Tax Abatement Responses
We wrote in the Jersey City Times about why tax abatements are a vector for financial mismanagement. In this post we’ll try to respond to the great questions and feedback to that op-ed. This post is a bit denser than the original, including the slightest bit of rudimentary algebra, so if you’d prefer to keep it simple, stick to the op-ed.
The discussion looks at tax abatements in 3 contexts:
1. Tax Abatements as Financial Instruments
1. Tax Abatements as Financial Instruments
Let’s start with what a tax abatement is and what it’s supposed to do.
Fundamentally, a tax abatement, at least in NJ, consists of two things: (a) tax relief and (b) a PILOT contract. A tax abatement is a tool in state law that permits states to buy goods and services in exchange for providing their sellers a tax break. In theory, the present value of that tax break should equal the market price of the goods or services the city acquires in exchange (which we’ll call “NPV”).
a. Tax Relief
Some abatement critics complain that abatements are intended to be a windfall or a benefit for a developer. We disagree. The purpose of the abatement is to compensate a developer for giving the city goods or services worth NPV.
Instead, we think the fatal flaw (or one of the fatal flaws) in abatements is that the positive case for them is weak. They don’t appear to actually solve any problem. A city can recreate an abatement’s buying power by simply either (1) paying the seller NPV in cash out of current revenue or (2) promising the seller to refund their future taxes by an amount that in sum, when discounted properly, equals NPV. The former is clearly already permitted by state law, and we aren’t aware of any legal prohibition against the latter.
Just like paying cash, an abatement scheme permits a city to buy a good or service it values today at NPV . . . but for an open-ended price. For example, let’s say the city wants to buy space in a to-be-built building that the city thinks is worth an NPV of $100. In a sane world, the city would buy the space for (1) $100 or (2) future tax rebates worth $100 in today’s dollars. Alternatively, it could issue a $100 abatement. If it issues an abatement, the actual settlement price is determined at a later date under the abatement terms. A common abatement length is 30 years, in which case, the settlement price would be set over those 30 years.
In the end, the taxes the city foregoes could have an NPV of $80, $100 or $120 (or some other price!). If the NPV is $80, there’s a windfall to the city, but if it’s $120, there’s a windfall to the developer. Why layer on this element of volatility for no apparent benefit to the city? The city could simply have just paid $100! We wrote about how the world’s greatest investor cautions heavily against open-ended price contracts.
You might respond that if the city is equally likely to have a windfall as it is to be screwed, the expected value of the trade equals $100, so the city isn’t harmed. We disagree. First, entering into an abatement involves significant transaction costs—including outside financial and legal advisors—that a simple cash purchase wouldn’t, so we should expect a deal with an abatement to result in a net expected value short of $100.
Second, there’s a substantial imbalance in the stakes for the principals, which we think stacks the deck against residents. While the city’s negotiators and their advisors will generally suffer zero personal consequences if their financial projections are wrong or if they don’t negotiate for a good deal, the developer’s principals generally will personally suffer if their financial projections are wrong or if they don’t negotiate a good deal. Let’s also not forget that the principals for developers are professional real estate investors whose livelihood comes down to their ability to make good deals. On the other hand, the incentive for the city’s financial advisors may even be to make sure the abatement deal gets done, even if it’s not in the interest of residents.
b. PILOTs
Perhaps recognizing that the open-ended price settlement mechanic exposes cities to uncapped volatility, NJ state law includes PILOTs in abatement agreements. A PILOT is a derivative instrument designed to limit a city’s downside (i.e., so $120 can’t turn into, for example $200) that state law requires be included with each long-term abatement. An abatement does this by requiring the developer to pay a fixed minimum payment (of course that’s expected to be substantially lower than what the developer would have paid if it paid normal taxes). Again, we wonder what problem PILOTs actually solve. If state lawmakers just didn’t trust cities to negotiate good deals, they could simply have capped abatement expenditures per year.
While the positive case for PILOTs is weak, we think what should kill them off is their downside. As we’ll discuss a bit more under “Tax Abatements as Patronage Opportunities” below, PILOT contracts can be quite complex, and that complexity leaves a lot of room for mischief. Under NJ law, PILOT minimum payments are based on future developer revenue. We think the PILOT agreement is where the developers are able to play games. They have shocking latitude to effectively fix the books and lie about their revenue and expenses to artificially lower PILOT payments. We wrote here about how we think KRE did this to Jersey City in a big way.
We aren’t the only ones to notice. See below commentary from an experienced advisor pointing out common developer tricks to extract value from less sophisticated cities.
Obligatory Berkshire, explaining similar incentives for fraud in the corporate context.
C. PILOTs as Financing Mechanic?
Some have defended PILOTs on the argument that PILOTs make it easier to finance developments. The thinking is that an otherwise desirable project needs property tax relief in order to hurdle—perhaps because a project lender wants to see that the project’s liabilities are predictable. We resist this logic for two reasons. First, property taxes are already highly correlated with project success, so we shouldn’t view them as a major project cash flow risk. For commercial properties, property tax assessment is typically indexed to anticipated future project income. Consequently, property taxes should rise when the project is doing well and fall if the project is expected to do poorly. In other words, it should be rare that a project’s property tax liabilities impact its ability to pay its bills outside of the most distressed situations.
Second, if developers and their lenders benefit from having fixed tax payments, they’re getting a financial benefit! Under our view of the purpose of tax abatements, developers should pay for the benefit of the city capping their tax obligations the same way you will generally pay a premium for a fixed mortgage versus a floating one. There are many easier ways for a municipality to give a lender downside or liquidity protection and be paid fairly for doing so.
2. Tax Abatements for Price Discovery
The other key dimension about abatements besides their appropriateness as financial instruments is how they perform as a price-setting mechanic. Bafflingly, tax abatements in NJ can generally only be entered into in respect of new projects (typically a redevelopment). This means that the city is prohibited from shopping for a deal among existing landlords, even if an existing property would suit its needs. For example, a city may want to provide a subsidy to make a given number of units affordable. Instead of going out and holding an auction among all landowners to get the best price, the city has to wait around until a new redevelopment meeting its needs is proposed and then negotiate exclusively with the developer.
Hopefully it’s clear enough that requiring a municipality to forego competition among developers will raise the price the city has to pay. We say a lot more about this in our op-ed.
3. Tax Abatements as Patronage Opportunities
The final distinction between abatements and simple cash purchases is that the former leaves a lot more room for backroom shenanigans. Abatement contracts are generally long and complex, including because they’re required to include a bunch of boilerplate box-ticking language to comply with state abatement law. In the folds and layers of that complexity is plenty of room for an unscrupulous politician to engage in the patronage game whereby they enter into a deal that’s less than optimal for constituents in exchange for a future favor from the developer or from a builder’s trade union (including an endorsement in the politician’s next campaign). Few will bother reading the terms in a hundred-page abatement contract, so it’s the perfect place to hide patronage.
Because of its woeful history of patronage-type corruption, the NJ state legislature has gone to great lengths to tie politicians’ hands so they can’t extract personal value from vendors, for example, requiring cities to set up transparent and competitive bid processes for third-party services. Abatements are a step backwards in this regard because as noted above, they’re difficult to audit and generally the costs are back-ended, often not hitting residents’ pockets for many years, sometimes long after the politician that negotiated them is out of office.
While we’re of course not pointing the finger at any particular politician, we think the incentives for dishonesty are so overwhelming that it’s implausible that they don’t lead to bad outcomes for residents with regularity.
In summary, we think it’s time to end abatements. They’re a flawed product that doesn’t appear to solve any particular problem but that introduce a lot of risk for residents.
