WASHINGTON, March 19 (UPI) -- The New Markets Tax Credit program offers a tax credit for making equity investments in community development entities that develop businesses in poor communities.
The objective is admirable, so the question arises: is this the best way to achieve it, and how do we measure success?
Assisting entrepreneurial business through tax breaks has been a frequent theme of Western governments in the past 50 years, as they have sought to rectify what they perceive as imperfections in the capital market without deploying government money directly.
The U.S. Small Business Investment Corp. structure was created in 1958 for this purpose, when conventional venture capital investors were few and far between.
The rise of the venture capital industry from the late 1960s onwards reduced the field of operation of SBICs, which, being more restricted in their ability to lend and invest, tended to get the less attractive deals that the market-driven venture capitalists spurned.
However, the one advantage of an SBIC over a venture capitalist investor was and remained that the SBIC investor would invest in situations where a relatively long time (seven to 10 years) was required until the investment could be realized, whereas a conventional venture capital fund is extremely, even excessively, short-term oriented and seeks to "cash out" within at most two to three years.
In Britain, the first tax incentives for venture capital investment came through the Business Start-Up Scheme, in the 1982 Budget, under which investors could deduct the whole of a BSS investment from their income for tax purposes, provided the investment was left in for five years, thus achieving a tax break of 60 percent (at the top earned income tax rate) of the cash invested.
In spite of this advantage, the restriction that only start-ups could be funded in this way proved hugely burdensome, with one large BSS fund, for example, losing 85 percent of its investors' capital during its five-year life.
In the following year, the restriction to start-ups was lifted, and any operating company could be funded through a Business Expansion Scheme investment. Regrettably, the poor history of the previous year's BSS investments had soured investors on venture capital investing, and the amount of money attracted to BES funds was always disappointing.
Perhaps for this reason, however, some BES funds were remarkably successful. One in which I invested returned four times the initial investment over its eventual life of 14 years (minority share stakes in small companies are hard to sell advantageously) plus the 60 percent tax break.
The final nail in the BES coffin was placed when the foolish British Chancellor of the Exchequer Nigel Lawson, in his 1988 Budget, extended the BES to residential real estate investment. Of course, the amount invested in true venture capital promptly disappeared, and the scheme became simply a tax dodge for the wealthy.
The NMTC scheme is somewhat similar in structure to the British BES. It allows investors a credit against their income tax for seven years following investment, provided the investee companies are still in business.
The credit totals 5 percent of the investment during the first three years, and six percent for years four to seven, for a total tax credit of 39 percent of the investment.
The money invested is allocated to CDEs, which bid for portions of the money expected to be invested through this structure, up to a total of $2.5 billion in 2003 and $15 billion over the seven-year life of the legislation.
The first allocation of 66 CDE allotments, relating to the hoped-for $2.5 billion in investment, was made on March 14.
Tuesday, I met with Roy Priest, chief executive officer of the National Congress for Community Economic Development, an umbrella entity that seeks to empower non-profit CDEs and represents 13 of the 66 recipients of CDE allotments. We discussed how the program works and how it might need to be improved in the future.
United Press International: Do you have any information on what socially targeted "two test" investments like this yield?
Roy Priest: This is a brand new program, so there's no performance to date on it. The 66 organizations that have received allocations will now have to enter into an allocation agreement with the CDFI Fund, that will cover such things as their investment strategies, business plan etc., and then they'll be ready to go out and start doing some work about trying to raise investor interest.
Whether or not the 39-percent return over seven years on invested capital (through tax credits) will be enough to induce major investment is still an open question. As you know, it's much less than a conventional venture capital return. This is a strategy for driving new capital into underserved market areas. It's a counterpart to the low-income housing tax credit (of 1986) which did succeed in driving substantial capital into low-income housing.
Q: What are the criteria for these investments?
A: The areas that qualify for this investment have to meet certain quality tests, and about 40 percent of the areas in the U.S. qualify for this program. The businesses in these neighborhoods tend to be small local businesses, though there are a few established companies. They also tend to be higher risk projects and often don't do a good job of accounting and documentation. There must also be a question as to whether there will be enough demand in these neighborhoods to absorb the whole $15 billion.
Q: But in the bottom 40 percent of standard metropolitan statistical areas there are some thriving businesses -- the bottom 10 percent would be a different matter. Places like Hudson, N.Y., for example -- fairly depressed but not desperately impoverished -- would fall into this category.
A: For the first couple of years we'll be seeing where investments are being made, the most difficult 10 percent or the rest of the 40. In practice I would expect investment will go to the least vulnerable of the vulnerable areas.
There are two challenges. One is on the investor side. And the other is on the producer side -- organizations that will bring these deals forward to try to find financing. The capacity of these organizations to put the deal together, know where to take it, and negotiate the best deal is where it will come together.
Q: Essentially you need investment banker type talent to put the deals together which will -- at a guess -- be a lot more available in the next 10 years than in the last 10 because of all the people who've been blown out of Wall Street -- these people will be much happier to work on a percentage basis or for a fairly modest salary and use their talents for a poor community. If we have a long recession, this kind of thing should do rather well.
A: I would hope so. Recently, a number of organizations have done a study of inner city marketplaces, and what they've discovered is that there's a lot of purchasing power in these places.
Q: Absolutely, these neighborhoods are places like Harlem, not Lima, Peru -- their inhabitants people have money. On the tax credit, don't you have a problem that half the investments disappear after two years, and then you don't get your credit?
A: That is a piece that we fought a lot about, when this bill was structured initially. It had some rather stringent retraction provisions that could have made it very unattractive -- you can't necessarily hold an investment through an entire seven-year investment life.
You have to work with the small business, but that's what the community development corporations and other non-profits are for: they provide the technical assistance to small business that helps them keep going.
But if the business isn't there, all the technical assistance in the world is not going to make it last seven years. That's why there isn't much direct capital investment in small business; politically, if a small business fails after two years, a politician who's put capital into it is going to look very bad.
Q: There are clearly some structural issues here.
A: Yes. Another is that (President George W. Bush's) tax bill on dividends is going to affect badly investors' desire for these tax credits, just as it will affect the municipal bond market. There's a problem too that the $15 billion is subject to the political will for the allocations to happen, so that if the first two to three years don't show the performance you'd want, the program can be closed down.
Q: But at the end of the day, if the investment is going into existing businesses in the 10- to 40-percentile areas, it will do some good.
A: Right, it will, generate some additional jobs, which is the objective.
Q: So it really comes down to design. If you get your $2.5 billion, you've got something that will make a difference. What's your best estimate of how the money will be raised?
A: Primarily from wealthy individuals, who of course don't by and large make their own investment decisions. So the companies that have been awarded grants will have to go to the advisers, the big accountants, Merrill Lynch, and so on.
That's why you need recipients who are smart enough and have the connections to pull together the resources -- both with investors and also in smoothing the way for the investee companies in the local jurisdictions.
For example, CFN Corp. in Washington is run by Chris Kellogg, who was formerly with the U.S. Treasury under a previous administration, so he knows how to make things happen in this community. The recipients have to be connected at two levels, to the community, and to the sources of finance.
Q: The difficulty initially is going to be persuading the advisers to the money that this is worth doing.
A: Yes. On a previous loan program, where recipients got a $2 million allocation each, they didn't have good connections to sources of finance, and also the total amount of $40 million was so small that the U.S. Treasury was dilatory in issuing tax letters, which made advisers very nervous -- they need as much clarity as possible before they'll steer investors into it. This one's much bigger, so that shouldn't be a problem.
Q: Since there's no limit on the amount of tax credit per individual, isn't the real potential among the very wealthy, the dot-com billionaires, because they have their own private offices, whereas the Merrill Lynches will be constrained by the high risks of these investments and their fiduciary duty to clients?
A: Yes, that's right. You want investors who will go into this through their individual interest and not be bound by fiduciary duty. This is by no means the perfect mousetrap; we need to take a couple of years to see how it develops and adjust the regulations accordingly. But the important thing is that the system exists, so we have something to build on.
