Tax credits’ essential issues: Part 1, unique features
The week before Thanksgiving, I made a whirlwind trip to
In this I was joined by AHI affiliates Kecia Rust (of South Africa) and Marja Hoek-Smit (of Wharton), as well as South African housing expert Dan Smit and Soula Proxenos, formerly of Fannie Mae IHFS and now with Howard Housing Solutions.
My presentation focused on three main topics: benefits of tax credits as soft equity, particular design features of an investment tax credit, and the ecosystemic preconditions of successful tax credits.
1. Nifty (and unique?) features
Investment tax credits (the most crisp, transparent, and controllable form of soft equity) have several very nifty features. Some of them can be replicated by appropriated programs — with some tortuous effort.
1.1 Targeting can be replicated by appropriated programs, although the regulatory and administrative detail normally added in the rollout usually mean that mission goals get fuzzed more in appropriated programs than in tax credit ones.
1.2 Adaptability and competitive forces are features of regional/ state allocation, with multiple funding cycles. In theory, appropriated programs can replicate these - just devolve responsibility to state/ or local allocators. (HOME and CDBG, for instance, are block-granted and devolved.) Nevertheless, in countries that lack a thickly populated Federal-state-local ecosystem, devolution is likely to occur faster with a tax-expenditure (something foreign to existing delivery channels) than with ‘yet another’ appropriated program that incumbent administrators might see as ‘rightfully’ theirs.
1.3 Market forces. When a commodity is sold for up-front cash — as in future tax credits for sponsor development capital — there is a very healthy dynamic tension between investor and sponsor, from which government is a major beneficiary but for which government need not do anything.
Dynamic tension builds strong markets
In theory, performance-based grants can replicate this feature, but in practice they seldom do, because investment tax credits must be sold, whereas future performance-based grants can be borrowed against. This distinction sounds minor, but the underwriting and credit decisions of equity investment are vastly more intrusive than those for lending. Equity holders’ first-loss exposure means they tend to be much more active in asset management to protect their investment.
Still, these three features, more effectively expressed via soft equity than soft debt, are peripheral issues. Several core features of investment tax credits cannot be matched by appropriated programs no matter how hard they try.
1.4 Risk transfer. This is the clear differentiator. With tax-expenditure programs, government pays only after performance. The resulting capital-markets transaction (investors buy future tax credits for up-front cash) is entirely equity-based, not-debt based. As a result, if the property gets into construction or operating difficulties, government can sit back, fold its arms, and watch the investor do all the work of rescuing the property.
I merely watch you rescue the property
This self-protective mechanism is no mere theoretical construct; it is demonstrated by the single biggest statistic to leap out of the Low Income Housing Tax Credit’s twenty-year history — the minuscule foreclosure rate, fewer than 1 in 1,000, that the program has sustained.
1.5 Collectibility. Hand in hand with risk transfer is collectibility. If an appropriated program goes bad, the government must collect actual cash, usually by litigation or foreclosure of collateral. If a tax expenditure goes bad, the government recovers via the tax collector. When the investors are large institutions, as is the case in the
1.6 Transfer of administrative responsibility. With tax expenditures, owners self-certify and the government may conduct post-audit compliance. Tax credit programs thus encourage outcome versus process compliance — itself an innovation. Moreover, it’s very straightforward to impose the administrative burden directly onto the owner (through self-certification and review by an independent auditor), a feature that is difficult to impose effectively on a grant-based program.
Automaticity
A neologism of AHI’s invention, automaticity describes a resource’s predictability of receipt — the degree to which a sponsor designing a financial transaction can rely on the resource’s being delivered, on-time-on-budget, provided the sponsor performs as set forth in the program.
1.7 Automaticity. Markets like clear boundaries, up to whose edges they always approach with asymptotic precision. Fuzzy boundaries add unquantifiable risk, and when risk is hard to quantify, it is usually overestimated. Conversely, when boundaries are clear and future commitments reliable, sponsors become more risk-tolerant — and in affordable housing, the lower the perceived risk, the greater the property’s resulting affordability (because it lowers the profit/ risk margins required by sponsors and their capital sources).
As a future funding source, tax credits are nearly automatic: they turn into money when the taxpayer files a self-certified tax return (subject to post-audit compliance and clawback). That’s about as clean as it gets. Conversely, any appropriated program turns into money only upon an affirmative funding of cash by the applicable department.
In appropriated programs, somebody has to print the check
[Continued tomorrow in Part 2, design variables]
