Tax Increment Financing: Financial Gaps and Bottoms Lines
Given the limited financial resources and tools available to municipalities, tax increment financing (“TIF”) is about the only meaningful tool available to finance larger infrastructure projects, and to incentivize private development activity. This post discusses a number of questions that need to be addressed when a municipality is deciding to support a development with TIF.
First, what is the municipality paying for? The least controversial projects involve the use of TIF to finance public infrastructure. Public infrastructure is the foundation for economic capacity. While public infrastructure may benefit a particular private development, it is a public asset, and frequently benefits the broader community. Public infrastructure can also be difficult or impossible for a developer to finance privately. That is not to say developers should never pay for public improvements. There are many projects where public improvements are needed primarily to serve the development, and where the private sector should bear the cost.
Using TIF money to finance private work is a more controversial and challenging proposition. This type of project requires what is sometimes called a “gap analysis.” A gap analysis examines whether there is a “gap” between what the private sector should be willing to pay to complete a project, and what the project will actually cost to complete. If there is a financial gap, then TIF can be used to fill that gap.
A gap analysis is a complex financial exercise, and should be performed by a qualified financial consultant with relevant experience. The municipality should question and examine the assumptions that are being used to justify the request for TIF. For example, if the land cost is high, it is worth asking whether the developer is paying too much. Is TIF creating an artificially inflated cost for the parcel? If there is expensive demolition and remediation work that needs to be done on the land, has the land cost been discounted adequately to reflect those costs?
Another assumption worth questioning is the developer’s return on investment. A gap analysis should show what rate of return the developer will earn on its investment, with and without TIF. Real estate development projects tend to be viewed as higher risk investments that demand a correspondingly higher rate of return. What rate of return is reasonable, given the nature of the project, the location and relative risk of the project, and the infusion of public support? These issues should be carefully considered, and a “reasonable” rate of return should be negotiated.
What will the municipality get in return for its investment? Answering this question is more challenging than one might think. People often point to increased tax base and therefore increased tax revenue. However, in TIF projects the increased tax base is often dedicated to funding project costs for many years. The technically correct response to this problem is that without the use of TIF, the project wouldn’t happen, and so the municipality isn’t giving up anything. It can be very difficult, however, to prove this fact, and to convince a skeptical audience that it is true.
Finally, it is generally assumed that after the project is paid for, the municipality and other taxing jurisdictions will benefit from the increased tax base. However, even this proposition is challenging to demonstrate, and may not be entirely correct. There is a complex interplay between local property tax revenues one the one hand, and state shared revenue and equalization aid programs on the other. I have seen some argue that as the tax base increases, shared revenue and equalization aids decrease, thereby diminishing the benefit of the expanded tax base to the municipality and the school district. I have worked on numerous TIF projects in my career, and I have never seen a rigorous analysis of this issue.
Because it is so difficult to show a direct benefit to taxpayers, TIF projects are generally undertaken for other reasons. One major reason is that TIF is sometimes the only viable option to finance public improvements the community believes are needed in the community. Other reasons generally relate to a decision that the project itself will provide things that are valuable to the community, such as housing (including affordable housing), job opportunities, businesses that meet community needs, and redevelopment of obsolete properties.
In conclusion, TIF is a powerful and frequently controversial economic development tool. When considering TIF, municipalities should question the assumptions, decide what the community is really gaining, and negotiate effectively to achieve a reasonable agreement.
This article originally appeared in the League of Wisconsin Munipalities' publication The Municipality.
