Tax Increment Financing (TIF)

Cities have accessed capital markets to help fund urban regeneration in a variety of ways. One possibility is through the issuance of TIF bonds. TIF has been used by American municipalities for more than 40 years. This method has provided them with a locally administered redevelopment financing tool that exploits the rise in economic value and associated increase in tax receipts that accompanies successful urban redevelopment.

TIF allows local governments to invest in public infrastructure and other improvements up-front. Local governments can then pay later for those investments. They can do so by capturing the future anticipated increase in tax revenues generated by the project. This financing approach is possible when a new development is of a sufficiently large scale, and when its completion is expected to result in a sufficiently large increase in the value of surrounding real estate such that the resulting incremental local tax revenues generated by the new project can support a bond issuance. TIF bonds have been used to fund land acquisition, sewer and water upgrades, environmental remediation, construction of parks, and road construction, among others. Over the past several decades in the United States, two project variations of TIF have evolved: bond financing and pay as you go.

Bond Financing
This is the most common form of TIF, in which a local government issues bonds backed by a percentage of projected future (and higher) tax collections caused by increased property values or new business activity within the designated project area. In this case, bond proceeds pay for present-day public improvements in the first year. These are projected to create the economic conditions leading to incremental increases in tax revenues, which can take place over a period of 15–25 years. Many bonds are revenue-backed; that is, they are not backed by the full faith and credit of the sponsoring government. Others require the backing of a general fund in order to access cost-effective bond terms. This means that the municipality bears the risk of repayment.

To determine the viability and appropriateness of using TIF, a municipality must first determine the market and financial feasibility of the proposed new development. It must also estimate the project’s financing gap, that is, the amount of public subsidy required—without which the private sector would not invest. The municipality would identify a geographic area from which a tax increment could be drawn. For a very large project of more than five or six hundred thousand square feet of new construction, for example, the TIF boundaries might follow those of an urban regeneration district; for other projects, the area from which a tax increment would be drawn might be broader and may encompass all of a central business district. Afterward, the city would establish the initial assessed value of all the land and existing tax collections within that designated area. The city would then estimate—based on the proposed development program, market feasibility, and estimated absorption rates—the likely incremental taxes that could be generated within that area over the tenor of the bond. At this point, based on assumed bond terms and estimated transaction costs, the city could assess whether the incremental increase in tax revenues would generate enough to pay for the financing gap.

Pay as You Go
Another form of TIF financing is known as “pay as you go,” in which the government reimburses a private developer as incremental taxes are generated. This form of TIF requires a developer to absorb some of the risk, in that the developer is required to invest its own capital in infrastructure costs. The developer can only get repaid (an amount that typically includes interest) after the project delivers and begins to be absorbed by the market.

Advantages of TIFs
Among the advantages of TIF as a source of financing is that it allows governments to invest in improvements without relying on other (more costly) sources of funding, for instance, intergovernmental transfers, capital reserves, or tax increases. Further, a TIF can facilitate the self-financing of a project with minimal negative fiscal impact. By contrast, the up-front timing of when infrastructure funds are made available through TIFs is more attractive than the timing of tax abatements or regulatory tools. Whereas TIFs have been used successfully to stimulate urban regeneration and positive fiscal impacts, this tool has also been poorly used, engendering opposition. One of the criticisms about TIFs as a financing tool is that some cities have deployed it for unnecessary investments, such as offering financial incentives to encourage companies to relocate. Another criticism is that some cities have drawn TIF districts so large that they capture revenue from areas that would have appreciated in value regardless of the TIF designation.

Conditions for Using TIFs
The use of a TIF requires robust real estate and economic conditions. A TIF is most appropriately used when land uses are up-zoned and when there is strong market demand. It is also appropriate in cases when the absence of prior development interest in a site with otherwise excellent attributes is related to a site-specific impediment, such as contamination of former rail yards. In such cases, reducing upfront costs of development can make the site more attractive to developers. An example of this type of TIF case is outlined in box.

Use of TIF in financing the redevelopment of Atlantic Station in Atlanta, Georgia

One example of a city’s successful use of a TIF as a tool to finance urban regeneration can be found at Atlantic Station, a 138-acre (56-hectare) former steel mill site in Atlanta, Georgia. Although the site was centrally located and well positioned along major thoroughfares, because of the significant environmental remediation required, the private sector would not invest. In this case, the public sector decided to finance the up-front costs of required environmental remediation in order to stimulate private sector investment and unlock a positive fiscal economic impact.

The specific policy goals that the city wanted to advance included addressing population growth in a sustainable way through the promotion of a higher-density, mixed-use, transit-oriented community (thereby discouraging urban sprawl); and remediating environmental contamination.

The city and the developers agreed to a redevelopment vision of a smart growth, live/work/play, mixed-use district. The city established a “tax allocation district,” and designated a 25-year term from 2001–26 for the project. It was agreed that the funds would be used to help pay for the costs of new roads, utilities, and environmental remediation (reimbursement). In addition, a multistory, below-grade parking structure was planned. Bond offerings were successfully issued in 2001, 2006, and 2007, in amounts of US$76 million, US$166 million, and US$85 million, respectively (Paul 2007).

Typical of TIFs, the bond proceeds covered the costs of issuance and capitalized interest, with the balance utilized to fund infrastructure costs incurred by the developers. In the Atlantic Station case, one of the developers purchased the bonds to finance the improvements, thereby avoiding the need for additional guaranties and credit enhancements.

Prior to the project, the site generated US$300,000 per year in property taxes; by 2013, the site generated more than US$30 million in annual property taxes. The performance of this TIF exceeded initial estimates. Indeed, the formerly blighted site has been redeveloped, and the city has achieved significant positive fiscal, economic, and policy impacts.

A city must negotiate a realistic time frame with developers for construction and absorption and then determine cost-effective timing for bond issuance. To be most cost-effective, a TIF should be issued at the last possible moment, that is, when the private sector is ready and has committed to construct a negotiated development program. Given high transaction costs (for instance, a bond counsel, or a public finance adviser to help a city size and structure the TIF appropriately), this tool is less appropriate for funding smaller projects. Also, a city must consider how best to mitigate the potential risks of repayment, as well as the potentially negative impact on a city’s credit rating as a result of providing a guarantee.

In addition to favorable market conditions, certain institutional and regulatory structures need to be in place. In assessing the attractiveness of a TIF bond, potential bond investors will look to a city’s underlying creditworthiness, the project’s market viability, the developer’s good faith, and any guarantors (perhaps from a higher-level government entity). Investors will expect certainty with respect to the ability of the city to meet its contractual duties. If significant risks exist, investors will want some form of third party guarantee, which can add to the overall complexity and cost of the transaction.