FROM THE OFFICE OF PUBLIC AFFAIRS

FOR TAX ANALYSIS JOHN KARL SCHOLZ

HOUSE WAYS AND MEANS COMMITTEE OVERSIGHT SUBCOMMITTEE

I am pleased to have this opportunity to present testimony today concerning the Empowerment Zone and Enterprise Community (EZ/EC) program. The EZ/EC program was established by the Omnibus Budget Reconciliation Act of 1993 (OBRA 93) and expanded by the Taxpayer Relief Act of 1997 (TRA 97).

The EZ/EC program is designed to help distressed areas improve themselves. The program encourages leadership at all levels of government to resolve some of American’s most difficult economic and social challenges. In the EZ/EC program, the Federal government is a partner in a ten-year long collaboration with residents, community-based organizations, businesses, and local and State governments. By designating an area as an EZ or EC, the Federal government will provide a special package of tax incentives and grant programs. The development in an EZ or EC is community-based, community-driven, and community-controlled.

My testimony today will describe for you the tax incentives that are a part of the EZ/EC program, the recent changes to the program reflecting taxpayer concerns, and the revenue effects of the EZ/EC program.

Tax incentives are part of a comprehensive approach to address problems facing EZ/EC communities. The Federal government provided flexible block grants to enable communities to undertake a broad range of activities that cannot easily be funded with tax incentives, such as community policing. Communities, in partnership with the private sector and local government, developed a strategic plan for community revitalization that leveraged these Federal resources in a wide range of creative programs.

RR-2023

OBRA 93

As a result of OBRA 1993, the Secretaries of the Department of Housing and Urban Development (HUD) and the Department of Agriculture designated a total of nine first-round empowerment zones (EZs) and 95 enterprise communities (ECs) on December 21, 1994. As required by law, six EZs are located in urban areas (with aggregate population for the six designated urban EZs limited to 750,000) and three EZs are located in rural areas. Of the ECs, 65 are located in urban areas and 30 are located in rural areas. Nominated areas were required to satisfy certain eligibility criteria, including specified poverty rates and population and geographic size limitations.

In addition to tax incentives, OBRA 1993 provided that Federal grants would be made to designated EZs and ECs. The tax incentives for EZs and ECs generally will be available for 10 years. An area's zone designation may be revoked if the local government or State significantly modifies the boundaries or does not comply with its agreed-upon strategic plan for the zone.

TRA 97

TRA 97 authorized the designation of 22 EZs: 2 additional first-round EZs and 20 "second-round" EZs. The Secretary of HUD is authorized to designate the 2 new first-round EZs, which are to be located in urban areas (thereby increasing to 8 the total number of first-round EZs located in urban areas), within 180 days after the enactment of the TRA 97. The designation of the 2 new first-round EZs will become effective on January 1, 2000 (though we would support moving this date forward), and will generally remain in effect for 10 years. The 2 new first-round EZs are subject to the same eligibility criteria as applied to the original 6 urban EZs.

The 20 second-round EZs are required to be designated before January 1, 1999, and the designations generally will remain in effect for 10 years. No more than 15 of the second-round EZs are to be located in urban areas and no more than five in rural areas. In addition, areas within Indian reservations are eligible to be included in a second-round EZ.

TRA 97 also made numerous technical changes to OBRA 93's tax-exempt private activity bond provisions and the "enterprise zone business" definition, in order to allow a broader range of businesses to borrow the proceeds of the tax-exempt bonds and, in EZs, to qualify for the additional section 179 expensing.

A. Description of tax incentives

The tax incentives lower the cost of the two primary inputs for business -- labor and capital in distressed communities.

First-Round. The first-round program contains three tax incentives as modified by TRA 97, all of which are available in first-round EZs and one of which is available in ECs. These incentives are divided among a labor incentive and capital incentives. In the EZs, the labor incentive is an employment and training credit, and the capital incentives are increased section 179 expensing and qualified enterprise zone facility bonds. In the ECs, the capital incentive is qualified enterprise zone facility bonds.

Second-Round. The second-round EZ program contains three tax incentives. These incentives are solely capital incentives: increased section 179 expensing and new tax-exempt financing with empowerment zone facility bonds. Unlike the first-round tax-exempt financing, the new empowerment zone facility bonds are not subject to the State private activity bond volume caps or the special limits on issue. In addition, EZs can designate 2,000 acres

1. Labor Incentive

Employment and training credit. An employment and training credit is available to first-round EZs. This is a 20 percent credit against income tax liability is available to all employers for the first $15,000 of wages paid to each employee who (1) is a zone resident (i.e., his or her principal place of abode is within the zone), and (2) performs substantially all employment services within the zone in a trade or business of the employer. This credit encourages the employment of zone residents by lowering the cost of labor for zone businesses.

To reduce the long-term cost of the credit, the rate of the credit is phased down after eight years by 5 percentage points per year. Thus, the maximum credit in 2002 would be 15 percent of the first $15,000 of wages, in 2003 it would be 10 percent of such wages, and in 2004 it would be 5 percent of such wages. (The wage credit available in the two new first-round EZs has been modified, so that these new EZs receive the wage credit for eight years.)

The maximum credit per qualified employee is $3,000 per year (prior to the phase down period). Wages paid to a qualified employee would continue to be eligible for the credit if the employee earns more than $15,000, although only the first $15,000 of wages would be eligible for the credit. The wage credit is available with respect to a qualified employee, regardless of the number of other employees who work for the employer or whether the employer meets the definition of an "enterprise zone business" (which applies for certain other tax incentives described below). In addition, the credit is allowable to offset up to 25 percent of alternative minimum tax liability.

Qualified wages would include the first $15,000 of "wages," defined as (1) salary and wages as generally defined for FUTA purposes, and (2) certain training and educational expenses paid on behalf of a qualified employee, provided that (a) the expenses are paid to an unrelated third party and are excludable from gross income of the employee under section 127, or (b) in the case of an employee under age 19, the expenses are incurred by the employer in operating a youth training program in conjunction with local education officials.

The credit is allowed with respect to both full-time and part-time employees. However, the employee must be employed by the employer for a minimum period of at least 90 days. Wages are not eligible for the credit if paid to certain relatives of the employer or, if the employer is a corporation or partnership, certain relatives of a person who owns more than 50 percent of the employer. In addition, wages are not eligible for the credit if paid to a person who owns more than five percent of the stock (or capital or profits interests) of the employer. An employer's deduction otherwise allowable for wages paid is reduced by the amount of credit claimed for that taxable year.

Work opportunity tax credit. As an additional incentive for both first and second-round EZs and ECs, zone youth are included as an eligible target group for the work opportunity tax credit, or WOTC. The maximum WOTC is 40 percent of $6,000 in wages paid during the first year of employment with a maximum of $2,400.

2. Capital Incentives

Eligible businesses. Unlike the labor incentive described above, the capital incentives described below are available only with respect to trade or business activities that satisfy the criteria for an "enterprise zone business." These limitations are designed to target the capital incentives to businesses that are likely to have a significant economic impact in the zone, while limiting the possibility of abuse. An "enterprise zone business" would be a corporation, partnership, or proprietorship if, for the taxable year, the following conditions are satisfied: (1) the sole trade or business is the active conduct of a "qualified business" (described below) within an enterprise zone, (2) at least 50 percent of the total gross income is derived from the active conduct of a qualified business within a zone; (3) a substantial portion of the use of its tangible property occurs within a zone; (4) a substantial portion all of its intangible property is used in the active conduct of such business; (5) a substantial portion all of the services performed by employees are performed within a zone; (6) at least 35 percent of the employees are residents of the zone; and (7) no more than five percent of the average of the aggregate unadjusted bases of the property owned by the business is attributable to (a) certain financial property, or (b) collectibles not held primarily for sale to customers in the ordinary course of an active trade or business.

A "qualified business" is any trade or business other than a trade or business that consists predominantly of the development or holding of intangibles for sale or license, or a business consisting of the operation of a facility described in section 144(c)(6)(B) (i.e., a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, and any store the principal business of which is the sale of alcoholic beverages for consumption off premises). Farming is also excluded unless the unadjusted basis of the assets used by taxpayer in the business total $500,000 or less. The rental of tangible personal property to others is a qualified business if and only if at least 50 percent of the rental of such property is by enterprise zone businesses or by residents of a zone or community. For this purpose, a lessor of any commercial property within a zone or community may rely on a lessee's certification that the lessee is an enterprise zone business.

Activities of legally separate (even if related) parties are not aggregated for purposes of determining whether an entity qualifies as an enterprise zone business. Notwithstanding the particular incentives described below, investments in enterprise zone businesses are subject to the general loss limitation rules (e.g., the passive loss rules and the at-risk limitations).

Certain of the investment incentives impose limitations based on the type of tangible property used in an enterprise zone business. Such property, referred to as "qualified zone property," is depreciable tangible property (including buildings), provided that: (1) such property is acquired by the taxpayer from an unrelated party after the zone designation takes effect; (2) the original use of the property in the zone commences with the taxpayer; and, (3) substantially all of the use of the property is in the active conduct of an enterprise zone business. In the case of property that is substantially renovated by the taxpayer, however, such property need not be acquired by the taxpayer after zone designation or originally used by the taxpayer within the zone if during any 24-month period after zone designation, the additions to the taxpayer's basis in such property exceed the greater of 100 percent of the taxpayer's basis in such property at the beginning of the period or $5,000.

Increased section 179 expensing. The primary capital incentive for first-round EZs, and an incentive for the second-round, is an additional $20,000 in the expensing allowance for depreciable business property under section 179. This additional expensing is extended to all qualified zone property, including buildings. This increase in the expensing allowance lowers capital costs for small zone businesses by allowing them to deduct the total cost of an asset in the year it is purchased.

Expensing is only available for small business. The section 179 expensing allowance is phased out for certain taxpayers with investment in depreciable business property during the taxable year above a specified threshold. For the allowance claimed with respect to qualified zone property, the phaseout range is extended to $476,000 of investment (exclusive of buildings) made by the taxpayer during the taxable year. All component members of a controlled group are treated as one taxpayer for purposes of the limitation and the phaseout.

The increased expensing allowance applies for purposes of the alternative minimum tax (i.e., it would not be treated as an adjustment for purposes of the alternative minimum tax). The allowance claimed with respect to qualified zone property would be recaptured if the property is not used predominantly in an enterprise zone business (under rules similar to present-law section 179(d)(10)).

Qualified enterprise zone facility bonds. OBRA 93 authorized a new category of tax-exempt private activity bonds for use in first-round EZs and ECs. "Qualified enterprise zone facility bonds" are bonds 95 percent or more of the net proceeds of which are to be used to provide (1) qualified zone property for an enterprise zone business, and (2) land located in the zone the use of which is functionally related and subordinate to such a business. Qualified enterprise zone facility bonds are exempt from the general restrictions on financing the acquisition of land and existing property (section 147(c)(1)(A) and (d)).

The aggregate face amount of qualified enterprise zone facility bonds allocable to any enterprise zone business may not exceed $3 million with respect to a particular zone. In addition, the aggregate face amount of qualified enterprise zone bonds allocable to an enterprise zone business in all zones may not exceed $20 million. Bonds satisfying these requirements may be pooled and sold as part of a larger issue.

TRA 97 waives until the end of a "startup period" the requirement that 95 percent or more of the proceeds of a bond issue be used by a qualified enterprise zone business. With respect to each property, the startup period ends at the beginning of the first taxable year beginning more than two years after the later of (1) the date of the bond issue financing such property, or (2) the date the property was placed in service (but in no event more than three years after the date of bond issuance). This waiver is only available if, at the beginning of the startup period, there is a reasonable expectation that the use by a qualified enterprise zone business would be satisfied at the end of the startup period and the business makes bona fide efforts to satisfy the enterprise zone business definition.

In addition, TRA 97 waives the requirements of an enterprise zone business (other than the requirement that at least 35 percent of the business' employees be residents of the zone or community) for all years after a prescribed testing period equal to first three taxable years after the startup period. Finally, in the case of property that is substantially renovated by the taxpayer, the property need not be acquired by the taxpayer after zone or community designation or originally used by the taxpayer within the zone if, during any 24-month period after zone or community designation, the additions to the taxpayer's basis in the property exceeded 15 percent of the taxpayer's basis at the beginning of the period, or $5,000 (whichever is greater).

In certain circumstances an issue of qualified enterprise zone facility bonds can continue to be treated as tax-exempt bonds despite the fact that the issue ceases to satisfy the requirements relating to financing qualified zone property for an enterprise zone business. This rule applies if the issuer and the borrower in good faith attempted to satisfy the applicable requirements and any noncompliance is corrected within a reasonable period after the discovery of the non-compliance. However, no deduction is allowed for interest on any tax-exempt financing for any period in which the financed facility ceases to be used in a zone or the principal user ceases to be an enterprise zone business.

Empowerment zone facility bonds. The second-round tax-exempt bond, the empowerment zone facility bond, is outside State private activity bond volume caps and not subject to the issue size limits. To control costs, total bond authorizing limits per zone were set. Second-round EZs in rural areas would be authorized to issue up to $60 million of bonds, urban EZs with populations under 100,000 would be subject to a bond cap of $130 million, and urban EZs with populations of 100,000 or more would be subject to a bond cap of $230 million.

II. Choice of Specific Tax Incentives

The Administration, working with Congress, has tried to be responsive to communities by modifying the first-round tax incentives to improve their effectiveness. The Administration’s proposal, and ultimately TRA 97, focused on modifying the original program to remove restrictive provisions. For example, there were concerns that the qualified enterprise zone facility bond requirements were too restrictive. Such restrictions resulted in an estimate of only five bonds being issued since the beginning of the program. As a result, the second-round tax-exempt bond, the empowerment zone facility bond, was created that is outside the State private activity bond volume cap and not subject to the issue size limits.

In addition, TRA 97 relaxed restrictions in the definition of qualifying "enterprise zone business" for the tax-exempt bonds and the section 179 expensing in both rounds . For example, instead of requiring at least 80 percent of total gross income of an enterprise zone business to be derived from the active conduct of a qualified business within an EZ or EC, the threshold is reduced to 50 percent. Similarly, "substantially all" requirements were generally relaxed to a "substantial portion."

In addition, rules applicable to rental businesses were clarified and relaxed. Specifically, a business that leases to others commercial property within a zone or community may rely on a lessee's certification that the lessee is an enterprise zone business. Similarly, the legislation provides that the rental to others of tangible personal property shall be treated as a qualified business if and only if at least 50 percent, instead of substantially all, of the rental of such property is by enterprise zone businesses or by residents of a zone or community.

Finally, TRA 97 relaxes and waives some requirements during the "start up" period of an operation financed with a qualified enterprise zone bond. For example, the requirement that 95 percent or more of the proceeds of a bond issue be used by a qualified enterprise zone business was waived until the end of a "startup period." In addition, the tax bill waives the requirements of an enterprise zone business (other than the requirement that at least 35 percent of the business' employees be residents of the zone or community) for all years after a prescribed testing period equal to first three taxable years after the startup period. Finally, the tax bill relaxes the rehabilitation requirement for financing existing property with qualified enterprise zone facility bonds.

As a result of these changes, we expect greater use of qualified enterprise zone facilities bonds.

Because the tax incentives are only a part of the EZ/EC program, a complete evaluation should examine all these components of the program and their effectiveness. Howard Glaser from HUD will discuss their plans for such evaluations.

Tax data will eventually provide useful information to monitor the EZ/EC program. However, we do not yet have detailed tax return data on these incentives. Tax return data for the 1995 tax year, the first full year in which the incentives were in effect, are available, but are based on a small sample that probably does not reflect accurately the use of the EZ/EC tax incentives by all businesses. Further, available data are unlikely to reflect the effects of the EZ/EC program because some zones are just beginning to implement their strategic plan. We also anticipate delays as taxpayers amend returns to take advantage of the incentives. To get a more complete understanding of the use of the EZ/EC tax incentives, the IRS is collecting data from the full population of business tax returns for the 1996 tax year. We expect to receive these data early next year.

Even with complete tax return data, consolidation rules can make it difficult to determine what zone is benefiting from a business taking advantage of a particular tax incentive. For example, a corporation may have operations in both the Detroit and Atlanta EZ's that can take advantage of the employment credit. The tax return for the corporation would show just the total employment credit taken in both zones.

With these caveats, tax return data should provide insights on the investment and employment activity benefiting from the credits as well as the characteristics of businesses claiming the credits. When tax return information are available for several years, it will also be possible to describe changes in economic activity in the zones over time. Even so, it will still be difficult to disentangle the effect of the tax incentives from other components of the zone program and other factors that may affect employment and investment in the designated areas, such as improvements in the economy or in the area surrounding the zone. This problem -- determining what would have happened in the absence of these incentives -- arises frequently in program analyses, and is probably best addressed by the five- and ten-year evaluations that Howard Glaser will describe. The tax data, which we intend to monitor, will play a role in establishing a baseline of how frequently the incentives are being used, and how those patterns change over time.

This concludes my prepared remarks. I would be pleased to respond to your questions.