Bear Left!

Bad Credit
Tim Francis-Wright

State legislators love targeted tax credits because they supposedly reward specific behavior with specific rewards. Some of these tax credits are dubious in and of themselves, but many of them fail a more important test. State tax credits aimed at corporations, even tax credits that reward the best of all good behaviors, have a fatal flaw. They are worth substantially less to the corporations than they cost the governments that issue them.

I will use two types of tax credits as illustrations of this phenomenon, because I work with them constantly. My regular job generally involves federal tax credits for developing affordable housing and rehabilitating historic buildings. Investors make capital contributions to partnerships in exchange for most of the tax credits that these activities generate. Because they can use the deductions for depreciation and interest associated with rental real estate, most of these investors are publicly-traded corporations.

Both of these federal credits are quite efficient; in other words, the capital raised as a result of the credits is quite close to the cost to the government of those tax credits. The historic tax credit often generates between 85 and 92 cents of capital per dollar of credit. For a credit that is earned as soon as a building is ready for occupancy, that ratio is on its face not too good. However, the depreciation on such a building is then calculated on the cost of the rehabilitation less the amount of the credit, so every dollar of credit arguably costs the federal government less than one dollar.

The low-income housing tax credit is earned over a ten-year period that starts when low-income tenants first rent units in qualified buildings. Because owners of qualified buildings claim the credit over a ten-year period, the capital per dollar of credit is lower than for the historic credit, often in the range of 76 to 83 cents. But the ten-year period means that the present-day cost to the government is lower, too. A ten-year stream of low-income housing tax credits costs the federal government 100 cents per dollar this year, but only 70 cents per dollar for the tenth year of credits, assuming a discount rate of 4% per year. The average cost of the credits is about 85 cents per dollar, very close to the actual price that the tax credit market assigns to them.

A host of states have added their own tax credits onto the federal tax credits for historic rehabilitation and low-income housing. At first glance, state tax credit programs have lots of merit. They use existing state resources, notably the state offices that already implement the federal low-income housing tax credit and work with the National Park Service on the federal historic credit. They reward activities that have clear benefits to societies. And they use a proven model of turning state expenditures into private investment. But with one exception, states have not found that the market for state tax credits is very efficient at all.

The first problem that states have is that state taxes represent federal deductions to many taxpayers. Individuals who itemize deductions on their federal taxes can include state income taxes as a deduction, so any reduction in state taxes results in a corresponding, albeit smaller, increase in federal taxes. A taxpayer in the 27% federal tax bracket who receives a $100 state tax credit will have $100 less in federal deductions and a $27 higher federal tax bill, so the net effect of the $100 credit is a $73 savings. Many individual taxpayers do not, of course, itemize deductions on their federal income tax returns, so some state tax credits avoid this pitfall. For example, several states supplement the federal earned income tax credit for low-income wage-earners with earned income tax credits of their own. Because these low-income taxpayers very rarely itemize deductions, almost every dollar spent by states on this type of tax credit results in a dollar of actual tax savings.

Most large corporations pay federal income taxes at an effective rate of 35%, and are able to deduct state income taxes from their net income. Any state tax credits that they receive decrease their deductions for state taxes, increase their federal taxable income, and therefore become worth only 65 cents per dollar. The cost to the state of these tax credits is, of course, still 100 cents per dollar.

A second problem affecting state tax credits is that in many states, paying state corporate income taxes can be a purely optional activity. A state like California taxes interstate corporations on a unitary basis, meaning that it calculates a corporation's taxes based on its overall activity in the state relative to its overall activities, either worldwide or domestically. But many states calculate taxes only on a corporation's activities in that state, and many corporations have taken advantage. Imagine a retailer called Agent Orange with stores across the country, all profitable. It sets up a Delaware limited liability company called Cartoon TLC, LLC, which charges each of its stores fees, which happen to approximate net profits, for the use of Agent Orange trademarks and service marks. Unless a store is in a unitary tax state, Agent Orange owes no state income taxes related to that store, because its net income is now nil. And if Agent Orange has set up its Delaware LLC correctly, it will not need to pay Delaware corporate income taxes on the royalty income because it lacks property, employees, or agents in Delaware.

A third problem with state tax credits for housing and historic rehabilitation is that two of the largest perennial investors do not pay state taxes at all, and many other investors do not pay significant taxes in every state. Both Fannie Mae and Freddie Mac put hundreds of millions of dollar per year into investments in federal tax credits for low-income housing and historic rehabilitation. But their status as quasi-governmental entities means that they are exempt from state income taxation altogether, so state governments are chasing a smaller pool of investors than the federal government is. Furthermore, many financial institutions, which represent a large segment of the market for the federal tax credits, lack substantial business in many states. Even large regional banks like Wells Fargo or Fleet lack enough of a nationwide presence to be large taxpayers in every state.

All three reasons contribute to the sorry state of the state tax credit programs for low-income housing and historic rehabilitation. State historic credit programs typically generate 50 to 55 cents per dollar of tax credit granted by states, for credits that cost the states a full dollar apiece. State low-income housing tax credit programs follow this lead. In Missouri and Georgia, the state low-income housing credit generates 20 to 25 cents per dollar of credit. In Massachusetts, it generates about 40 cents per dollar of credit. Each state forgoes the equivalent of about 85 cents of current revenue for each dollar of these tax credits. The exception to this rule is California, where state low-income housing tax credits that are earned over three to four years generate upwards of 75 cents per dollar of credit. In that state, a number of financial institutions have been willing to accept minimal returns on their tax credit investments in order to meet the terms of the Community Reinvestment Act and similar state laws.

States are not wrong to try to encourage investment in historic buildings or affordable housing. But they should be finding ways to make their expenditures in these areas more efficient. Making grants or low-interest loans requires determination on the part of state legislatures to keep the appropriate state departments adequately funded. Issuing tax credits requires only inertia on the part of the Ways and Means Committees. Tax credits may be trendy, but state legislators should consider whether they are wise.