In one form or another, tax-increment financing (TIF) is a fairly common
financial tool available to local governments. In 1982, 37 States permitted it
in one form or another. In
Tax increment financing is a technique for financing a capital project from the stream of revenue generated by the project. Projects suitable for tax increment financing entail a "free rider" problem: One jurisdiction (e.g. a municipality) incurs the costs of attracting or retaining a business. That business generates a flow of tax revenues, and the increased revenues accrue to the jurisdiction which financed them and to all the other jurisdictions which share in the tax base, even if they did not share in the cost of financing the improvements. The other jurisdictions get a free ride at the city's expense. Legislation was needed to permit the jurisdiction incurring the costs to shelter the increased revenue from the project until the cost of the project is repaid. Once the costs of the project are retired, all share alike in the increased revenue generated by the project.
A tax-increment may be used for a variety of purposes. Usually it is used to acquire property which is to be resold at a reduced price (this is called "writing down" the price). TIFs are also used to pay the costs of relocation assistance if current residents are to be displaced, to pay demolition costs, and to finance on-site improvements (utilities, lighting, repaving streets, etc.).
Tax increment financing is obtained through a general obligation bond. This means that, should the project fail to generate sufficient revenue, the city is liable to pay any shortfall from its general revenue. In other words, the city is accepting a risk on the project.
In order to float a tax increment issue, the city must first declare a "tax increment district." The district is the area that will be directly affected by the project. Usually it is a self-contained, enclosed area, although there have been some issues which included multiple sites. The bulk of the parcels within the district must be directly affected by the project, although some unaffected parcels may be included if they lie within reasonable boundaries. A tax increment district is restricted in time. Housing and redevelopment districts are limited to a maximum of 25 years; economic development districts are limited to a 10 year payback period. The legislation requires that the responsible authority must consult with the other taxing jurisdictions in the process of declaring a tax increment district. There is no requirement of formal approval from the other jurisdictions which are receiving income from the district.
Once a tax increment is declared, the assessed value of the property in the district is determined. This is called the "original assessed value." Any increase in the assessed value of the property from the original value is called the "captured assessed value," or the annual tax increment." The captured assessed value is what justifies the cost of the project; it is what is used to repay the bonds which financed the project.
This position is not as harmless as it might first appear. The legislation gives one jurisdiction the right to make decisions which affect the revenues of other jurisdictions. In principle, only the increased revenue due to the project are sheltered; in practice, all increased revenue is taken. It is possible that some of that increase would be due not to the project but to larger forces (inflation, tightening markets, historical trends). Proponents of tax increment financing point out that the argument cuts both ways: Since incentives were necessary to attract or retain the businesses, it is equally likely that tax revenue would have decreased without the project, and thus the responsible jurisdiction is receiving less of the increment than its due.
The legislation also permits local authorities to engage in speculative financing. This is standard operating procedure in the private sector, where risk-taking is part of the value added to almost any product. But traditionally the public sector has been enjoined from speculation, on the grounds that the role of a public authority is not to generate a profit (which is the justification for taking a risk), but to provide necessary goods with as much security as possible. If a private party takes a risk and fails, the business can be dissolved and only the investors suffer the consequences; if a city takes a risk and fails, it cannot dissolve but must pass the cost of the failure on to all its taxpayers.
© 1996 A.J.Filipovitch
Revised 11 March 2005