Photo by dctim1 on Flickr.

New data from the Office of the DC CFO reveals that the initial wave of development subsidies, such as Gallery Place, have repaid to the city well ahead of schedule. While excellent news for the city’s finances, these subsidies also provide important lessons that some present-day corporate subsidies don’t always follow.

The hefty return to the city’s coffers vindicates proponents who have faced years of criticism for their deals with developers. Authors of these successful subsidies followed 2 important rules.

First, they identified corporate activities that would yield indirect, “knock-on” benefits that are strategically important beyond the direct tax revenues of the activities. Second, they narrowly targeted the subsidies to only the size necessary to create that “knock-on” benefit.

First wave of subsidies reap healthy return

Most pre-recession subsidies were made through tax increment financing (TIFs), in which future gains in sales and/or property taxes from a development are used to repay bonds that finance a developer subsidy.

Each of these TIFs are repaying to the city well ahead of schedule, providing needed funds for schools, social services and other cash-strapped priorities in DC.

Many of these projects were harshly criticized at the time as corporate giveaways. So the speedy repayment of these subsidies lends credibility to the arguments of their proponents, such as Councilmember Jack Evans and former Mayor Williams, and to TIFs in general.

Spy Museum2001$6,900,000Paid in 2007 instead of 2014
Gallery Place2002$73,650,000Returned $15,175,861 to city above debt payments
Mandarin Oriental Hotel2002$46,000,000
Embassy Suites2003$11,000,000Paid in 2011 instead of 2016
DC USA2004$40,000,000Estimated to be paid in 2015 instead of 2026
Capitol Hill Towers2006$11,500,000$2.4 remaining, matures in 2029

These TIFs were successful because they were designed in accordance with two principles of effective corporate subsidies. As will be seen below, present-day corporate subsidies haven’t always followed one or the other of these two principles.

1) Focus on knock-on benefits: Advocates for corporate subsidies often appeal to the tax revenue that would be lost if a developer doesn’t build a building or a company chooses not to locate in one’s city. Successful subsidies, however, are more focused on knock-on benefits that are strategically important to a city’s finances.

Granting subsidies so that a company’s activities — developing a property, locating in one’s city — will yield tax revenue only encourages rent seeking by all companies who develop a property or choose to locate in the city.

When the desired activity is to locate in one’s city, a “race to the bottom” ensues between states which only hurts their collective ability to pay for education and social services.

That’s why effective subsidies are designed to yield knock-on benefits that support a city’s strategic goals, like developing a particular sector or a particular part of the city.

The first wave of TIFs were intended to steer the development of downtown away from office buildings and towards multi-use. As Councilmember Evans explained it, “The highest [revenue] use is an office building but then you end up with a Crystal City complex which I can’t stand.”

The knock-on activities — more downtown residents and more downtown shoppers — the downtown TIFs triggered are not only strengthening those investments, but also producing tax revenue from downtown in many other forms. That’s what happens when knock-on benefits are the goal, not the direct tax revenues of an investment.

2) Narrowly target subsidy to yield knock-on benefits: There are always risks with corporate subsidies. The company could pick up and leave without it, or maybe they would have completed the project even without the subsidy.

That’s why it’s critical to limit a city’s exposure. Subsidies are investments, and investments have risks. The DC CFO narrowly targeted the first wave of TIFs to be only as much as is needed to stimulate the intended knock-on benefits for the city.

For each TIF application, the CFO conducted a gap analysis. This analysis compares the amount of private financing that should be available for a development to the costs of the project. The CFO would only certify TIFs at that subsidy amount. The head of economic development finance for the DC CFO, John Ross, explained the process this way:

CFO had to do a certification, and that certification had to include a list of issues. One of them was whether the TIF would cover the debt service payments. One was whether the project would move forward without government support. One was the level of benefits of the TIF that would go to the community. Without that, the TIF could not even go to the Council.

While time-consuming, such a process ensures that subsidies are narrowly targeted to yield the benefits intended.

Present-day subsidies often veer from principles of early TIFs

If the District’s first corporate subsidies have reaped such healthy returns, several present-day subsidies veer from the principles behind the successful subsidies.

Some recent large TIFs, like Southwest Waterfront and O Street Market, as well as the proposed LivingSocial tax break, don’t follow these principles.

There has been no financial gap analysis for more recent TIFs. Without ensuring that any financing gap actually exists, DC doesn’t know if development projects would have happened anyway and it risks overpaying.

The first wave of TIFs were granted under the TIF Authorization Act of 1998 which required a thorough financial analysis and certification by the CFO.

Though no longer empowered to certify TIFs, the CFO still provides financial assessments of TIF applications to the Council and Mayor. These assessments raised particular concerns about 2 TIFs: City Market at O Street and the Southwest Waterfront.

City Market at O Street2008$46,500,000
Southwest Waterfront2014$198,000,000

The CFO, in his assessment, complained that both the O Street and Southwest Waterfront TIFs were being granted with less information about the project than would be required to issue a complete financial evaluation. There were no final plans or cost estimates for either project.

In fact, neither application included a specific financial commitment from the private developer, making impossible any analysis of the necessary size of the subsidy. The O Street application said that the developer for the hotel hadn’t even been identified yet, even though the hotel was supposed to provide 44% of the incremental tax revenues to repay the bond.

While the CFO’s office was included in negotiations with the developers after raising concerns in their analyses, the process for granting these TIFs was clearly intended to increase speed at the expense of financial scrutiny.

More recently, the proposed LivingSocial subsidy of up to $32 million to remain and consolidate their operations in the District also veers from proven principles of corporate subsidies.

Proponents of this subsidy often appeal to the tax revenues from LivingSocial that will far exceed this subsidy. Paying for tax revenue, however, only rewards companies who threaten to leave while encouraging a race to the bottom between states competing for companies.

The LivingSocial proposed subsidy is intended to be targeted. The subsidy doesn’t begin until 2015 and scales based on the number of DC residents employed, which must be at least half of LivingSocial employees.

But are these jobs that we should be paying for? They aren’t strategically aligned with the needs of the city’s unemployed, and most of the jobs won’t contribute to building a tech sector.

According to a source, only 15% of LivingSocial jobs are in technology, IT, and product development. A subsidy that was targeted to generate knock-on benefits that are strategically important would thus focus on retaining that 15% of LivingSocial positions.

The debate around corporate subsidies is too often dominated by loud voices at the extremes. But experience shows that corporate subsidies can work, and they can also be a waste of precious dollars.

The next time you read of a proposed corporate subsidy, avoid these hyperbolic extremes and ask if the subsidy adheres to these two proven lessons for effective subsidies. If it does, defend the administration that proposes the subsidy, If it doesn’t, as recent subsidies have not, then ask questions.