After almost a year of accomplishing nothing, the Republican-led US Congress has managed to enact a far-reaching tax law and budget legislation that will shape the contours of future government spending. Neither will solve America’s most pressing economic challenges, but each does include at least one sensible idea for tackling poverty.
BERKELEY – The tax legislation that US President Donald Trump signed into law last December will dramatically increase inequality and the federal budget deficit. Yet, hidden within it – and within budget legislation enacted in February – are two promising programs for helping state and local governments address the needs of disadvantaged Americans.
The new tax law creates generous incentives to encourage private investment in distressed urban and rural areas; and a provision in the budget package will establish a competitive grant program to help states fund “pay-for-success” contracts. Both ideas have their roots in the Democratic administrations of Presidents Bill Clinton and Barack Obama; but they attracted congressional Republican support because they empower state and local governments, rely on public-private partnerships, and encourage rigorous impact assessments.
The provisions in the tax law to encourage private investment in impoverished areas center on the creation of “Opportunity Zones” (a term coined more than 30 years ago by New York Governor Mario Cuomo). The OZ program grants US governors the authority to designate up to 25% of low-income census tracts – those with an individual poverty rate of 20% or higher, and median family income below 80% of the state or territorial average – as OZs.
Private investors are then granted significant tax incentives to reinvest their unrealized capital gains into OZs through “Opportunity Funds.” OFs can choose the nature of the assets (the risk/return profiles) they offer their investors, but must be organized as corporations or partnerships, which invest at least 90% of their capital in OZs.
Individuals who invest in OFs are eligible for several tax benefits. These include a temporary tax deferral on unrealized capital gains; a step-up in basis on the capital gains earned and reinvested in such funds; and a permanent exclusion from taxes on capital gains earned on fund investments held for ten years or more. A recent Brookings Institution report estimates that, “Individuals in a high-tax state and with short-term capital gains can avoid $7.50 in taxes for each $100 they invest, even before considering any return on their Zone investments.”
Still, the OZ program is not without risks, and much will depend on how it is implemented. It is possible that OFs will displace rather than develop low-income areas, and that the lion’s share of the benefits will accrue to investors and developers who already have stakes in locations that qualify for OZ designation. And the program’s emphasis on capital appreciation could result in rising property values, and thus higher rents that drive low-income tenants out of their homes.
Moreover, unlike the “Empowerment Zones” introduced by the Clinton administration in 1994, the OZ program does not include grants, loan guarantees, and other fiscal tools to finance investments in training, infrastructure, affordable housing, and local services. Investments in these areas are crucial for local socioeconomic development, even if they are not particularly attractive to private capital.
To ensure that the program benefits distressed communities, and not just wealthy investors, governors will have to choose wisely when designating low-income zip codes as OZs. Fortunately, California, Colorado, and several other states have already developed transparent and open processes to identify the neediest investment-ready areas. As other states and territories do the same, they should keep an eye on key factors such as child-poverty rates, the quality of education and training opportunities, and infrastructure and transportation conditions that affect local economic development.
States and territories will also need to bring their tax systems into line with federal law, especially if they are currently taxing capital gains as ordinary income, as California does. And, finally, they will need to provide for transparent and consistent reporting on outcomes, measuring not just financial returns, but also impact on economic development and poverty reduction. Leading “impact investment” firms such as DBL Partners, Omidyar Network, and Bridges already provide this kind of comprehensive reporting on their own investments; and the Impact Management Project, a corporate consortium, can offer additional guidance.
The new provision in the Bipartisan Budget Act of 2018 that holds promise for low-income communities is the Social Impact Partnerships to Pay for Results Act (SIPPRA), which establishes a $100 million federal fund to facilitate pay-for-success (PFS) contracts by state and local governments. In PFS contracts, a government raises private funds from investors and uses these funds to pay external organizations (often non-profits) to provide essential social services.
This approach enables government to raise private capital that would otherwise not be available to support such services, and to cut their costs by working with proven providers to achieve measurable outcomes. Taxpayers bear no financial risk, because the government pays a return to investors only if a contractor meets predetermined targets.
Beyond providing state and local governments with access to investable private capital, pay-for-success contracts encourage risk-free experiments in public policy. State and local governments, acting as “laboratories of democracy,” can pursue innovative solutions to persistent problems in impoverished communities. Some are already doing so with respect to recidivism, child and maternal health, homelessness, and workforce training.
Moreover, because pay-for-success contracts must be validated by metrics and independent evaluations, it is easy to tell which experiments have succeeded and which have failed. As it stands, an estimated $400 million in private capital has been invested in around 108 such projects in the United States and around the world. Of the 27 completed projects that have reported to date, only one has failed to achieve its target and pay a return to its investors.
Laura Tyson, a former chair of the US President’s Council of Economic Advisers.
Lenny Mendonca, Chairman of New America, is Senior Partner Emeritus at McKinsey & Company.