To encourage private investment in low-income areas, the 2017 Tax Cuts and Jobs Act established Opportunity Zones, a new community-based economic development program.
Opportunity Zones are supposed to stimulate economic growth in low-income areas by creating a tax-friendly environment for private investment. The final nominations for designated Opportunity Zones were submitted to the Department of the Treasury on April 20, and some submissions have already been approved.
This would address a concern best expressed by Manhattan Institute Senior Fellow Edward Glaeser, who recently suggested that the United States is moving towards “durable islands of wealth and poverty” which limit upward mobility. Regional disparities in income and employment are not shrinking. Rather, the gap between thriving economies and stagnant communities is expanding at a troubling pace. That polarization will continue to grow worse, as over 80 percent of all venture capital is now going to three elite areas: New York, Boston, and Silicon Valley.
Opportunity Zones could help reduce the divide. Individual states and U.S. territories can nominate 25 percent of their low-income Census tracts as Opportunity Zones. However, to qualify as a zone, the tract must meet specific requirements set forth by the Treasury. The criteria were created to ensure that investments flow to areas with high unemployment and low median incomes.
After approval by the Treasury, investors who sell unrelated assets yielding capital gains will have 180 days to reinvest the gains into Opportunity Funds, in which they can defer taxes on those gains until December 31, 2026, a strong tax incentive. In addition, investors will be able to increase the basis of the gains invested by 10 percent if the investment is maintained for 5 years and by an additional 5 percent if maintained for 7 years. After 10 years, gains from the investments in Opportunity Zones will become tax-free.
This encourages individuals to invest in these funds in the long term. Opportunity Zones, and the communities within them, attract additional capital and a safeguard that outside investors will not choose to withdraw funds unexpectedly.
There have been two major criticisms of the new program.
First, Opportunity Zones, similar to previous “distressed community programs,” may not effectively create a healthier economic environment.
Programs such as the Enterprise Zones of the 1980s have produced mixed results. Some of the most positive estimates showed only marginal gains in employment and economic growth. Additionally, businesses interviewed during the 1980s by the Government Accountability Office reported that the Enterprise Zones were not a significant reason for their investments.
According to a paper by economists Jared Bernstein, former Chief Economic Advisor to Vice President Joe Biden, and Kevin Hassett, current Chairman of the Council of Economic Advisors, the lack of substantial results were caused by underutilization of the programs which stemmed from a mix of weak incentives and an overly-complicated investment process.
Opportunity Zones may overcome these problems by streamlining the process for investors and increasing the time they have to allocate funds for investment from 60 to 180 days. Most important, Opportunity Zones will not have a restriction on the maximum size an investor can place in the funds, as had some previous programs.
This will allow larger investors in search of a tax-free return to diversify into the funds, potentially bringing substantial capital. Large investors should also attract smaller investors who feel more comfortable following the first mover.
Opportunity Zones will not bring a major project such as Amazon’s new headquarters to a distressed area right away. However, by attracting investment in the initial stages of an area’s recovery, they could help lay the groundwork for future employers and development more effectively then have previous programs.
Second, critics claim that funds might not go to low-income locations. Instead, they might go to places that have attracted capital without the tax incentive.
While the nominations were made to target areas with low-income residents and high unemployment, some statistical discrepancies could come into play. For example, tracts were selected using the 2010 Census; however, the economy has grown significantly since then and some eligible areas may no longer be distressed. Adam Looney, a Senior Fellow at the Brookings Institution, found that in South Dakota, Idaho, and Mississippi the areas chosen as Opportunity Zones are better off on average than the areas that were not.
It is important to note, that while these criticisms are valid, they do not reflect an overall failure of the selection process. The first 18 states to have their nominations approved selected Opportunity Zones that had an average poverty rate that was more than double the national average.
Shortly after submitting its initial nominations, California received a letter from the Economic Innovation Group (EIG) concerning poor choices in its selection of possible zones. EIG suggested California ensure that any contextual information be overlaid with the most up-to-date data, with a key focus on an accurate qualitative approach so as to avoid any poorly made and subjective choices by the state.
Following EIG’s suggestions, 45 percent of California’s designated zones now represent areas in the top ten percent of economic distress.
By adopting an evaluation methodology focused on accurate poverty measures, programs such as Opportunity Zones have the potential to increase investment in low-income areas and narrow the economic gap.
By reducing taxes, Opportunity Zones can help channel funds to specific areas of the country. They could potentially bring over $6 trillion to low-income areas, which could reduce geographic inequalities while increasing innovation, employment, quality of life, and other socially desirable economic outcomes.
Investments go where the after-tax return is highest, and Opportunity Zones have ensured that money may go to some of the most economically distressed areas of the country.
Jacob Reyes is a contributor to Economics21. Follow him on Twitter @Jacob_DReyes
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