The Heritage Foundation

Issue Bulletin #62

July 10, 1980

July 10, 1980 | Issue Bulletin on

The Urban Jobs and Enterprise Zone Act (H.R.7563 -S.2823)

(Archived document, may contain errors)

62

July 10, 1980

THE URBAN JOBS AND ENTERPRISE ZONE ACT

(H.R. 75639. S. 2823)

INTRODUCTION

Two years ago, President Carter stood amidst the rubble and burnt-out tenements of the South Bronx and promised federal aid to rebuild the area "brick by brick and block by block." But like so many promises to the depressed inner cities, the pledge proved to be a hollow one. An ambitious White House policy, calling for an expenditure of $13.5 billion by the fall of this year,. was whittled down by Congress to just $2.5 billion. Even a plan to rebuild Charlotte Street, where Mr. Carter had made his promise to the cities, was eventually scuttled.

The demise of the Carter urban policy is symptomatic of the disarray surrounding urban initiatives in recent years. Grandiose projects are introduced with great fanfare, only to become bogged down in the budget-bargaining process. Meanwhile, the inner districts of our older cities continue to decay as skilled, middle-income residents move to the suburbs and businesses close down, leaving behind the poor and unemployed. Even when government- sponsored projects have gone ahead, the results have often been disappointing or even counter-productive. As Senator John Chafee (R-RI) stated recently to the press:

Since the great "urban renewal" surge of the 1960s, all we have been doing is bulldozing great holes in our cities and throwing billions of federal dollars down them. Little has resulted, little has changed. We need a bold new approach.

Fortunately for the cities, that bold approach seems to be under way. A bill was introduced in Congress recently which would adopt a radically different policy in dealing with the problem of inner city decline. Based on the premise that what these areas need is real economic growth coming from innovative business enterprises, rather than ever more federal dollars, the Urban Jobs and Enterprise Act (H.R. 7563, S.2823) seeks to create a more attractive commercial climate for entrepreneurs in the inner cities by dramatic reductions in business-related taxes. The bill is a modified vers'ion of legislation introduced this spring by Representative Jack Kemp (R-NY). Kemp's chief co-sponsor in the House is Robert Garcia (D-NY), a liberal Democrat from the South Bronx. The Kemp-Garcia coalition is testimony to the wide appeal of the measure. The bill was introduced simultaneously in the Senate by Senators John Chafee and Rudy Boschwitz (R-Minn.).

BACKGROUND

The concept of the Enterprise Zone was first discussed publicly two years ago in Britain, in a speech by the then opposi- tion Treasury spokesman (now Chancellor of the Exchequer) Sir Geoffrey Howe. Sir Geoffrey drew on the work of a number of planning experts who had grown skeptical of traditional approaches to urban revitalization, and who were advocating policies aimed at encouraging entrepreneurs to establish job-creating businesses in the depressed areas. The essence of Sir Geoffrey's proposal was for districts of a square mile or so, in the most depressed parts of the cities, to be designated "Enterprise Zones," within which the following changes would be made:

a) Zoning and similar planning regulations would be drastically simplified, so that new businesses would only have to comply with basic pollution and safety standards.

b) Property taxes would be suspended on industrial and commer- cial property.

c) Capital gains and other business taxes would be significant- ly reduced.

d) Paperwork required by government agencies would be kept to the bare minimum.

e) Impediments to job creation, such as the closed shop and minimum wage laws, would not operate in the zone.

f) Wherever practicable, a free trade zone would be incorporated into the Enterprise Zone.

g) The government would guarantee the continuation of the above provisions for a minimum number of years.

In March of this year, the British government announced that it would set up five or six such zones by the end of 1980. The announcement gained an enthusiastic welcome from business and city leaders of widely differing political views. The reaction of the city development officer for Liverpool was typical. If a zone were to be created in the declining English port, he said, "It will.be a shot in the arm for the whole town."

The idea of the Enterprise Zone was first intrTduced to the United States last year by The Heritage Foundation. It has aroused wide interest among journalists, businessmen, minority groups and legislators. An Enterprise Zone bill was introduced in Illinois last year and was only narrowly defeated in the state senate, having passed the house comfortably. After the 1980 elections, similar bills are expected to be introduced in a number of states, in addition to Illinois.

In May of this year, Congressman Jack Kemp introduced his Urban Jobs and Enterprise Zone Act (H.R. 7240). A revised version of this bill was introduced on June 12 in the House (H.R. 7563) and in the Senate (S. 2823).

PROVISIONS OF THE BILL

General

The Urban Jobs and Enterprise Zone Act does not deal with matters which would fall under the jurisdiction of state and local government, such as zoning. Furthermore, it differs from the British approach in that there is no provision aimed at reducing the regulatory burden within the zones; nor does the bill make any change in the minimum wage laws.

The measure does not specify sites where "Enterprise Jobs Zones" (as the sponsors term their version of Enterprise Zones) would be located. What it does instead is to allow for tax and other changes in federal law in areas designated by local govern- ments, provided these areas meet certain requirements.

Specific

1) Unemployment and Poverty Requirement

To be eligible for Enterprise Jobs Zone status: Either there must have been an average rate of unemployment in the area of twice the national average for'the most recent 24 mo@th period, and 30 percent of families are below the poverty level, or the

1. For a description and analysis of the original British proposal for Enterprise Zones, see Stuart Butler, "Enterprise Zones: A Solution to the Urban Crisis?" (Heritage Foundation International Briefing #3, February 20, 1979). 2. Defined by the bill as 85 percent of the average lower living standard income level determined by the Secretary of Labor and published by the Bureau of Labor Statistics.

The average unemployment rate during the most recent period was at least three times the national average, or at least 50 percent more families are below the poverty level-.

2) Area Requirement

The area to be considered as a zone must have a continuous border and must have a population of at least 4,000 (or be an Indian Reservation).

3) Property Tax Requirement

The appropriate local government 'must agree to a "permanent" reduction of property taxes within the zone of not less than 20 percent of the effective real rate. This reduction must be made within 4 years of the area being designated an Enterprise Jobs Zone by the federal government.

If the Secretary of Commerce is satisfied that an area recommended by a local government complies with the unemployment, poverty and area requirements, and if the local government has agreed to the 'roperty tax change, the Secretary would declare p the area an Enterprise Jobs Zone. This designation would last for a minimum of 10 years, unless the Secretary determined that the local government was not carrying out the property tax reduc- tion; in which case, the designation would be revoked.

4) Incentives

Once an area had been designated an Enterprise Jobs Zone, the following incentives would apply, in addition to the property tax reduction and any other local incentives.

a) Non-Corporate Property Owners

The capital gains deduction would be increased from 60 percent to 80 percent on personal property. This would include tangible property and real estate used predominantly for business purposeg within the zone, and any interest in "qualified" busi- nesses. The deduction would be available to non-residents of the zone. In addition, residents of the zone would be permitted to deduct capital gains on residential property at the higher rate. The capital gain would also not be taken'into account as a preference for the purposes of assessing minimum tax.

3. A company is a "qualified business" if at least 50 percent of its employees are "qualified employees" (see Note 4) and if at least 50 percent of those qualified employees are residents of an Enterprise Jobs Zone (not necessarily the one in which the business is located).

b) "Qualified" Employees of Companies4

For any employee who performs at least 50 percent of his services within one or more zones, the employee and employer's social security tax would be reduced by 90 percent if the worker was below 21 years of age, and by 50 percent if he or she were 21 or older. This change in rates would not affect the amount or extent of benefits available under the Social Security Act had the full rate been paid. The social security fund would be reimbursed by the Treasury to the amount that payroll tax revenue was reduced.

c) Corporations in General

The capital gains tax rate payable by corporations would be reduced to 15 percent on tangible or real property used for trade within an Enterprise Jobs Zone. The corporation would continue to pay the 28 percent rate on all other property. Again, the capital gain would not be considered as a preference for the minimum tax.

5 d) "Qualified" Businesses

Such a business woul d enjoy a 15 percent reduction in corpor- ate tax rates. In addition, the company..would be eligible for a three-year, straight-line depreciation on all property (other than land) placed in service in a zone, subject to an annual limit of $500,000. Qualified businesses could also carry over losses, for tax purposes, for up to 10 years. The extended carryover would apply to operations both inside and outside the zone. The business could also elect to use a cash method of computing taxable income.

e) Foreign Trade Zone Provision

The bill contains a sense of the Congress provision to encourage the designation of Enterprise Jobs Zones as foreign trade zones. The Foreign Trade Zone Board of the Department of Commerce would be required to deal speedily with such applications, and to take into account the future development anticipated from the operation of the act in its evaluation. In other words, a foreign trade zone could be established before the facilities and business conditions normally required for foreign trade zone status were actually in existence.

4. An employee is a "qualified employee" if substantially all-the services performed by the employee are performed in one or more Enterprise Jobs Zones. 5. As defined in note 3. Note that at least 25 percent of the employdes of such a business must reside in a zone.

COMMENT

Creating a Climate for Entrepreneurs

This bill differs from previous measures to assist inner cities in two crucial ways. In the first place, it aims to encourage risk-taking by small entrepreneurs, and to use such new businesses as the principal vehicle for revitalization. There are good reasons fgr taking this approach. Studies by MIT and other institutions have shown clearly that company closure rates differ little from city to city. It is the creation rates that differ markedly. The bill aims to improve that rate in the depressed inner city districts. Small businesses are also the primary creators of jobs: two-thirds of all new emp@oyment is generated by companies with fewer than 25 employees.

The second distinctive strategy of the bill involves the establishment of a favorable business climatel rather than the more orthodox approach.of supporting specific projects. This would not only be more economical, from an administrative point of view, but would also be more likely to succeed in stimulating. economic growth. The chances of successfully identifying the new companies which would be the best job creators are small. The "climate" approach avoids the need.

"Qualified" Businesses

Under the definition contained in the bill, only companies with a minimum of 50 percent of employees working within a zone (of whom 50 percent must be zone residents), would be entitled to the corporate tax, depreciation, loss carryover and cash account- ing incentives. The others would benefit only from the capital gains and property tax changes. This distinction would have important effects. It would encourage companies located in the zone to hire local workers, rather than bringing in all their employees from elsewhere. It would also reduce the incentive for a company to establish a very limited operation in a zone, merely to obtain some tax benefits for its non-zone activities. Unfortu- nately, it would also mean that incentives would be reduced for a large corporation to open a small plant in a zone, even if this employed exclusively local labor (given the residency percentage rule). A way around this might be for the company to establish a semi-dependent subsidiary within the zone, although it is not certain that this would satisfy the bill's provisions. New, small businesses established by residents of the zone, employing local residents, would qualify for all the benefits -- which is one of the principal goals of the bill.

6. See, for example, David Birch, The Process Causing Economic Change in Cities (MIT Program-on Neighborhood and Regional Change, 1978). 7. David Birch, The Job Creation Process (MIT, 1979). For a discussion of the importance of small business to the Enterprise Zone concept, see Stuart Butler, "Urban Renewal: A Modest Proposal," Policy Review, #13, Summer 1980.

Targeting Requirements

The poverty, unemployment, and population stipulations are necessarily somewhat arbitrary. According to the bill's sponsors, no more than 5 percent of the nation's population currently reside in areas meeting the criteria. It could be, however, that the 4,000 population base might exclude some old former industrial districts which have become depopulated. The poverty requirement chosen in the bill has the advantage that it is related to the local cost of living.

Social Security

The social security tax changes in the bill are likely to prove controversial. The purpose is to lower the cost of labor in the zones, making it attractive for companies to hire young, unskilled people who are currently rendered uneconomic by the minimum wage laws. A simpler method would have been to suspend these laws within the zones, or at least to experiment with a youth-differential minimum wage. Countless studies provide strong evidence to show that minimum wage laws dissuade companies from employing those on the bottom rung of the employment ladder --in particular young blacks." Given the limited application of Enterprise Zones, they would seem to be ideal places to test the validity of this evidence.

Using social security tax changes as a more politically palatable alternative to suspending minimum wage laws could open a Pandora's box of problems. It would establish the precedent of supporting the social security fund out of general revenues, which would disturb many. And by using tax breaks, rather than the marketplace, to rationalize the labor market, it would open up the possibility of all manner of subsidies to manipulate employment patterns.

The supporters of the bill do point out the loss to general revenues in making up the shortfall in social security tax income would be offset - possibly totally - by income tax revenue from inner city residents who become taxpayers thanks to job creations.

Capital Gains

The capital gains provision should encourage capital formation within a zone, and would be an added incentive to risk-taking. The wording of the bill also implies that non-resident stockholders of qualified companies would be able to take the increased deduc- tion. This-would encourage investment in companies willing to conduct most of their business within Enterprise Jobs Zones.

Applying the capital gains deduction to residential property would be a stimulus to the housing market, as would the required decrease in property tax rates, and so one could expect consider- able rehabilitation and improved maintenance. It may be argued, however, that much of this improvement could be frustrated by a continuation of rent control, particularly if permitted rents were to be reassessed downward to reflect the tax benefits to landlords. Rent control perhaps more than any other factor is responsible for abandonment and the decline of housing standards in many cities.

De reciation, cash Accounting, and Loss Carryover

The straight-line depreciation available to qualified busi- nesses would allow these companies to write-off new assets quickly, and so would strengthen their financial position during the first few years. Straight-line depreciation has the added advantage of simplicity, thereby reducing accounting costs and IRS violations by new firms. Cash accounting is also much simpler than accrual methods, and it would involve a lighter tax burden for businesses during a period of inflation, since inflated inventory values are subject to tax in normal circumstances. By extending the loss carryover to 10 years,.the bill would encourage companies to continue during difficult periods.

Foreign Trade Zones

The foreign trade zone provision is an important feature of the bill. It would urge the Department of Commerce to award foreign trade zone status to Enterprise Jobs Zones even if they had not yet reached the standards normally required. Foreign trade zones around the world have proved to be remarkably success- ful at stimulating local economic growth -- Hong Kong and Taiwan are good examples of what can be achieved.

Within a foreign trade zone imported goods are not liable for customs duty until they leave the zone, and if they are re-exported no duty is payable. So importers do not have to tie up capital in goods awaiting final delivery or re-exportation. Furthermore, goods which are reprocessed within a zgne are not subject to duty on the value added within the zone. Thus it is often advantageous for a foreign company to invest in assembly plants in a U.S. foreign trade zone to finish its goods, in order to avoid part of the duty. In trade zones around the world, foreign installations are a major source of employment.

If foreign trade zones were to be incorporated into Enterprise Jobs Zones, it would undoubtedly lead to the attraction of sub- stantial amounts of foreign capital into the inner cities, and the creation of a large number of new jobs concerned with finish- ing, re-exporting and warehousing.

8. This has only been true since Spring 1980 in the case of the United States. Prior to that the added value was subject to duty, and so American foreign trade zones were far less attractive to companies than those of other countries. With the change in the regulations, however, a major incentive to the construction of assembling plants has been provided.

h) Regulation

The Urban Jobs and Enterprise Zone Act is almost solely 4 tax measure, and that may be its greatest weakness. There are no provisions within it which would have the effect of relaxing federal regulatory obstacles in the zones -- other than the simplification of accounting procedures. Yet the small business sector has made it clear repeatedly that government paperwork and regulations are a severe handicap, particularly for new businesses opened by people with limited education. These are precisely the kinds of businesses which the Enterprise Jobs Zone is aiming to encourage. Unless there is a streamlining of regulations in these areas, the tax incentives cduld be seriously blunted.

Sponsors of the bill argue that this bill is not the place for regulatory reform, since it would require extremely complex provisions and would divert attention from the main thrust of the bill. Furthermore, there are already moves in Congress to exempt small businesses from many unnecessary regulations, and these changes would apply to the zones. While this may be tactically sound, the impression is given to anyone examining the bill that taxation is the principal -- indeed only -- impediment to economic growth in the inner cities. Even if other bills are expected to deal with the regulatory issue,.it would seem sensible that this bill should at least make it clear that to revitalize the inner cities a sharp knife must be applied to agency red tape as well as the tax code.

Zoning

Zoning simplification is essential to any revival of the inner cities. Change of use must be facilitated to allow busi- nesses to use old buildings, in order to reduce start-up costs and to encourage balanced neighborhoods. The bill does not require local governments to make zoning changes in order to obtain federal tax incentives. Again, only tax changes are required.

It is easier to defend this omission than the lack of provisions dealing with regulation. Specifying zoning changes would be very difficult to do with any precision, given the complexity and variety of local rules. Even attempting to do so could antagonize local governments. In addition, it could be argued that any local government which is seriously entertaining the possibility of setting up an Enterprise Jobs Zone is also going to be the kind of government which will be considering zoning changes in any case: so a provision would be unnecessary.

Cost

The sponsors of the bill have made the following cost estimates for FY 1981, assuming that half the qualifying areas decide to become Enterprise Jobs Zones.

Social Security Tax Reduction $1,137 million

Capital Gains Tax Reduction 75 million

Corporate Tax Reduction 131 million

Accelerated Depreciation 53 million

Cash Accounting 12 million

Administrative Costs 21 million

Loss Carryover negligible

Total Cost to Federal Government $1,429 million

As the sponsors point out, this is only one-seventh of the cost of CETA, and an equally small proportion of the budget for the multitude of current programs aimed at rejuvenating inner city areas. If changes in the minimum wage, rather than social security tax changes, were used to stimulate employment, the cost would be substantially lower -- under $300 million. The estimate is also a static one, assuming that there will be no inflow of funds as a result of economic growth. If this is built into the cost estimates, using the CBO assumption of a 30 percent reflow, the cost would fall to approximately $1 billion. of course, if the stimulus to the inner cities were as dramatic as "supply siders" like Jack Kemp contend, there could be considerable inflows of income tax and other revenues, more than offsetting income foregone by the business tax incentives.

Property Tax

One of the arguments often made against the Enterprise Zone idea is that cities which are already in dire financial straits cannot afford to lose property tax revenue. But property tax is not collected on empty buildings and rubble. And the loss on currently occupied residences a'nd businesses is likely to be more than offset by the economic benefits to a city arising from increases in local incomes and employment, and reductions in welfare costs.

Relocation

A second criticism often voiced against the concept is that providing incentives in one area might simply lead to businesses already established elsewhere in a city uprooting and relocating in the zone in order to obtain the tax benefits. While this would certainly help the depressed area, it is said, it could cause a decline and tax loss elsewhere.

In practice, however, relocation is far less common than is generally supposed. It is expensive and risky to move from a known location to an uncertain one. Even the "movement" to the sun belt and the suburbs consists in the main of new businesses, and new subsidiaries, rather than the physical movement of esta- blished businesses.

In any case, the provisions of the bill are aimed at encour- aging new, small businesses. The incentives relate much more to start-up costs than to most other aspects of business. Given that, and the fact that to be regarded as "qualified," an esta- blished company would have to hire -- and presumably train -- local residents, the inducement to relocate would be far less than the incentive to create a new business.

CONCLUSION

Although some detailed criticisms can be made of the Urban Jobs and Enterprise Zone Act, it does provide a bold new starting point for the discussion of inner city revitalization. The breadth of political support it has already received gives an indication of the soundness of its approach. It appeals to fiscal conservatives just as much as it does to minorities and other urban residents, who have grown critical of the federal bulldozer approach to city problems. It builds on already proven ideas, such as foreign trade zones and inexpensive self-help projects, and turns them into a general policy. No doubt there will be changes made in the bill in the months ahead, but the nucleus is there for a fresh debate on the city.

There are several areas of discussion which should be pursued, some of which will be considered in future Heritage Foundation publications. For example, the possibilities of using Enterprise Zones partly as experimental areas might be examined. Homesteading, shopsteading, a youth-differential minimum wage, etc. could be introduced in selected zones on a trial basis. Another possibility to consider would be the use of a modified version of the Enterprise Zone in cities like Detroit, where a major industry is in decline. By encouraging innovation and new businesses in such cities, the restructuring of the local economy could be accelerated dramati- cally, to the benefit of displaced workers and with the minimum of federal wrangling and expenditures.

The Enterprise Zone concept is an important development in thinking on urban affairs. It is indicative of a significant shift in the attitude of many experts: away from the belief that the only solution to decay is a massive injection of tax dollars and artificial jobs, and towards a realization that the real need is to unharness the innovative abilities of the entrepreneur.

Stuart M. Butler, Ph.D. Policy Analyst

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