Law Professor Argues Opportunity Zone Program Is Harmful

Professor Calvin Johnson of the University of Texas recently trashed an innovative tax program with an article in Tax Notes titled Repeal Opportunity Zones (available on SSRN). His thesis is that OZ projects must destroy affordable housing and increase tenant rents.

The Billionaire And The 501(c)(4)

Much credit for OZ becoming law goes to billionaire Sean Parker, who was looking for a way to allow those left behind to benefit from investor capital. Parker backed the creation of the Economic Innovation Group(EIG) to be independent, bipartisan, and pragmatic – “basically representing the poor people in America“. Professor Johnson seems to think that Parker and EIG should be making reparations.

John Lettieri, president and CEO of the (EIG) has seen a lot of criticism of Opportunity Zones. EIG was instrumental in getting OZ into the Code. Mr. Lettieri is prepared to give Professor Johnson some sort of prize for the most egregious and misinformed thing ever written on the subject.

Opportunity Zones

Although EIG had been promoting OZ as stand-alone legislation – The Investing In Opportunity Act – it became law as part of the Tax Cuts and Jobs Act of 2017, with one important piece left out. 

Opportunity Zones are census tracts designated by state governors. They must have a poverty rate of at least 20% or median income below 80% of the state or metro area. 5% of the census tracts can be contiguous to a qualifying tract as long as the income of that tract is not more than 125% of the contiguous tract.

It is complicated. Census tracts are defined based on how many people live in them, so they can be of widely disparate size. New York City with 303 square miles has 307 opportunity zones. Wyoming with 97,914 square miles has 25. 

All in there are over 8,000 opportunity zones in the country. The program has not been running very long and the plague has definitely put a crimp in things. So it is probably way too early to attempt to determine whether the program is overall good, bad, or indifferent when it comes to helping those left behind.

Professor Johnson cites an article by Dees Stribling  A Yacht Club, Michael Milken And Tesla: Meet 10 Of The Nation’s Swankiest Opportunity Zonesto support his thesis,

Mr. Lettieri followed up with a list of projects that tends to contradict Professor Johnson’s notions that OZ designation might be bad for the poor people living in a census tract. For example, there is:

Philadelphia, PA: Black-owned development firm, Mosaic, is developing a mixed-use project in one of the city’s most distressed communities. The project includes affordable homes, and new retail including a grocery store, bank, healthcare center, and restaurant. The developer worked with an online crowdfunding platform, Small Change, to offer a sidecar equity fund that allowed community members to make small-dollar investments and earn a return alongside other investors. 

Measurement

Both stunning success stories and tales of fraud waste and abuse are by necessity anecdotal. As I mentioned there was an important part of the Investing in Opportunity Act that was left out when it was incorporated into TCJA. Here it is in part:

(c) Report To Congress.—The Secretary of the Treasury, or the Secretary’s delegate, shall submit a report to Congress on the opportunity zone incentives enacted by this section beginning 5 years after the date of enactment of this Act and annually thereafter. ……… The report shall also include an assessment of the impacts and outcomes of the investments in those areas on economic indicators including job creation, poverty reduction, and new business starts, and other metrics as determined by the Secretary.

In its report Opportunity Zones Improved Oversight Needed to Evaluate Tax Expenditure Performance, the Government Accountability Office (GAO) notes the lack of means to evaluate the program.

Compared to some other community development tax expenditures, OZ generally has fewer limits on the project types that can be financed and fewer controls to limit potential revenue losses. While OZ can generally be used to support investment in any type of tangible asset class within a Zone, some other tax expenditures, such as the Low Income Housing Tax Credit, are targeted at specific project types. OZ is also not subject to limits on the aggregate dollar amount that can be claimed, unlike the New Markets Tax Credit.

Congress did not designate an agency with the responsibility and authority to collect data, evaluate, and report on OZ performance. GAO has previously reported that the Department of the Treasury (Treasury) could be the most appropriate agency to evaluate any tax expenditures that do not have logical connections to program agencies. GAO has also previously reported that achieving complex outcomes can benefit from collaboration among agencies. A member of an interagency council has issued a report estimating the effects of OZ, but the long-term future of this council, including any plans to continue evaluations over the duration of the tax expenditure, is uncertain

In my discussion with Mr. Lettieri, he indicated that EIG is hopeful that monitoring and measurement will become part of the program as Congress acts to reform it.

From The Practice Front Line

I spoke with Kenneth Weissenberg of EisnerAmper, Mr. Weissenberg has been working with both developers and investors. He has not seen projects which are likely to displace poor people. To the contrary, he has seen, among other things, the development of housing tailored to the needs of distressed lower-middle-income people. He sees such projects as potentially taking the pressure off displacement rather than the reverse.

In the OZ investment space, there are some mega-funds and there are quite a few small funds, where there might be a developer raising money from a small group of family, friends, and acquaintances. Investing in a partnership committed to a ten to twelve-year hold is different from investing in marketable securities where you can be confident about the liquidity of your investment.

 Many of the people Mr. Weissenberg sees investing in OZ deals are used to investing in illiquid partnerships. There are others for whom the OZ incentive was a factor in looking at investments that they might not otherwise have considered.

One of the big concerns for OZ investors is that capital gains rates might be higher in 2026 when they have to pick up the can they kicked down the road. Mr. Weissenberg would like to see some sort of rate protection if the plan is tweaked down the road.

Different Views Of Tax Policy

Professor Johnson’s article is part of a larger effort called the Shelf Project. Although the Shelf Project is largely the work of Professor Johnson, he has had some collaborators over the years. You can read the rationale behind The Shelf Project in a 2007 Tax Notes article The Shelf Project: Revenue-Raising Projects That Defend The Tax Base.

Congress needs to have well-developed projects on the shelf when it is ready to raise revenue. Otherwise, it will raise the revenue with whatever is available.

In a Catalog of Projects: 2007-2012, we can see a variety of revenue raisers that do not require rate increases or new taxes. They essentially broaden the base. Here is one from 2010 that would make Professor Johnson real popular in the tax planning community.

This proposal would disallow the deduction of the costs of tax planning, return preparation, tax audits, litigation, collection, and refunds. Payments to tax experts – including in-house experts – and the costs of tax litigation would be disallowed in full. An intermediate remedy – denying 25 percent of the costs – would apply to investment planning and structuring by professionals who are not tax specialists and when the work is not primarily tax-related but tax issues are present.

Professor Johnson’s second job out of law school (Stanford) was with the Treasury Department as Tax Legislative Counsel from 1973 to 1975. He was involved in the Tax Reform Act of 1976 and some of the thinking from that carried over into the Tax Reform of 1986. A big theme of those efforts was a broadened base allowing a lower rate.

A provision like Opportunity Zones moves in the opposite direction.

A Brilliant Idea

John Lettieri is very impressive. Along with Sean Parker and Steve Glickman he founded the Economic Innovation Group. According to its website:

EIG is a bipartisan public policy organization that combines innovative research and data-driven advocacy to address America’s most pressing economic challenges. From our headquarters in the nation’s capital, EIG convenes leading experts from the public and private sectors, develops original research, and advances creative policy proposals that bring new jobs, investment, and economic dynamism to U.S. communities.

One of the problems that EIG has developed a great deal of data on is how uneven growth in prosperity has been in a geographic sense. They developed a Distressed Community Index in order to measure the phenomenon.

When we consider the health of the U.S. economy only in aggregate terms, we miss out on the textured—and deeply uneven—story of how national growth and prosperity lift up, or leave behind, individual communities and the residents who call them home. The DCI is therefore an attempt to understand the spatial distribution of U.S. economic well-being. It is a lens through which we can evaluate where and for whom the country truly lives up to its promise as a land of opportunity.

In a 2015 paper for EIG – Unlocking Private Capital to Facilitate Economic Growth in Distressed Areas – economists Jared Bernstein and Kevin Hassett wrote:

In our view, policies promoting the establishment of investment funds specifically designed to allow all Americans to invest in the restoration of depressed areas could serve many positive goals. Most importantly, in a resource-constrained environment, such funds could provide the capital needed to reshape our most distressed communities by incentivizing those who have benefited from the American dream to invest in ways that seek to serve the common good.

The OZ legislation achieved that vision to an extent. The Novogradac Opportunity Zones Resource Center reports 811 Qualified Opportunity Funds on its Opportunity Fund List.

OZ legislation pretty much guarantees that anybody who has a capital gain of significant magnitude will have one or more advisers tell them that they should look at investing the gain in a fund that backs projects in a distressed community.

Even somebody like me who did not think it is such a hot idea for investors will mention it as an option just to be thorough. How did they manage it?

How Bipartisan Tax Legislation Happens

EIG is exempt under 501(c)(4). Its funding sources are not public and Mr. Lettieri told me that they are bound by confidentiality agreements. He did indicate though that their chairman Sean Parker is a significant backer of the organization.

Sean Parker is #319 on the Forbes billionaire list. His fortune is mostly attributed to his brief tenure at age 24 as President of Facebook. Steven Bertoni tells the story on Forbes with An Unlikely Group Of Billionaires And Politicians Has Created The Most Unbelievable Tax Break Ever.

“The incentive needs to be powerful enough that it can unlock large amounts of capital, aggregate that capital into funds and force the funds to invest in distressed areas,” says Parker, the original Facebook president whose think tank, the Economic Innovation Group, created the policy and helped press it into law. “Instead of having government hand out pools of taxpayer dollars, you have savvy investors directing money into projects they think will succeed.”

Mr. Bertoni traces the story back to 2007 when Mr. Parker was reflecting on how to get investment capital.

“People were sitting on large capital gains with low basis and huge appreciation. There was all this money sitting on the sidelines,” Parker says. “I started thinking, How do we get investors to put money into places where they wouldn’t normally invest?”

Beginning in 2014 Mr. Parker, already a donor to Democrats started also giving more to Republicans. From there it is a matter of hiring people who know how to make things happen in Washington. In 2015, 2016, and 2017 about $9.5 million flowed through the Economic Innovation Group. Besides salaries, there were payments to Hamilton Place Strategies LLC, Steptoe Johnson LLP, Washington Tax Group and Prime Policy Group.

The dive into the 990s is all I have to add to the story that Steve Bertoni told so well.

By 2016 the Opportunity Zone bill had won the support of 72 legislators from both parties. It was ideological surf and turf. For Republicans, it promised a tax cut, a market-based solution and a way to put power in the hands of state and local governments. Democrats, meanwhile, liked the prospect of pouring money into areas in dire need of funding. Also in the idea’s favor: It was new. “If you come up with something that’s completely novel,” Parker says, “there’s no organized opposition against it.”

Mr. Bertoni’s story anticipates the concerns that Professor Johnson has expressed about the dangers of gentrification.

Reflection

There is something of a generational thing going on here. Professor Johnson is a bit older than me. He graduated from Columbia in 1966, the year I started high school. He was part of the group of people who did the intellectual spadework to give us the Internal Revenue Code of 1986 which broadened the base while lowering rates.

It seems though that the impetus to tinker with the Code to achieve goals other than raising the right amount of revenue with the least collateral damage is irresistible. Tax expenditures have a way of seeming like a free lunch. So when a young billionaire reflects on how to make the world a better place by directing capital to areas that need it, why not add another section to the Internal Revenue Code? If it works society will have gotten quite a bang for his activist bucks.

In terms of Professor Johnson’s concern about gentrification, I would like to say that the jury is still out, but I can’t. It is not clear as to whether there ever will be a jury. We can count on there being a strong constituency for the OZ program. It happens that I am of the school that opposes the use of the tax code as the Swiss Army knife of social policy, but then there is Reilly’s First Law of Tax Planning – It is what it is. Deal with it.