Tax credits’ essential issues: Part 3, preconditions
Because of its unique features and design variables, investment tax credits are intellectually appealing.
Yes, I drool over their advantages
Before introducing them, a country needs to assess whether it has the essential preconditions for success:
3. Preconditions for successful introduction
As the most sophisticated form of money, soft equity requires the most complex and well developed ecosystem to reach its full potential.
A successful introduction depends on seven factors:
3.1 Focus. Tax credits are simply a financial stimulus, different in kind but not in impact from appropriated stimuli. Before launching a tax credit, government must know precisely what housing delivery problem it is seeking to solve.
A well designed program will hit only one of these.
3.2 Sponsors. As the great Yogi Berra said, “If people don’t wanna come to the ballpark, nobody’s gonna stop ‘em.” Sponsors are economic animals, constantly scanning for the most profitable, least risky use of their time.
If it sees money, it gets excited
As compared with conventional development, affordable housing is harder. Likewise, as compared with appropriated grants or loans, investment tax credits are intellectually more challenging, and sponsors may be uninterested in going to school long enough to understand them.
But the reward will be worth it
This is a particular problem in developing fusion-country nations with booming real estate markets. When you can make money hand over fist in the normal property markets, why mess around with affordability or government regulation?
3.3 Investors. A similar mentality applies to capital — in fact, it’s stronger. Capital likes scale; it doesn’t like variety. It likes certainty not volatility, numbers not bricks. It likes the unknown, eschews the new. In all these ways, capital is skittish. It expects a premium for being the first mover, and even then, capital often is uninterested in moving.
“And for investing in this tax credit, I bestow upon you this CRA investment test credit!”
In light of all this, capital must be goosed. The Community Reinvestment Act, which predates the LIHTC by a decade, has proved incredibly effective during this two-decade interval of regional, national and global bank consolidation. Will it continue to influence the markets?
3.4 Allocators. Giving out investment tax credits is no harder than allocating appropriated funds — in many ways, it’s easier. But setting up a transparent and executable competition round, as we have in the US, takes a little tinkering. And when it begins, the allocators are ignorant — everybody’s ignorant — so they make ‘mistakes’ (the term of art for decisions that turn out wrong and allow sanctimonious bystanders later to second-guess them).
At least, not in the pilot phase
Making mistakes is an essential stage of regional capacity growth, but is seldom seen in that light. It needs to be; those snafus, and the allocators’ response to them, are the seeds of wisdom.
3.5 Investment bankers. Between sponsors and investors, capital markets form. Even as sponsors and investors are seeking to do individual transactions, the investment bankers who typically intermediate between them also have to learn the business. Learning a business means intellectual investment, and acceptance of risk (whether for uncompensated services or even financial exposure in the writing). As a result, investment bankers initially charge huge premiums (‘all the traffic will bear’) for creating a market between capital providers and capital consumers. Over time, their services commoditize, and their spreads narrow.
3.6 Volume. It’s one thing to pilot a program to prove its concept and learn lessons. That’s intrinsically valuable in its own right. For a program to become efficient, however, it must become an incumbent, so the authorizing government (whether Treasury, Ministry of Finance, or executive) must make the market large enough to attract the biggest fish — so initially, one must create the program in enough volume.
Crank it up, fool!
3.7 Debt products. Of the four kinds of money, soft equity tends to come last after a country has already created hard equity (grant), hard debt (cheap loans or credit enhancement), and soft debt (shared ownership, intermediated lending to localities or sponsors).
I want you to enact tax credits!
4. Conclusions for tax credit program designers
Nations contemplating introducing housing investment tax credits as a fiscal stimulus should bear in mind for principles:
1. Before government introduces a new tool, it should be precise about the affordable housing problem it is seeking to solve. Financial instruments are an economic tool. They come in different shapes and size, and have different per-unit costs or benefits, but when all is said and done, they are forms of money used to close the cost-value gap that characterizes the pursuit of sustainable affordable housing.
Both useful tools … but only one good for unlocking things.
Before government invests the legislative horsepower and administrative brainpower to create, enact, implement and monitor a program, it should decide what particular problem it wants to solve.
Choose the right one to solve
This requires a gimlet-eyed assessment of the value chain, the ecosystem’s gaps, and what current market behavior we want to change.
2. As soft equity, tax credits are a unique form of money with peripheral benefits, some of which cannot be replicated by appropriated programs … but at a startup cost. Tax credits transfer risk in ways that appropriated programs cannot. They encourage regional autonomy in ways that appropriated programs have difficulty emulating. They positively change the nature of administration (that is, outcome versus process compliance) in ways that appropriated programs cannot. They cut administrative burdens.
All these features are nifty — at least, to a financier or investment banker, or even to an enlightened liberalizing policy maker. These features come at a cost – new channels, discount from par, learning curve – that have to be seen as worthwhile governmental-conceptual-infrastructure expenditures in their own right.
3. Tax credits as a tool work best if a country also already has a particular existing suite of tools. Of the four kinds of money, soft equity is the most sophisticated form of capital. It tends to come last after a country has already created hard equity (grant), hard debt (cheap loans or credit enhancement), and soft debt (shared ownership, intermediated lending to localities or sponsors).
Countries that lack a fully diversified product suite are not entirely unsuitable for tax credits, but it’s certainly a feature to consider.
4. Program design should precede feasibility analysis. Feasibility is specific – will a proposed intervention work? That can’t be answered in the abstract; instead one needs a concrete proposition. Britain uses the approach of a consultation period. In a consultative approach, government is the customer and convener, stakeholders offer input out of public spirit, but when the input process is over, government then proceeds to deliberate internally (with such advisors as it hand-picks and without stakeholder observation) to form its own views.
You won’t get anywhere that way