reduce crime. Of course, the most the wage credit could even theoretically raise wages is be 20 percent--and by probably much less in reality. For employees earning the minimum wage, this is a little more than a dollar an hour wage increase.

Alternatively, the wage credit could also increase labor supply through an increase in immigration into (or a reduction it out migration from) the Washington metropolitan area. Such an increase in labor supply may improve the District business climate by increasing the availability of workers. It is important to recognize, however, that this may not improve the economic status of current residents. Also, any residents lured into the District by the positive effects of the wage credit could face unemployment when the wage credit expires at the end of 2002.

Economists use the term involuntary unemployment when individuals are willing to work at the going wage but simply cannot find a job. This situation is particularly common if there are laws which set a minimum wage above the wage rate which would prevail in the free market. Under current law, the federal minimum wage is $5.15 per hour ($10,712 annually for full-time employment). The District of Columbia has a minimum wage of $6.15 per hour ($12,792 annually for full-time employment). For employers who pay the minimum wage to full-time employees working in the DC enterprise zone, the employer receives $2,558.40 of wage credit for each employee.

As noted above, the wage credit is particularly important for low-wage employment. For businesses that would like to increase employment of low-skilled individuals but are deterred by the minimum wage, the wage credit should be a significant incentive to increase employment. For these employers, the wage credit is equivalent to a 20 percent reduction in the minimum wage (i.e., from $6.15 to $4.92 cents an hour).

This section has suggested many different channels of influence that the wage credit could have on area employment. But the large variety of possibilities should not be confused with high probability. It is possible, even with its $500 million price tag, the wage credit could have no appreciable impact on overall employment in the District of Columbia or in the surrounding areas. Except in the case where the minimum wage is the cause of unemployment, there has to be an increase in both (1) the demand for labor and (2) the supply of labor. If a 20-percent reduction in wage costs to low-wage workers does not (1a) induce firms to switch to more labor-intensive production or (1b) expand their markets share by passing on lower cost and if the wage credit does not also (2a) increase immigration or (2b) reduce voluntary unemployment, then overall employment credit will not increase in the DC metropolitan area.

If minimum wage laws are not a significant deterrent to employment (particularly in the current robust business climate), the potential for the wage credit to increase employment is further restricted. There is much debate among economists and politicians about the impact of the minimum wage on unemployment. It is clear that the minimum wage is much less significant in a strong economy where the demand for labor is high and market wages are rarely below minimum wage.

In addition, the credit's relatively short life span of five years has to be a serious deterrent to its ability to increase employment even temporarily. It may not be worth the cost and the effort to recruit new workers that may be uneconomical to retain at the end of 2002 when the credit expires. Obviously the temporary nature of the credit is an impediment to increasing permanent employment.

If there is no increase in overall employment, the wage credit's impacts are confined to shifting the composition of employment in the DC labor market. The following paragraphs discuss shifts in the composition of the labor force that might occur with or without an expansion of overall employment.

One possible response to the new wage credit by employers conducting business in the DC enterprise zone is to favor hiring (and encourage retention) of District residents over employees and potential employees who are not residents of the District. This seems likely if employers are indifferent to the residence of their employees.

Another possible response to the wage credit by DC area employers is the relocation of business facilities into the DC enterprise zone. This is much more likely where small changes in location do not significantly affect operations. For example, a garage that services cars and trucks and whose location is already close to the DC enterprise zone could relocate into the zone with little impact on its business.

Many businesses may wish to keep their front offices in prominent downtown locations, but they may be able to shift their "back room" operations (accounting, billing, keyboarding, telephone sales, administration, etc.) into the DC enterprise zone with little or no impact on their customers.

On the other hand, location is extremely important to retail outlets, bank branches, and personal service firms. It is often difficult for these businesses to change locations (although moves of one or two city blocks, e.g. across Wisconsin or Pennsylvania Avenues are not bad even for these location-sensitive businesses). But even location-sensitive business may be able to relocate some of their back office operations into the DC enterprise zone.

iii. Outsourcing and Employee Leasing by the Government of the District of Columbia

One of the largest employers in the District of Columbia is the DC government. The DC government, however, cannot directly benefit from the new wage credit because it does not pay any federal income taxes.⁽⁷⁾

One possible response to this limitation of the new wage credit would be for private-sector firms to perform government services now performed by the District employees. This would make it possible for private firms to earn tax credits that would otherwise not be available. And it would be possible to share the economic benefit of these credits with the DC government. There are at least two ways this could occur:

Employee leasing. First, the DC government could enter into contracts where they lease their employees from private firms. In an employee leasing arrangement, a business (in this case, the District government) could arrange for an outside company to become the legal employers of its workers, but in day-to-day operations the workers are directed by the business's own managers. The outside company handles such issues as pensions, taxes, and insurance. The $3,000-per-employee wage credit could be shared by the DC government and the outside firm by the leasing firm reducing its fees with the credit to a level lower that what fees would be without the credit. (See the example on the following page.)

Outsourcing and privatization. The DC government could contract out services now performed by employees of the District government. For example, janitorial services performed on buildings in the DC enterprise zone now performed by employees of the DC government could be performed by private firms. These private businesses would share the benefits of the tax credits with the District government through lower fees for the services provided.

The economy of District of Columbia has a large nonprofit sector. Because nonprofit organizations pay no federal income taxes,⁽⁸⁾

they are not able to claim any tax credit for wages paid to their employees who work in the DC enterprise zone. Just as in the case of the DC government (described immediately above), nonprofit organizations with operations in the District of Columbia enterprise zone may be able to indirectly garner the benefits of the employment tax credit by entering into employee leasing arrangements with outside firms or by contracting out services currently performed by in-house employees.

Example.--A large nonprofit organization located in the DC enterprise zone publishes several monthly newsletters and does extensive fund raising by mail. It currently employs a staff of 20 individuals full-time to perform these operations. The average salary of these employees is $20,000 and each individual earns over $15,000. The total annual payroll of the staff is $400,000, and the total annual compensation costs (including taxes and benefits) amount to $475,000. Twelve of these individuals are DC residents. Beginning in January 1998 the organization arranges for the entire staff to be hired by a firm in the business of employee leasing. The employees still work on the premises of the organization, they perform the same duties, they earn the same salaries, and they are still supervised on a day-to-day basis by the organization's managers. On its 1998 federal tax return, the leasing firm includes $36,000 of tax credits on the wages of the 12 District residents employed in the DC enterprise zone. For the services of the 20 employees, the leasing firm charges the nonprofit organization $457,000 annually. This is a saving of $18,000 to the nonprofit organization over its total costs without leasing. After paying employee salaries, payroll taxes, and benefits of $475,000, collecting $475,000 from the nonprofit organization, and claiming $36,000 of tax credits, the transaction has yielded a gross profit of $18,000 for the leasing firm.

As shown earlier in Figure 3, the value of the employment credit per dollar of wages paid is three times greater for a employee with an annual salary of $15,000 than it is for an employee paid $45,000. As a result of the credit, businesses operating in the DC enterprise zone have an incentive to replace high-skilled employees with low-skill employees. For example, a nursing home would now have more incentive to replace nurses with nurses aides.

Just as employers will have incentive to shift from high- to low-skill workers, employers will also have incentive to use more part-time employees. As noted above, a full-time employee earning the DC minimum wage earns under $13,000. As shown in the table below, for these lowest paid workers, there is no incentive for employers to shift from full-time to part-time employees. But for wage rates higher than the minimum wage, the incentive to move to part-time instead of full-time employment grows larger.

Just as the credit encourages part-time employment, the credit also encourages temporary employment of all but the lowest paid employees. Once an employee who is a DC resident is paid $15,000 during a year, no additional wage credits can be earned in that year. From the standpoint of minimizing taxes, it is better to use a series of temporary employees rather than foster permanent employment. The tax incentive for high turnover is larger, the higher the salary of the employee. The only requirement of the statute is that the employer employs the District resident for at least 90 days.

For example, a business operating in the DC enterprise zone may have a variety of computer programming projects it needs accomplished over the following year. If that firm hires a single programmer (who is a District resident) with an annual salary of $60,000, the business earns $3,000 of wage credits. Alternatively, if that firm hires three computer programmers (who are District residents) for four months each, and pays each $20,000, the business earns $9,000 of wage credits.

viii. Incentive to Shift to Part-Time Employees from Part-Time Independent Contractors

As a result of wage credit, businesses may want to reconsider their relationships with independent contractors. Wages paid to owners of a business (and their relative) do not qualify for the wage credit. This includes the earnings of self-employed individuals. Therefore, if an individual who currently performs services as an independent contractor became an employee, the payments to that individual would become wages qualified for the credit (as long the individual were employed for at least 90 days). This reconfiguration from independent contractor to temporary employee or part-time employee can be particularly lucrative to DC residents who currently have contracts with multiple firms in the DC enterprise zone. DC residents can generate more than $3,000 per year of wages credits by working for multiple employees as long as they earn more than $15,000 and they work a least 90 days for each employer.

Including in the definition of wages qualified for the credit are payments by the employer of an employee's undergraduate education expenses. And, for employees age 18 or under, the definition of qualified wages includes any amounts paid or incurred by an employer for any youth training program that the employer operates in conjunction with local education officials. This could be an important incentive for temporary employees, for part-time employees, and for full-time employees being paid wages less than $15,000 annually. Unfortunately, these employees in practice are least likely to attract employers' investment in education and training--particularly out-of-pocket expenses.⁽⁹⁾

There is no marginal incentive once the amount of wages paid in any year exceeds $15,000. Therefore, the credit provide little incentive for training full-time employees earning more than the minimum wage. Furthermore, because the credit favors low-wage over high-wage jobs, businesses may deliberately keep their operations "low tech" to accommodate workers with the least skills.

On the other hand, the $15,000 annual limit may have an indirect effect on employee training, particularly with regard to "soft skills," i.e., good work habits. Because the credit only applies to the first $15,000 in wages, it encourages entry-level employment that by its nature elicits more on-the-job training by employers. For example, instead of hiring an experienced salesperson for $40,000 (and get $3,000 of wage credits), a business could hire two inexperienced salespeople for $20,000 (and get $6,000) of wage credit. The amount of on-the-job experience and learning will be greater for the two younger recruits than it will be for a seasoned veteran.

In addition to the wage credit, Congress provided businesses in the District of Columbia three new incentives for investment. The first is the availability of $20,000 of additional expensing for purchases of machinery and equipment by small business located in the DC enterprise zone. The second is the availability of up to $15 million of tax-exempt bond financing of business facilities inside the DC enterprise zone. The third is a zero-percent rate on the gain from the sale of a business formed after 1997, located in the DC enterprise zone (including census tracts with 10 percent poverty), and owned by the investor for at least five years.

Before discussing the many important differences between these three capital incentives, it may be helpful as a point of reference to note how they are similar. In brief, for investments that qualify, each of the three capital incentives provide an exemption from federal income tax, or the equivalent of a tax exemption, on income from that investment:

Expensing. The acceleration of tax deduction in effect allows taxpayers to pay taxes late but without any interest charges for those late payments. The value of this interest-free loan is approximately equal in value to a tax exemption for the underlying investment.⁽¹⁰⁾ The effective tax rate on the investment is approximately equal to zero.

Tax-exempt bonds. Interest income paid on bonds used to finance qualified investments is exempt from federal income tax. The effective tax rate on the debt-financed portion of the underlying investment is zero.

Zero-percent capital gains. Capital gains from the sale of qualified DC enterprise zone investments are exempt from tax. If the income from business capital can be retained by its owners until it is sold (that is, not be paid out in interest or dividends), the effective tax rate on the underlying investment is zero.

The equivalency in the value of these incentives holds pretty well when the underlying investments earn a "normal" or average rate of return. As discussed below, when investment returns are uncertain or not "average," the equivalency breaks down. But as a first approximation, it is useful to recognize that these three tax incentives basically exempt income from qualified investments from tax. So per dollar of qualified investment, the incentive effects are similar. The major differences lie in the dollar amounts and types of investment that qualify.

There are many reasons to expect that the provision for additional expensing will not have any significant impact on capital investment in the District of Columbia. First of all, for the businesses that qualify, the value of the incentive is small. On a present value basis, if a business utilizes the full $20,000 of additional expensing available, the value is in the neighborhood of between $500 and $2,000 per year. Tables 2A and 2B each show an example of the value of expensing. In general, the value of the expensing is larger for firms with higher tax rates, with higher discount rates, and that make longer-lived investments. The only circumstances where the economic value of the credit conceivably could exceed $2,000 is where a business was extremely strapped for cash and was willing to pay usurious rates for, what is in effect, a $20,000 term loan from the federal government.

Table 2A The Value of Expensing, First Example Assumptions: Five-Year Property, Straight-Line Depreciation (With Half-Year Convention), Discount Rate = 12%, Rate of Return = 12%, Tax Rate = 15%

Table 2B The Value of Expensing, Second Example Assumptions: Seven-Year Property, Sum-of-the-Years-Digits Depreciation (With Half-Year Convention), Discount Rate = 12%, Rate of Return = 12%, Tax Rate = 15%

The second reason why expensing is likely to have limited impact on investment in the District of Columbia is that a firm must meet several other requirements in order to qualify.

First, like all the other income tax incentives, a business must be subject to tax for it to be of any value. Accordingly, governments and non-profit organizations located in the District generally do get any benefit from the availability of expensing. But also businesses that do not generate any taxable income because they are starting up, or because of a business downturn--do not get any immediate benefit.⁽¹¹⁾

Furthermore, expensing is only available to enterprise zone businesses operating in the District of Columbia. In order to be an enterprise zone business in District of Columbia, an entity must conduct most of its business inside census tracts in the District with more than 20 percent poverty.

Also, additional expensing available in enterprise zones only provides benefits to businesses that are not too small and not too large. As discussed in more detail in Appendix D, expensing is already available inside and outside of empowerment zones for the first the $18,000 of investment in qualified equipment. (This amount will be $18,500 in 1998 and gradually increase to $25,000 by the year 2003.) Because firm with less than $18,000 of qualified investment are already fully eligible for expensing, they get not additional benefit from the 1997 legislation. Expensing is phased out for firm larger firms with more than $200,000 of qualified investment. The additional benefits of empowerment zone expensing start to phase out at investment levels exceeding $200,000. In summary, only mid-sized firms get any additional benefit from the new expensing provisions for District of Columbia. Businesses with qualified investment in any year below $18,500 or above $288,000 get no benefit at all.

The final reason to expect that additional expensing will have little positive impact on investment in the District is that the incentive is designed in such a way that it does not play a major role in investment decisions. For example, a firm that currently invests $50,000 each year in equipment will qualify for additional expensing, but expensing is not likely to have any impact on marginal investment decisions. For example, suppose this firm is trying to determine whether it should increase its investment from $50,00 to $150,000.⁽¹²⁾

Because increasing investment does not increase the amount that can be expensed, the credit provides no marginal incentive. The business earns the credit, but the credit has not affected its decision to invest.

In summary, the availability of additional expensing in the District of Columbia enterprise zone provides limited tax benefits. It is unlikely to have any significant impact on business investment in the District of Columbia. Nevertheless, because the benefit has an annual value of approximately $1,000 in each of the next five years, a large number of business owners will qualify.

The only aspect of expensing that is more generous than the other two new investment incentives for the District is that there are no restrictions on how the investment is financed. Investment qualified for additional expensing may use either debt or equity. In contrast, tax-exempt bond financing can only benefit investment projects with debt-financed projects while the zero-percent capital gains rate is only available to equity-financed projects.

The second new capital incentive available in the District of Columbia is the expanded availability of tax-exempt financing for business property in areas of the District with poverty rates of 20 percent or more. These new bonds may be issued during the five-year period beginning after December 31, 1997. No business in the District of Columbia may have more than $15 million of these bonds outstanding at any one time.⁽¹³⁾

A qualified zone facility is any tangible property (including buildings and their structural components) and any land which is functionally related and subordinate to such property. In order to be eligible, the property must be used in the active conduct of an enterprise zone business and this business must be the principal user of the property. (Bond proceeds may not used for real estate speculation.) For a business that can obtain this financing, the benefits can be substantial.

Example: Distribution center.--A business decides to build a new warehouse and distribution center in the DC enterprise zone at a cost of $10 million. The business decides to use 25 percent equity and 75 percent debt to finance the project. The District government allocates some of its private activity volume cap to this business so it may issue $7.5 million in bonds with a 15 year maturity. With the tax-exemption, the business is able to obtain financing with a rate of interest of 6.5 percent instead of the 9 percent rate that otherwise would have been available. This saves the business $187,500 per year for the entire 15-year life of the loan.

It is not necessary for enterprise zone facility property to be owned by the DC enterprise zone business to qualify for tax-exempt financing. The only requirement is that the property is used by enterprise zone businesses. Therefore, the property can be leased to enterprise zone businesses and still qualify for tax-exempt financing.

Unlike business stock eligible for the zero-percent capital gains (discussed below), tax-exempt financing for enterprise zone business cannot be used to finance business start-up costs, inventories, or the development of intangibles (e.g. through research, though advertising, or through training of employees). This excludes from eligibility a lot of the capital needs of the service sector in the District of Columbia.

From a District-wide perspective, the authority to issue enterprise zone facility bonds may be of limited benefit. Under current law, the District of Columbia may issue no more than $150 million in private activity bonds annually. In addition to enterprise zone facility bonds, private activity bonds include:

(1) exempt facility bonds, used to finance airports, docks and wharves, mass transportation, water works, sewage facilities, solid waste disposal facilities, residential rental projects, electric and gas facilities, heating and cooling facilities, hazardous waste facilities, and high speed intercity rail facilities;

(2) mortgage revenue bonds;

(3) veteran's mortgage bonds;

(4) small issue bonds;

(5) student loan bonds;

(6) redevelopment bonds; and

(7) tax-exempt organization bonds ("501(c)(3) bonds").

All of the types of bonds can help promote economic development in the District. If--because the volume cap is binding--less of these bonds are issued when enterprise facility bonds are issued, the overall positive impact for the District is limited.⁽¹⁴⁾

In general, however, the District of Columbia does not utilize all of its authority to issue tax exempt bonds so it is likely more private activity bonds will be issued in the District of Columbia as a result of the new federal law.

From a business's point of view, tax-exempt financing is an excellent incentive if qualifications can be met and if the authority exists under the private activity volume cap. Unlike the capital gains incentive (discussed below), existing business are eligible. However, unlike expensing or tax-free capital gains, there is a lot more involved than filing the appropriate tax returns at the end of the year. The business must undertake an extensive application process with no guarantee of success. Moreover, as discussed above in more detail in Appendix D, the business must remain qualified for a significant portion of the life of the bond.

In summary, for an existing business contemplating an expansion into the DC enterprise zone, enterprise facility bonds are an attractive alternative--if the financing can be obtained. The financing is only available through the District government which is subject to a $150 million cap on its issuance of private activity bonds.

Like enterprise zone facility bonds, the zero-percent rate on capital gains is a substantial incentive for investment in the DC enterprise zone. The good news for investors is that unlike tax-exempt bond financing, it does not require the approval of a government body and there are no dollar limitations. The bad news is that existing businesses are not eligible.

As noted above, if an investment has an average rate of return, the zero-percent capital gains rate is like expensing or tax-exempt financing in that income from the investment is totally tax-free (or equivalent to being totally tax-free). When an investment has an above-average rate of return, however, an exemption from capital gains tax is superior to the other two investment incentives available in the DC enterprise zone. If an investment has above-average profitability, only the normal return on the asset is tax-free when cost of that investment is expensed. Similarly, with tax-exempt bonds, the investment is tax-free only to the extent of the stated rate of return on the bonds. In contrast, all capital gain of qualified assets is exempt from tax irrespective of the rate of return. Therefore, the greater the profitability of the investment, the greater the value of the tax-free capital gains relative to the other two capital incentives available in the DC enterprise zone.

In addition to lack of limits on the rate of return exempt from income, there are no dollar limitations on the size of the investment. The availability of expensing is limited to $20,000 of investment per year. Tax-exempt bond financing is limited to $15 million of bonds outstanding at any time. An investor could invest a billion dollars or more in a business in the DC enterprise zone and be exempt from all capital gains tax on that investment.

For a business's stock to qualify for the zero-percent capital gains rate, it must generate at least 80 percent of its gross receipts from business conducted in DC census tracts with greater than a poverty rate of 10 percent. This rule is both less restrictive and more restrictive than the rules that apply to the two other new investment incentives. It is more restrictive because the other incentives generally only require 50 percent of gross receipts be generated in the qualifying area. But it is less restrictive because the area that qualifies is much larger and generally more attractive than census tracts with 20 percent poverty. On net, because the geographic area is significantly expanded in terms of both size and desirability of location, the capital gains incentive is probably the least geographically restrictive of the three capital incentives. For example, investors that are considering constructing a new hotel in the District of Columbia are probably not significantly affected by the increase in the gross receipts test from 50 to 80 percent. But the expansion of the eligible geographic area from census tracts with more than 20 percent poverty to census tracts with more than 10 percent poverty probably more than doubles the list of potential sites.

In most respects, the definition of qualified investment is broader for enterprise zone capital gains than is expensing or exempt-bond financing. Expensing is only available for investment in new equipment. Tax-exempt financing is only available for equipment, new buildings, and renovated buildings, and for land functionally related to these buildings. Tax-free capital gain is available upon the sale of all of these assets but also upon the sale of ownership interests in certain corporations and partnerships. (In addition, the definition of substantially renovated property is much less restrictive.) If a business operates in the zone as a corporation or partnership, that corporation and partnership has wide discretion on how to invest it funds and still qualify for the zero capital gains rate. It can invest in both old and new buildings as well as equipment and land as long as it is related to the active conduct of a trade or business. Moreover, the corporation or partnership may also invest in the purchase and development of intangible assets as well (as long as they are related to the trade or business). For example, capital gains from investment in the form of expenditures on salaries for research and development (e.g., to develop a patent) or of advertising expenditures (e.g., to get recognition of brand name) qualify. Any return on these investments realized on the sale of stock or partnership interest would be exempt from tax.

If earnings of a corporation are distributed, tax must be paid on the full amount of the dividend at the shareholder's tax rate. For upper-income taxpayers, these rates are 28, 36, and 39.6 percent. In the new DC enterprise zone, earnings realized upon the gain from sale of stock from an a qualified business will pay a zero percent rate. This creates a large incentive to retain earnings. A business that distributes all of its income may realize little or no benefit from the lower capital gains rate.

Firms that generate most of their value from the services of a few key individuals who are also owners of the firm are not good candidates for the new DC zero percent capital gains rate. This is because such a service firm has little to sell when its owners leave. (In addition, because these firms generally must provide current income for their owner-entrepreneurs, much of the income of the firm must be paid out in wages and dividends. This can significantly diminish the opportunity for capital gain income brought about by reinvestment of profits into the business.) Firms that can develop intangibles--such as brand names, customer lists, patents, customized software, or even a loyal and well-trained work force (so-called "workforce in place")--have assets that can be sold at the end of the owners tenure that can generate tax-free capital gain.

The new law requires that 80 percent of the gross receipts must be derived in the expanded DC enterprise zone redefined to include all census tracts with at least 10 percent poverty. Also, a substantial portion of the assets of the business and a substantial portion of the services performed in census tracts in the District with at least a 10-percent poverty rate. As discussed previously, it is unclear exactly what is meant by a "substantial portion." This uncertainty in and of itself poses potential risk to investors whose companies operate inside and outside the zone.

But even in the case of a business where there is no question as to its current qualification as a business whose stock is eligible for the rate, there may be tremendous uncertainties as to qualification in the future. Suppose a new business is indeed successful, the requirement that the business remain largely within the areas of the District with rates of 10 percent or more may be like an economic straight jacket.

Example: Demand side risk.--A District of Columbia enterprise zone business develops a new type of solar cell that works particularly well in cold climates. Because there are lots of solar cells that work well in warm climates, this new solar cell is only economically viable in regions considerably north of the District of Columbia. This business may need to set up substantial operations outside of the District of Columbia to stay in business. If this occurs within five years after the stock is initially offered, the stock of this business may completely lose its eligibility for a zero percent capital gains rate.

Example: Supply-side risk.--A data management firm qualifies as a business whose stock (issued in 1998) is eligible for the DC enterprise zone zero capital gains rate. Because economic development efforts in the District (and throughout the surrounding region) have been successful, it has become increasingly difficult to hire experienced computer programmers. Suppose also that an opportunity arises in 2001 for the DC firm to acquire another business in Prince George's County whose workforce in place can relieve the DC firm's shortage of computer programmers. This strategic acquisition solution may disqualify its stock from eligibility for the zero percent capital gains rate.

Any individual contemplating the purchase of stock in a DC business intending to realize tax-free capital gains has to take into account tax risks like these. Because the stock must be held for at least five years, it is extremely difficult for investors to forecast if it will make sense to stay in the qualified areas of the District for the entire holding period. If the investor is not the majority shareholder, investors may not even have control over the business decisions that could eliminate eligibility for the zero-percent capital gains rate. One thing is clear, however: if the fondest hopes of the investors are realized and the business does become large and successful, it will become extremely awkward to keep the business contained in the District in such a manner that retains eligibility for the zero-percent rate.

If after five years, the stock becomes disqualified, the gain accumulated through the date of disqualification remains tax free (and any subsequent gain is subject to the normal capital gains rate--generally, 20 percent). This means that in practice any particularly successful DC business that grows out of the zone only has a partial exemption from capital gains--and the greater its growth, the smaller the tax benefit.

The statutory rules restrict the type of assets eligible for the new zero percent rate on DC capital gain: Gain from the sale of land does not qualify unless the land is used in the conduct of an active trade or business. Gain from the sale of businesses existing before the existence of the DC zone does not qualify. But economics as well as legal statutes can effectively restrict the types of investment that are likely to benefit from the capital gains rate. For example, if a sole proprietor (who is not a dealer in used equipment) invests in equipment and uses it in his business for more than five years, he may be eligible under the law for a zero rate on a portion of capital gain resulting from that sale. But this is a trivial benefit because no business has much prospect of reselling their own obsolescent equipment with any significant capital gain.

There are many other circumstances where the availability of a zero-percent capital gains rate is not particularly helpful even for businesses that qualify. For example, suppose an individual establishes a retail food store in a census tract in the District which has a poverty rate of 10 percent or more. Assuming the business is not disqualified for selling alcohol for consumption off-premises, this business may be eligible for the zero percent capital gains rate. Typically, most income generated by "mom-and-pop" business must be distributed to the owners (in the form of either wages or dividends) to meet the owners current living expenses. This income is fully taxable at the owner's tax rate. If earnings are not reinvested in the business, the opportunities for growth (and large capital gains) are diminished. If the owner wishes to sell before the end of the five-year holding period, there is no preferential capital gain rate. If the owner intended to retain the business until death, the zero-percent capital gains rate provides no additional benefit because under current law ownership can be transferred to an heir without any income tax on gains accruing during the owner's lifetime. (With or without a zero-percent capital gains rate, this business still may be subject to estate tax under current law or the new law.)

Another type of business where the zero-percent gains rate is not particularly useful is a small service business where the skills, experience, and business contacts of the owners are the firm's primary asset (e.g. a small law or consulting firm). When this owner wishes to end this line of work (whether for retirement or to join with another firm), there is little left to sell that can generate a capital gain.

In addition to small firms, large firms may not get much benefit from a zero-percent rate either. For example, if a group of venture capitalists were to invest in an entirely new technology in the hope of establishing the next Microsoft, the DC enterprise zone would not be an attractive alternative because the likelihood of obtaining 80 percent of gross receipts from its DC operations may be practically impossible. Violation of this 80-percent rule during the first five years eliminates the availability of the zero-percent rate on any gain. Even after five-years, violation of the rule may still severely limit the portion of any gain eligible for the preferential rate.

The type of businesses that are likely to get the most out of the zero-percent DC capital gains rate are new business start-ups that are neither too large or too small. Investors in these businesses should not be risk averse, should not require current dividends, and can hold their stock for more than five years. This profile would suggest venture capital funds or wealthy individuals are the types of investors most likely for the DC zero percent rate. Also, the business should be one that can grow without being hampered by remaining in relatively tight geographic constraints. If it is a technology firm, it will need to be able to draw a steady supply of high-skilled labor into the DC census tracts with less than 10 percent poverty.

If a business by its nature provides services in a number of locations, there may be difficulty generating 80 percent of gross receipts entirely inside the 10-percent poverty areas of the District. But if the services can be provided readily at single locations or in small geographic areas (e.g., a hotel, a restaurant, guided tour business) the ability to retain eligibility for the zero percent rate is simpler. In the case of manufacturing, a business is more likely to be eligible for the zero-percent rate if production is in the DC zone and the firm can then readily "export" outside of the zone.

Taxpayers who have not recently owned a home in the District of Columbia may be eligible for a tax credit of up to $5,000 of the amount of the purchase price a principal residence in the District of Columbia . Households with high incomes receive reduced credits or no credits at all. For single individuals, the credit is reduced by 25 cents for each dollar than adjusted gross income exceeds $70,000. Therefore, no credit is available for single individuals with incomes in excess of $90,000. For married couples, the credit is reduced by 25 cents for each dollar than adjusted gross income exceeds $110,000. Therefore, no credit is available for married couples with incomes in excess of $130,000. The credit is available for home purchases after August 5, 1997 and before January 1, 2001. Any credit not used because the taxpayer has insufficient tax liability in the year of purchase may carried forward excess credit and use it to reduce income tax in any following year.

The credit is not refundable and it is only creditable against federal income tax. If an individual or family does not have sufficient income to owe any federal income tax, the availability of the homebuyer credit does not provide any benefit. Under current law, a family of four with approximately $25,000 of adjusted gross income does not have any income tax liability. At the other end of the income scale, the credit does not provide any benefit to high-income households above the phase-out ranges. The adjusted gross income phase out range is between $110,000 and $130,000 for married couples and between $70,000 and $90,000 for single individuals. So, the first-time homebuyer credit is a tax cut targeted to the middle class.

Even among middle class taxpayers, however, the benefits of the credit may be less generous than the $5,000 may at first appear. For lower-middle class families--particularly those eligible for the new $500 per child tax credit--relatively low tax liability makes the credit hard to absorb. For example, a family of four earning $40,000 would need at least three years to generate sufficient federal income tax liability to fully utilize the credit. Because of the time value of money, deferred tax credits are less valuable than credits that can be used immediately.

For middle-class families with higher incomes--again, particularly those eligible for child credits--the minimum tax can become a problem. The homebuyer credit is not creditable against the minimum tax.⁽¹⁵⁾ Because minimum tax credits may be carried forward indefinitely, and because the credit is a one-time credit, the presence of the minimum tax usually means just a delay in receiving a credit rather than its outright denial. But as in the case of low-income taxpayers with little or no tax liability, the carryforward of tax credits to years when regular tax liability is larger than minimum tax liability means a reduction in the value of tax credits. So, in conclusion, even for the middle class for whom it is targeted, the homebuyer credit's benefit may be less than advertised. The delay in up-front benefits from the credit may be particularly significant to cash-strapped home buyers that have greatly reduced liquidity in their efforts to make a down payment.

Because the value of the homebuyer credit does not vary with the size of the home purchased, it provides a relatively larger incentive for homes that are less expensive. This is illustrated in Figure 4. For a $50,000 one-room condominium, a $5,000 homebuyer credit is 10 percent of the purchase price. For a modest $200,000 home in a middle class neighborhood, a $5,000 homebuyer credit is only 2.5 percent of the purchase price. For this reason, and for reasons mentioned in the preceding paragraph concerning income levels of home buyers, the credit will probably have the most impact on homes typically purchased by lower-middle class home buyers.

If the supply of middle-income housing is fixed, there is every reason to expect a rise in the property value of middle class homes by amount equal to some significant fraction of $5,000. For this to occur, there would have to be a rise in demand. If renters in large numbers leave their apartments for owner-occupied housing, and there is no conversion of rental units to owner-occupied units, housing prices will increase while rents decline. If there is an influx of population into the District as a result of the homebuyer credit, it is likely that both housing prices and rents will increase. In any case, however, it seems unlikely than increases in housing prices or rents will be enough to significantly affect prices. The most that a $100,000 unit could increase in price would be five percent and--because not all buyers are eligible, because those that are may get less than $5,000 in value from the credit, and because supply is probably not fixed--the increase in the housing price will probably be significantly less. Similarly, an apartment that rents for $800 dollar a month is not likely to have a rent increase of more than $40 as a result of the credit. It will probably be significantly less. And, as noted, it is conceivable that rents could even decline as a result of the homebuyer credit.

There are several reasons to expect the credit to have minimal impact on the market for expensive homes. First, as a percentage of the purchase price, a $5,000 home credit is smaller for these higher priced homes. For a $400,000 home, a $5,000 homebuyer credit is only 1.2 percent of the purchase price. Moreover, most purchasers of these large homes also have large incomes and would not qualify in any case. Well-off retirees might have incomes low enough to qualify, but these individuals generally do not need or want large homes. (They are more likely to use the credit for high-priced condominiums.) It also important to note that current District homeowners who wish to move into larger and more expensive homes do not qualify for the credit because they are not first-time District homeowners.

The first-time homebuyer credit is an incentive that may attract new homeowners into the District. It is worth noting, however, that the first time homebuyer credit provide no incentive for to retaining current District homeowners in the District. Also, there may be some potential for the homebuyer credit to encourage gentrification. The credit does not provide any incentive for renters or for low-income homeowners without taxable income to remain in their neighborhoods. The credit does, however, provide a lot of incentive for middle-income families to purchase inexpensive housing.

Under current law, there is considerable controversy as to whether expenses incurred to clean up contaminated sites may be deducted against federal income tax. The reasoning for not allowing the deductions is that clean-up expenses are permanent improvements to land. Improving land is equivalent to purchasing land, and the purchases of land does not in and of itself justify any sort of tax deduction. Moreover, because land generally does not decline in value in any predictable way, there is no justification for allowing deductions for depreciation.

There is an alternative view, however. Current deductions for environmental clean-up expenses may be justified if, for example, a site became contaminated after it was purchased by its current owner, the environmental clean-up expenses are more like maintenance expenditures than capital improvements: the owner is incurring them to maintain the value of property. In this case, deductions might be justified even though they are clearly capital in nature because the owner never realized losses on the decline in property value that resulted from the contamination.

A 1994 IRS ruling (Revenue Ruling 94-38) does allow--under certain conditions--current deduction of environmental clean-up expenses for businesses whose property was contaminated while the business owned the property. As a result of this ruling, the major benefit of the new law is provided to remediation expenses incurred by businesses that acquired the property in its contaminated state (i.e., the business did not contaminate the site itself). In this case, for a large corporation paying the 35 percent corporate tax rate, the availability of expensing in the zone can reduces the after-tax cost by 35 cents on the dollar. As is always the case for tax incentives provided in the form of deductions, the incentive effect will be less for businesses that have lower tax rates or that do not have current tax liability.

There are no dollar limitations on the amount of property that any one business may expense. So, for example, if a large corporation with lots of tax liability spends $50 million to clean up a hazardous waste site in the DC enterprise zone, that corporation's taxes will be reduced by $17.5 million in the current year. Under the right circumstances, the availability of expensing can provide provides a significant incentive for private business to clean-up their contaminated sites in the DC enterprise zone.

Because this tax incentive is not available uniformly throughout the country, but only in certain targeted areas (including the DC enterprise zone), large corporations with numerous contaminated sites may give priority to sites in the DC enterprise zone and other designated areas. In addition, the pace of environmental clean-ups in the District may be accelerated because expensing for environmental clean costs in the DC enterprise zone will expire at the end of the year 2000.

F. Work Opportunity Tax Credit for Youths Residing in the DC Enterprise Zone

The Taxpayer Relief Act of 1997 modified the structure of the work opportunity tax credit (WOTC) and extended it through the first half of 1998. Under the new credit structure, the credit rate is 25 percent for employment of less than 400 hours of employment and 40 percent for employment of 400 or more hours.

The WOTC is only available for employees who are members of certain targeted groups. Among the targeted groups eligible for the credit are high-risk-youths and qualified summer youth employees. A high-risk youth is an individual certified as being at least 18 but not yet 25 on the hiring date and as having a principal place of abode within an empowerment zone or enterprise community. Qualified summer youth employees are individuals: (1) who perform services during any 90-day period between May 1 and September 15, (2) who are certified by the designated local agency as being 16 or 17 years of age on the hiring date, (3) who have not been an employee of that employer before, and (4) who are certified by the designated local agency as having a principal place of abode within an empowerment zone or enterprise community. Because the DC enterprise is an empowerment zone, qualified summer youth employees and high-risk youth employees residing in the DC zone qualify for the WOTC through the first half of 1998 when the credit is scheduled to expire.

There are several aspects of the WOTC there are worth noting. First of all, if an employee is eligible for both, an employer of part-time employees will generally want to claim the WOTC than the empowerment zone wage credit. For wages paid to full-time employees, the empowerment zone wage credit is generally more favorable. This is illustrated in Figure 5.

Secondly, as long as the high-risk youth resides in the DC enterprise zone, the employer of that youth is eligible for the credit irrespective of where the services are performed. The service may be performed anywhere inside or outside the District of Columbia.

Finally, it must be noted that George Washington University, Howard University, and Georgetown University--and the areas immediately surrounding them--are all part of the District of Columbia enterprise zone. Ironically, students at these schools qualify as "high-risk youth" whose wages are eligible for the work opportunity tax credit. As a result, employers will have a large incentive to hire these students part-time or over the summer. A student who works for $6.50 per hour for 23 weeks full time or for 50 weeks half-time generates approximately $2,000 of tax credits. This is the same incentive available to 18 through 24-year old youths in impoverished areas of southeast DC. This incentive is not available to many poor youths residing in the District but not inside DC enterprise zone.

I-1. This estimate does not include the tax benefits of allowing immediate write-off of environmental remediation expenses (the so-called "brownfields" initiative) or the temporary extension of the work opportunity tax credit. These benefits are available in many areas of the United States in addition to the District of Columbia and no separate estimates for this provision's impact on the District of Columbia are available.

I-2. Census tracts are small, relatively permanent statistical subdivisions of a county. Census tracts are delineated for all metropolitan areas and other densely populated counties. The District of Columbia is covered entirely by census tracts. Census tracts usually have between 2,500 and 8,000 persons and, when first delineated, are designed to be homogeneous with respect to population characteristics, economic status, and living conditions. Census tracts do not cross the District's borders. The spatial size of census tracts varies widely depending on population density. Census tract boundaries are delineated with the intention of being maintained over a long time so that statistical comparisons can be made from census to census. However, physical changes in street patterns caused by highway construction, new development, etc., may require occasional revisions; census tracts occasionally are split due to large population growth, or combined as a result of substantial population decline.

I-3. In addition, the wages of a resident of any part of the District can generate employer tax credits for their employers if the resident performs most of his or her service in the poorest parts of the District.

I-4. The poverty rate of an area is the number of area residents living in households with income below the poverty level divided by the total number of area residents. Census data for 1990 indicate that of 570,826 residents of the District of Columbia 96,278 were living in poverty. Thus, the District had a poverty rate of 17.2 percent in 1990.

II-1. Stephen T. Mark, Therese J. McGuire, and Leslie E. Papke (1997), "What Do We Know About The Effect Of Taxes On Economic Development: Lessons For The District Of Columbia," State Tax Notes, August 25.

II-2. Fisher, Peter S. and Alan H. Peters. (1997). "Tax and Spending Incentives and Enterprise Zones." State Tax Notes, June 30, p. 1959-1964.

II-3. As discussed in the previous chapter, employers receiving in the wage credit must reduce their deductions against federal income tax by the amount of the credit. So, if a corporation is paying a marginal rate of corporate income tax of 35 percent, the net reduction in tax from the credit is not $3,000 but $1,950 (that is $3,000 less 35 percent of $3,000). So in pre-tax dollars the value of the credit is $3,000 but in after-tax dollars the value of the credit is $1,950. This report describes the credit as a "$3,000 credit" because in day-to-day commerce figures (e.g. salaries, profits) are usually discussed in terms of pre-tax values.

II-4. In other words, the total rental cost per employee is $4,625. The $3,000 of tax credit is 65 percent increase in value per DC resident. (Only 75 percent of the employees were DC residents in the example.)

II-5. As another example, consider a firm with 100 employees that rents 22,000 square feet of prime office space at $32 per square foot. If 50 percent of the employees are DC residents, the business will generate $150,000 of tax credits--on average $1500 per employee. The value of the tax credit is equal to 21 percent of the rental cost. If the value of the tax benefits were shared equally by the lessor and lessee, the rent of that property would rise by more than 10 percent.

II-6. The attraction of criminal activities as an alternative to legitimate work for residents of inner city neighborhoods is discussed in William Julius Wilson (1997), When Work Disappears: The World of the New Urban Poor, Vintage Books.

II-7. The District of Columbia government does, however, incur substantial federal social security and unemployment taxes on the wages it pays to its employees.

II-8. A not-for-profit organization that engages in business that is not related to the exempt purpose of that organization must pay corporation income tax on what is known as "unrelated business income" ("UBI"). Tax exempt organizations that have UBI could benefit from tax benefits available to corporations.

II-10. For the equivalency to hold, the underlying investment has the same rate of return as the investor's borrowing rate. In general, this is the case, but--as discussed below--there are important exceptions.

II-11. A business that did not have current taxable income would receive some benefit from expensing if it were to become taxable in later years. But these benefits are small. For example, a business that invests in $20,000 of equipment with a five-year depreciable life and that did not become profitable until three years after that property was placed in service would get a tax benefit with only one-eighth the value of what it would be if the business were always full taxable. In this case the value of the credit could be less than $100 for the $20,000 of investment.

II-12. Ironically, the availability of expensing can be a disincentive for increasing investment. For example, suppose a firm is considering expanding its qualified investment from $200,000 to $250,000. Because $200,000 is the beginning of the phase-out range, this firm would lose tax benefits if increased investment.

II-13. Businesses are also subject to an overall enterprise zone volume cap of $20 million. So, for example, if a national chain already had $12 million of enterprise zone bonds outstanding relating to investments in other empowerment zones and enterprise communities, that business would only be eligible for $8 million of enterprise zone facility bonds in the District of Columbia. (In general, businesses are subject to a $3 million per zone limitation. The $15 million of exempt financing available to each business in the DC enterprise zone is an exception to that rule.)

II-14. One reason why the new enterprise facility bonds may be of little value to the District is that many type of facilities that might qualify as enterprise zone facilities can be financed under existing rules. In particular, small issues bonds provide assistance to private businesses seeking financing, but the amount of financing was limited to $10,000,000 per business (as opposed to $15 million for enterprise facility bonds) and many types of nonmanufacturing businesses were not eligible. The proceeds of qualified redevelopment bonds can be used for local governments' acquisition and rehabilitation in "blighted areas" (but cannot be used for new construction). The ability to issue exempt facility bonds does, however, give the District more versatility in its choice of private activity bond financing.

II-15. Some families--like those with a number of children and who use the dependent care credit--may find themselves on the minimum tax for many years or even permanently

D.C.: A Capitalist City? Martin A. Sullivan October 1997

PART II. ECONOMIC IMPACTS OF THE TAX INCENTIVES

D.C.: A Capitalist City?
Martin A. Sullivan
October 1997