Tifs in the Hinterlands

Leveraging future revenues to build urban-like infrastructure is getting special attention in small towns that are growing like Topsy.
August 2000
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

For years, cities have promoted tax-increment financing as the magic bullet for paying for infrastructure. Target a place for development, turn it into a special district and earmark future taxes and fees to repay money borrowed for development. As the area develops, both its value and the value of the activities that take root will increase. Naturally, the new value created will be fair game to be captured through taxes and fees.

TIFs fit into financing schemes nicely by solving the twin problems of the development process: There have to be expenditures on public facilities in order for development to occur, and the burden for such improvements should fall on the principal beneficiaries--developers and newcomers, not the existing community.

This alignment between the needs of growth and the limitations on public money has taken a variety of shapes in a host of cities. Although the general idea of special-service districts has been around, the concept of value capture--using growth in property- and sales-tax bases as a means of leveraging debt for urbanizing expenditures--is getting special attention. And that attention is particularly focused in small towns and hinterland locations that have begun to grow like Topsy and to experience congested roads and a demand for more sophisticated, city-like services.

Unlike a special-assessment bond, which is floated in order to allow property owners to finance improvements related to their property, new tax assessments don't come after the fact--that is, after the individual properties have already been developed but are seeking to become urban in their service levels. The tax-allocation or tax- increment bond is future-oriented, since funds to pay for improvements are specifically the anticipated increment of increase in the property-tax base. The calculation is disarmingly simple: Governments can continue to have their existing, pre-development assessed value as the basis of taxation, but any increase in that base is devoted to repaying the bonds that have been sold. This device focuses the burden of growth on those properties that benefit from it. Moreover, it appears to protect the rest of the community from having to pay higher taxes in the process.

So far, so good. Unfortunately, there are also some overriding questions of risk. Tax-allocation bonds in rural areas are inherently more risky in part because the tax base there is generally based on agricultural uses, which typically demand little in the way of municipal services. Thus, the property-tax rates are generally very low. What taxes are collected tend to be used predominantly by school districts, which are often reluctant to forgo future increases in taxable value. The reason is that development of commercial or residential properties tends to attract workers and families. But if the growth in the assessed value is locked up in paying off bonds, there is none left over to pay for educating more children unless rates are raised.

Even more fundamental is the volatility of land values, which are the tax base in most circumstances. Time and again, the value of "raw" land has been on a roller coaster. In good times, land that is prime for development will see big increases in value. This suddenly pushes up the tax base, which makes it look like it can support lots of debt when the development occurs. But when the cycle ends, values go whooshing down. Savvy investors, having been burned in the past by such plunges, demand either additional security (such as a pledge of general taxes) or very high rates of interest on the bonds.

Moreover, rural areas have only a few major taxpayers and a lack of diversity in their economies. That means that a rural tax-increment district's fortunes could rise and fall on the success of a business or two. Investors are aware of the risk of concentration and exact a premium for a lack of diversification.

Value capture through devices such as the tax-increment or the development district can make good sense, but only if the risks are addressed. Use of such vehicles leveraged on the fruits of future growth should be bounded by prudent rules. By their nature, TIFs demand good local development policies and effective economic development agencies to carry them out. For example, local communities should not be on the hook for public improvements until they are in fact in place. This means that such financing devices should be implemented through agreements that pace the acquisition of the public facilities, which are the financial obligations of the developers, with the progress of the development. In addition, real estate appraisals need to be conservative and investors appropriately warned of the many risks.

If rural areas are to use these devices, it is incumbent on the states to provide, or require that there be, adequate professional support in the design and implementation of a value-capture financing program. Otherwise, it could deteriorate into speculations that are costly and rancorous for upset citizens and disappointed developers alike.