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Legislation to reform Opportunity Zones misses the forest for the trees
Earlier this month, legislators introduced bipartisan and bicameral legislation to modify Opportunity Zones (OZs). The beneficial changes would include a reporting requirement, which is overdue for the program,[i] as well as decertification of relatively wealthy zones. However, the bill also introduces questionable changes, including extending the program by two years, shortening the holding period for one of the tax benefits by one year, adding zones with zero population in former industrial sites, and proposing to spend up to $1 billion on technical assistance. The bill also fails to address several fundamental concerns with OZs.
The legislation does not appear to address the difficulties of using OZs to invest in small businesses. As Economic Innovation Group’s John Lettieri shared on an SSTI webinar in January 2018, a central goal of the program was to catalyze investments into operating businesses (as well as for business formation). Unfortunately, the design of the incentive and the subsequent program regulations made realizing this purpose largely impossible. The program instead continues to be focused on real estate investment — something that this legislation would not change.
More fundamentally, the bill fails to address the structural problem with OZs: that the incentive provides very wealthy investors[ii] with a tax benefit for investing in projects that they already believe will generate a positive return[iii] without requiring any threshold for the necessity of the incentive or the impact of the project[iv] beyond its physical location.
Given this structure, no amount of post-hoc reporting or other tweaks are going to alter the fact that OZs are not designed to differentiate between projects that need or deserve the tax benefits from those that do not. For example, the recent bill proposes $1 billion in technical assistance funds that states can use to support activities including outreach to investors and site preparation for desired projects. This spending may help communities attract OZ investments to high quality projects. While such an outcome would improve the overall impact of OZs, this spending-based approach would do nothing to guarantee the flow of investments to desirable projects, nor would it curb the flow of incentive dollars to low quality projects.
To the extent that lawmakers are interested in generating better OZ outcomes, legislation should focus on redesigning the incentive itself to ensure that the citizens residing in the zones get more of a benefit than the wealthy investors.
Short of such a fundamental reform, allowing the program to expire would seem to be a better policy than allowing Opportunity Zones to absorb additional taxpayer dollars.
[i] The original Opportunity Zones legislation would have required reporting. However, these provisions were stripped out when the language was attached to the 2017 tax legislation due to rules limiting authorization provisions on bills passed through budget reconciliation procedures.
[ii] Eligible OZ investments must be derived from capital gains. Practically, the capital gains must be substantial enough to form the basis for a new investment on their own, placing an effective restriction on the number of people with sufficient funds to benefit from the program.
[iii] While all investments can provide investors with deferred or reduced taxes, the most significant benefit of the Opportunity Zone incentive is that investors can waive capital gains taxes on the returns of eligible investments held for 10 years. This structure only provides a benefit if the eligible investment generates a return – and the greater the return, the more generous the incentive becomes. Profit-maximizing investors therefore have a strong incentive to use OZs to invest in projects that seem the most likely to be profitable.
[iv] Another way to phrase this is that a project’s location in an eligible Opportunity Zone is considered a sufficient public benefit in its own right, and there is no test or approval process to assess (a) whether the project can attract sufficient financing without the incentive or (b) if it is likely to yield tangible benefits (such as well-paying jobs or affordable housing).