(Archived document, may contain errors)

80

March 29, 1982

THE ENTERPRISE ZONE TAX ACT OF 1982: THE ADMINISTRATION PLAN

INTRODUCTION

The Administration's enterprise zone proposal, unveiled by Ronald Reagan on March 23, promises to break the logjam that has built up in Washington on the concept. While several states have passed their own versions of the enterprise zone and many cities have been pressing Washington to enact a program, congressional supporters of the idea have been frustrated by the absence of a concrete Administration plan, despite Reagan's long-professed enthusiasm for the innovation.'

Several bills were introduced last year but not acted upon. Commanding the widest interest and support was the Urban Jobs and Enterprise Zone Act (H.R. 3824, S. 1310), introduced in the House by Jack Kemp (R-NY) and Robert Garcia (D-NY), and in the Senate by John Chafee (R-RI) Rudy Boschwitz (R-MINN).2 Other versions included bills introduced by Senators John Heinz (R-PA) and Donald Riegle (D-MI) (S. 1240), Senator John Danforth (R-MO) (S. 1829), and Representatives Henry Nowak (D-NY) (H.R. 2965), Charles Rangel (D-NY) (H.R. 2950), and Wes Watkins (D-OK) (H.R. 4576).

The Administration plan is the culmination of protracted discussions, chiefly between the Departments of Housing and Urban Development and Treasury. Its slow progress was due in large part to disputes between these two departments; HUD pressed for a bold approach and Treasury, skeptical of the concept's promised

For the history and development of the enterprise zone concept, see Stuart Butler, Enterprise Zones: Greenlining the Inner Cities (New York: Universe Books, 1981). 2 For an analysis see Stuart Butler, "The Urban Jobs and Enterprise Zone Act of 1981," Heritage Foundation Issue Bulletin No. 68, July 16, 1981.

2

payoffs and fearful of possible revenue losses, pushed for a weaker version. The President's plan draws mainly on HUD recom- mendations. Nevertheless, Treasury blocked some key tax elements, and this action threatens to reduce the program's effectiveness. Indeed, the whole program could be seriously weakened.

The President's plan, entitled The Enterprise Zone Tax Act of 1982, was introduced in the Senate by John Chafee and Rudy Boschwitz, who were chief Senate co-sponsors of the 1981 Kemp- Garcia bill, with John Heinz as the other principal co-sponsor. In the House, the legislation was introduced by Barber Conable (R-NY), ranking minority member on the Ways and Means Committee, William Stanton (R-OH), ranking minority member on Banking, Finance and Urban Affairs, Jack Kemp and Robert Garcia. It appears that most House and Senate co-sponsors of the Kemp_Garcia bill will co-sponsor the President's plan.

The bill will be referred to the House Ways and Means Commit- tee and the Senate Finance Committee. At the time of writing, bill numbers had not been released, nor was it clear if the measure would also be referred to the House Banking, Finance and Urban Affairs.Committee.

In submitting the bill to Congress, the President summarized the difference between the enterprise zone concept and earlier urban revitalization programs:

The old approach relied on heavy government subsidies and central planning. A prime example was the Model Cities Program of the 19601s, which concentrated govern- ment programs, subsidies and regulations in specific, depressed areas. The Enterprise Zone approach would remove government barriers, freeing individuals to create, produce and earn their own wages and profits. In its basic thrust, Enterprise Zones are the direct opposite of the Model Cities Program of the 19601s.

He noted that the zones will not require appropriations at the federal level, other than for administrative expenses, and that in the spirit of New Federalism, state and local governments will have broad flexibility to develop contributions to their zones most suitable to local conditions and preferences.

THE ADMINISTRATION PLAN

The Administration's plan is designed to stimulate new economic activity in depressed inner city areas by creating a climate conducive to enterprise. Barriers to business are to be removed and tax incentives used to encourage risk taking and job generation. The plan calls for no grants or direct federal involvement in the development process.

3

The intent is to spur economic activity within the zones that would not otherwise have occurred in any other location. In short, the zones should stimulate -@he dormant potential of the selected neighborhoods rather than merely prompt existing busi- nesses and jobs to move to the inner cities.

Like the 1981 Kemp-Garcia bill, the Reagan plan leaves it up to cities and states to initiate the enterprise zone concept. They must cooperate in developing a package of local incentives? to which the federal incentives will be added. Any detailed planning and expenditures within the'zones are to be undertaken by the state and local governments.

1) Eligibility

Eligibility criteria essentially are those of the earlier Kemp-Garcia proposal. The targeted area must be suffering perva- sive poverty, unemployment, and general distress and must satisfy the eligibility criteria of the Urban Development Action Grant program. The area must contain at least 4,000 residents, if it is within a city of 50,000 or more; if not, the area must have at least 2,500 inhabitants or be entirely within an Indian Reserva- tion. In addition, it must satisfy at least one of the following requirements:

Average unemployment of at least one and a half times the national average;

A poverty rate of at least 20 percent for each census tract, minor civil division or census county as determined by the most recently available census data;

\u239\'95 At least 70 percent of the proposed zone's households with incomes below 80 percent of the residents in the jurisdic- tion of-the government requesting the designation;

\u239\'95 At least a 20 percent drop in population between 1970 and 1980.

2) Designation

Areas meeting the eligibility criteria can be nominated for enterprise zone designation by cities, with the support of the state, but they will not qualify automatically for designation. The Secretary of HUD will select the zones. Upon designation, the federal tax incentives and regulatory relief described below will apply within the zones. The Secretary is limited to seventy- five designations over a three-year period. Exactly how long an area is to be an enterprise zone is a matter of negotiation,'but the period cannot exceed twenty years plus a four-year phaseout.

The Secretary of HUD is to consider the merits of the appli- cations in designating the enterprise zone. In this competitive process, the local package of incentives and deregulation proposed

4

by the city and state will be important. Priority is to be given to those emphasizing:

\u239\'95 Tax relief;

\u239\'95 Regulatory relief;

\u239\'95 Improved public services, especially experiments with private sector providers;

Involvement of neighborhood organizations and other pri- vate groups.

In addition to the level of distress in the proposed zone, the Secretary is to take into account the fiscal and constitutional restraints on the ability of the state or local government to grant tax relief. Consideration too is to be given to job train- ing programs, investment commitments, and other proposals of the applicant.

The designation process is to be flexible. A local package weak in tax incentives, for instance, could be balanced by stronger local deregulation. If the state and local governments fail to meet their commitment, the designation later could be withdrawn. While zones can be designated in small towns, or even rural areas, it appears that the bulk of the zones, at least in the program's early years, will be in large urban areas.

3) Federal Tax Incentives

Investment Tax Credit

A bonus investment tax credit, in addition to that available to any American business, will be available for new plant and machinery in the enterprise zones. For property depreciable in three years, the credit will be 3 percent; for five-year property, it will be 5 percent. The construction or rehabilitation of commercial, industrial or rental housing structures would qualify for a 10 percent credit.

Capital Gains Tax

capital gains tax is not to be levied on the sale of "quali- fied" property in the zones held for over twelve months.3 This exemption also is to cover the first sale or exchange made after the zone designation ends.

3 Defined as any real or tangible property used predominantly for business purposes in an enterprise zone, or any interest in a company, providing that for at least three years the company was engaged in active zone business at least 80 percent of its revenues came from zone opera- tions, and substantially all of its facilities were located in an enter- prise zone.

6

7) Federal Regulation

Federal agencies are to have discretion to relax or eliminate regulatory requirements, while maintaining standards mandated by Congress, upon the request of the state and local governments with jurisdiction over a zone. The federal agency is not to act without such a request. This provision does not cover statutory regulations such as minimum wage.

In addition, the zones will be defined as "small entities" under the terms of the 1980 Regulatory Flexibility Act (P.L. 96-354).

ANALYSIS

5

Payroll Tax Credit

Employers will be allowed a non-refundable tax credit equal to 10 percent of the total payroll paid to "qualified" employees, in excess of the payroll paid to such employees in the year prior to the zone.4 The credit is not to exceed 2.5 times the FUTA base wage for each qualified worker. This currently is $15,000, which would mean a maximum credit of $1,500 per worker.

A non-refundable credit will be available for qualified workers who are also disadvantaged (based largely on the CETA criteria) and hired after the zone designation. The credit is to be equal to 50 percent of wages paid in the first three years, declining by 10 percent of the wages in succeeding years. The general 10 percent credit would be added to this credit.

Employee's Tax Credit

"Qualified" zone employees will also be allowed an annual non-refundable personal income tax credit equal to 5 percent of taxable income earned in the zone, with a maximum based on 1.5 times the FUTA wage base (meaning a credit of up to $450).

4) Operating Loss Carryover

Enterprise zone firms will be allowed an operating loss carryover for the life of the zone plus the four-year phaseout period, up to twenty-four years, compared with the normal fifteen years. The carryover also is to apply to the tax credits.

5) Industrial Development Bonds

Industrial Development Bonds are to be retained and made more available to small firms in the zones, even if their use is curtailed elsewhere.

6) Foreign Trade Zones

7

The general employment credit is available only for additions to the payroll. A firm already in the zone will obtain credits only for new workers -- or for disadvantaged workers hired to replace current employees. Thus, existing firms will have an incentive to close down and reincorporate in order to become a "new" firm with "new" employees. They will also be rewarded, especially if they do not reincorporate, if they replace their less skilled personnel with disadvantaged workers. As a result, low-income workers who have struggled successfully to obtain a job and acquire basic skills might be displaced.

The credits in the Reagan plan are non-refundable, in contrast with the Kemp-Garcia credits. so they will be of little value to new, small companies, most of which earn little or no taxable income for several years. These businesses will not be able to use the credits to offset the Social Security payroll taxes which even loss-making firms must pay.

The Administration plan drops the Kemp-Garcia requirement that a business earmark 40 percent of new jobs for CETA eligibles before it can qualify for most enterprise zone tax incentives. Administration officials have argued persuasively that this would be a burden on small firms and would be difficult to enforce. In order to encourage the hiring of disadvantaged workers, the Administration therefore has decided to use an attractive tax incentive rather than a rigid requirement that would dissuade firms from locating in a zone.

Employee Incentives

The income tax credit for employees in zone firms is twice that of the Kemp-Garcia scheme. Like the business credits, it is non-refundable and will therefore be of limited benefit to low- income workers.

Business Incentives

Earlier drafts of the Administration plan restricted the elimination of capital gains on zone business property to busi- nesses with no corporate shareholders. This restriction was intended to prevent corporations from transferring assets to a zone subsidiary to resell them and utilize the capital gains tax elimination. By removing this restriction in the final plan, the Administration evidently believes that the need to encourage corporations to provide start-up capital for new, independent zone firms outweighs possible revenue losses arising from asset transfers.

The Kemp-Garcia bill, on the other hand, provided for a tax allowance equal to 50 percent of the interest received by a taxpayer who provided capital for zone businesses. This was designed to remedy the capital shortage plaguing new companies, particularly in distressed neighborhoods. The Treasury has com- plained that the provision invites abuse. The Administration

8

package replaces it with the investment tax credit (ITC) and industrial development bonds (IDBs). But the ITC is available only for investments in plant and machinery and is therefore of limited use to labor intensive firms. ITCs can be credited only against income tax, so the provision will not tend to help fledg- ling companies.

IDBs are a poor tool for financing new, small firms. The large, institutional lenders who use IDBs generally avoid small, risky companies, especially in depressed areas. Will they change their practices because IDBs are made more available? unlikely. IDBs have been widely criticized, moreover, as susceptible to local politics and favoritism.

Regulation

For new businesses, federal regulation is usually less of a burden than local regulation, but federal rules do create problems. The Kemp-Garcia bill sought to remedy this in enterprise zones by applying to them the provisions of the 1980 Regulatory Flexibility Act, which allows for some discretion in rule making. The Admini- stration enterprise zone proposal adds to this mechanism a provi- sion that would enable an agency to alter non-statutory rules, but only if requested by the state and city. This means regula- tory change cannot be effected without the agreement of all three levels of government. This requirement will probably mean that little federal deregulation will occur in the zones..

Earlier versions of the Administration's plan would have allowed cities and states to petition for a youth subminimum, wage in a zone. Political pressure led to the removal of this provision from the final version. This is unfortunate. Many experts maintain that the minimum wage law prices young, unskilled people out of the labor market, and is a major cause of high unemployment in the inner cities. The Commerce Department's Minority Business Development Agency found strong support for this view among minority businessmen when it surveyed their views on the enterprise zone concept.6 By eliminating the provision, the Administration has removed the possibility of cities testing the thesis that minimum wage laws are a significant factor in chronic youth unemployment.

Cost

The Treasury-Department estimated that for a sample zone containing 10,000 employees the cost would be $12.4 million per year in terms of lost tax revenue. Based on this estimate, the tax loss associated with the program's target of twenty-five

6 Minority Business Development Agency Task Force Report on the Impact of Enterprise Zones on Small and Minority Businesses (Washington, D.C.': U.S. Department of Commerce, 1981), p. 41.

9

zones in the first year would be $310 million -- smaller than the annual expenditure under the Urban Development Action Grant program.

But this is a worst case estimate, based on the assumption that virtually no new economic activity will be created that would not have occurred elsewhere. If the program is successful in generating genuinely new businesses and jobs, and reducing the welfare roles, the cost would be substantially less. Indeed, if the program resulted in a high proportion of genuinely new busi- nesses and employment - and hence new taxpayers -- the zones could conceivably be revenue earners!

THE SPECIAL IMPORTANCE OF SMALL BUSINESS

The Administration insists that a primary aim of the plan is to generate new businesses, and new businesses mean small busi- ness. Fortune 500 companies grow from small concerns, they do not sprout overnight. Moreover, small firms are by far the most effective job-creators in the economy, accounting for virtually all the net new jobs in the northeast and most new jobs across the nation.7

Small firms are vital for other reasons. Development of a strong, local business community is an important ingredient in successful revitalization of depressed neighborhoods. Small entrepreneurs with a direct stake in the community strengthen the social fabric. Small companies are also the most innovative and adaptive firms, the most likely to develop those products and services best suited to their neighborhood. Large companies, on the other hand, are not significant job generatorss and invariably dominate the neighborhood economy.

Despite the key role of small business in the enterprise zone concept, the Administration's proposal offers such firms almost nothing. Because most new companies do not usually show taxable profits for several years, tax credits are of little help. Indeed, the National Federation of Independent Business discovered in a recent survey of urban small businesses that taxes are well down on the list of problems faced by new companies. The biggest worry: start-up capital.9 Eliminating the capital gains tax will provide only modest help in solving the capital shortage. The prospect of a small tax benefit at some future date, and then only if a zone business is successful, will hardly prompt investors to flock to inner cities.

7 David Birch, Job Creation in Cities (Cambridge, Massachusetts: MIT, 1980). 8 Ibid. 9 Report on Small Business in America's Cities (Washington, D.C.: NFIB, 1981), p. 12.

10

In short, the Administration's plan confronts new, small firms with a Catch-22 situation. To encourage new companies to form and grow, the plan offers credits against business taxes so that more money can be retained for expansion. But businesses must be successful and profitable before they will owe enough tax to benefit from the breaks designed to make them successful and profitable.

RECOMMENDATIONS

If the enterprise zones are to reach their full potential, the Administration's proposals should be modified in some basic areas.

Incentives to Investors

When small businessmen say taxes are unimportant to them as they start their ventures, they ignore the impact of taxes on the investor who might provide capital for the firm. It is clear from the history of IRA accounts, housing, wildcat oil drillings, and similar cases that Americans are prepared to invest in long- term or high risk ventures if they can enjoy an immediate tax break. This characteristic should be applied to enterprise zone plans. Investors in new, small zone firms should be permitted to deduct the entire investment from their taxable income (subject to a maximum of, say, $25,000 per taxpayer), providing the money is kept in the firm for a minimum period -- perhaps three years. This could produce a considerable flow of funds from individual investors -- the traditional backers of new ventures. Unlike the ITC, this proposal would provide general capital and would help labor-intensive companies. The total cost of the deduction to the Treasury would be small, because the investors would tend to be taxpayers who normally would shield their investments from taxation in any case. In fact, federal coffers would probably gain as job creation spawned new taxpayers and trimmed welfare outlays.

A provision of this kind was introduced recently in Britain as an experiment on the national level. Already it appears to be channeling capital to new ventures. It also has encouraged the creation of investment clubs operated by professional managers. These clubs pool and invest the money of many individuals. It is likely that granting tax deductions for enterprise zone investment in the U.S. would lead to the emergence of enterprise zone loan funds. Senator John Danforth (R-MO) included this notion in his Rural Enterprise Zone Act of 1981 (S. 1829).

Contributions to Neighborhood Organizations

Danforth's bill also provided a special tax credit to any taxpayer making a contribution to a tax-exempt neighborhood

organiz ation providing services in a zone'O or to a community development corporation located in a zone. At the very least, enterprise zone legislation should remove federal taxation from state tax credits for contributions to these important neighbor- hood groups. Missouri and Pennsylvania are among the states that provide such credits.

Displacement

Whenever successful development takes place in a blighted community, property values tend to rise, new residents arrive, and many earlier residents with no direct stake in the develop- ment find themselves squeezed out of the neighborhood. Though the emphasis on local involvement and ownership in the enterprise zone concept should reduce this problem, means should be found to ensure that residents are the enterprise zone's primary benefici- aries.

In the designation process, priority could be given to local plans seeking to spread ownership in an enterprise zone. Such plans might include versions of homesteading or shopsteading. In addition, cities could be encouraged to give neighborhood organi- zations title to city-owned property, such as vacant lots and abandoned buildings. If enterprise zone land values were to increase, the organizations would then hold assets of rising value. They could derive an income from sales, or lease revenue could be used to benefit residents or provide new services. This would give neighborhood groups a financial incentive to work closely with business since both would gain from successful development.

The federal government could supplement such experiments by amending the IRS code pertaining to General Stock Ownership Corporations (GSOCs), to allow states to charter GSOCs within enterprise zones. An enterprise zone GSOC then would be a corpo- ration consisting of all the zone's residents. It would engage in business activity, but would not be liable for corporate taxation if at least 50 percent of its profits were distributed to members. The federal government could stipulate that any state and city wishing to create an enterprise zone GSOC must provide the corporation with title to vacant city-owned property as a base for its acitivies. By ensuring this flow of benefits, the GSOC could provide extra income to low-income residents to offset rent increases and other costs that increase displacement. A bill to apply GSOCs to enterprise zones, in a similar way to this, is being prepared by Senator Gary Hart (D-CO).

10 That is, an organization described in Section 501(c)3 of the tax code as exempt under Section 501(a).

12

CONCLUSION

The President is strongly committed to the enterprise zone concept and shares the belief of mayors and inner city leaders that depressed neighborhoods possess considerable potential. As Reagan told the National Urban League during his presidential campaign:

Those who view poverty and unemployment as permanent afflictions of our cities fail to understand how rapidly the poor can move up the ladder of success in our economy. But to move up the ladder, they must first get on it. And this is the concept behind enterprise zones.

The problem is that the Administration plan combines the best of intentions with an incomplete tax mechanism. By concentrating on tax credits rather than investor incentives, it will help profit- able, taxpaying businesses rather than new, small businesses. It will, in short, tend to help those who are already on the ladder.

The emphasis on neighborhood participation is an extremely valuable part of the plan, however. Neighborhood organizations are the social entrepreneurs of the inner cities. To be effective in their efforts to combat crime and other problems, they need flexibility and government cooperation. The local package of action required in the designation process should strengthen such groups -- an objective of the President's call for increased voluntarism as well as of the enterprise zone.

A hidden danger in the plan is its complexity. The Treasury, true to tradition, has saddled almost every incentive with detailed restrictions and qualifications. It is unsettling that a measure intended to spread economic freedom and cut red tape in the inner cities occupies 79 pages and requires 28 single-spaced pages of official explanation. When regulations are eventually added to all this, the final product may become a consultant's dream and businessman's nightmare. Every effort must be made to simplify the language, or the incentives might be unobtainable by the very people for whom they were supposedly created.

The Administration's long-delayed plan clearly has some serious flaws, but they are correctable. The legislation is consistent with the President's view of federalism, and it will complement action already taken by several states and cities. With suitable improvement, particularly regarding small business incentives, it could provide the appropriate vehicle to unlock a new era of enterprise and creativity in our inner cities.

Prepared at the request of The Heritage Foundation by Stuart Butler, Ph.D Senior Fellow, The National Center for Neighborhood Enterprise and Consultant, The Heritage Foundation