local financial incentives on location decisions. Econometric evidence on the effects of such programs on location decisions is inconclusive.

Surveys of business managers usually conclude that tax and other financial inducements are of secondary importance to a firm's location decision. However, many economists suggest caution in interpreting the findings of survey research because responses to survey questions may not accurately forecast the economic behavior of decision makers.

Some case study analyses of business location decisions have concluded that financial incentives are relatively important to the decision. Others have concluded that such incentives are relatively unimportant.

Efficiency and neutrality of tax incentives for enterprise zones

If investment in enterprise zones merely replaces investment that would have taken place elsewhere, the primary effect of the investment incentives would be redistributional. If the investment is redistributed from local labor markets with low unemployment to local labor markets with high unemployment, the incentives may generate efficiency gains for the economy as under-utilized resources are tapped.

Preferential tax treatment for certain investments or for employment within enterprise zones creates economic inducements that may lead to an inefficient allocation of resources. Such efficiency losses must be weighed against the social goal of increasing economic growth and opportunity in distressed areas.

Incidence of enterprise zone benefits

The ultimate division of the tax benefits associated with enterprise zones among the potential beneficiaries depends on demand and supply conditions in the affected markets and the particular characteristics of the proposals. In general, the incidence of a tax (or subsidy) falls most heavily on the factor of production that is least mobile. Within an enterprise zone, land is an immobile factor and it may be expected that tax benefits granted for economic activity undertaken in an enterprise zone will tend to result in higher prices for land in the enterprise zone. Persons living within the enterprise zone or employed within the enterprise zone and entrepreneurs also may gain some of the tax benefits provided.

Complexity

Proposals to create tax preferences for taxpayers located within certain geographic areas may create complexity for both taxpayers and tax administrators. Such complexity may impose a relatively larger burden on small businesses and individual taxpayers than on larger businesses.

Tax incentive provisions

II. PRESENT LAW

Targeted geographic areas

The Internal Revenue Code does not contain general rules that target specific geographic areas for special Federal income tax treatment. Within certain Code sections, however, there are definitions of targeted areas for limited purposes. For example, targeted areas are defined under the qualified mortgage bond provisions of the Code as a means to promote housing development within economically distressed areas. Within these areas, which are defined on the basis of the income of area residents or the general economic conditions of the area, the rules for the financing of owner-occupied homes with qualified mortgage bonds are less restrictive than the generally applicable rules. Similarly, for purposes of the lowincome housing credit, certain geographic areas are designated as high cost or difficult to develop areas. In these areas, the amount of the low-income housing credit is 130 percent of the amount that would otherwise be allowed.

In addition, present law provides favorable Federal income tax treatment for certain U.S. corporations that operate in Puerto Rico, the U.S. Virgin Islands, or a possession of the United States. Under these rules, a U.S. corporation that satisfies certain conditions may elect to eliminate U.S. tax on certain foreign source income that is related to the operation of a trade or business in Puerto Rico, the U.S. Virgin Islands, or a possession of the United States. These special rules were enacted in order to encourage U.S. corporations to establish and maintain trades or businesses within these areas.

Tax credits for employers

Under present law, the income tax liability of an employer does not vary based on where an employee performs services on behalf of the employer. The targeted jobs tax credit under present law, however, provides a tax credit for a portion of the wages paid to individuals from nine targeted groups. These groups generally are defined according to the individual's physical condition, participation in a specified education or rehabilitation program, or economic

status.

The credit generally is equal to 40 percent of the first $6,000 (or, in the case of a qualified summer youth employee, $3,000) of qualified first-year wages paid to a member of a targeted group. Thus, the maximum credit allowed with respect to any employee general

(10)

ly is limited to $2,400. The employer's deduction for wages must be reduced by the amount of the credit claimed. 3

Tax credits for employees

Under present law, the income tax liability of an employee does not vary based on where the employee performs services in the United States on behalf of an employer. However, an eligible individual who maintains a home for one or more qualifying children is allowed an advance refundable income tax credit based on the earned income of the individual and the number of qualifying children. For 1991, the earned income tax credit equals 16.7 percent (in the case of an individual with one qualifying child) or 17.3 percent (in the case of an individual with two or more qualifying children) of the first $7,140 of earned income. For 1991, the credit begins to be phased out if adjusted gross income (or, if greater, earned income) exceeds $11,250 and is completely phased out if adjusted gross income (or, if greater, earned income) exceeds $21,240.

In addition to the regular earned income tax credit, present law provides for two supplemental credits: a supplemental young child credit for taxpayers with a qualifying child under the age of one (a 5-percent credit rate), and a supplemental health insurance credit for taxpayers who purchase insurance coverage for their qualifying children (a 6-percent credit rate). These supplemental credits are computed using the same earned income base (including phaseouts) as is the regular earned income tax credit.

Tax credits for investment

An income tax credit is allowed under present law for certain expenditures incurred in rehabilitating certified historic structures and certain nonresidential buildings that were originally placed in service before 1936. The credit rate is 20 percent for expenditures incurred in rehabilitating certified historic structures and 10 percent for expenditures incurred in rehabilitating buildings originally placed in service before 1936. The basis of any building with respect to which the rehabilitation credit is claimed is reduced by the full amount of the credit.

Before 1986, a 10-percent investment tax credit was allowed for the cost of eligible tangible personal property that was used in a trade or business or for the production of income. The basis of the property was reduced by one-half of the amount of the credit. The investment tax credit was not allowed with respect to real property.

Low-income housing tax credit

An income tax credit is allowed in annual installments over 10 years for qualifying low-income rental housing. Both substantially rehabilitated existing housing and newly constructed housing are eligible for the credit. The credit percentage is adjusted monthly to maintain a present value of 70 percent for the costs of most new construction and rehabilitation. The credit percentage (similarly adjusted) has a present value of 30 percent for the costs of acquiring existing property that is substantially rehabilitated and for creditable costs associated with property that receives other Federal subsidies (e.g., property that is financed with the proceeds of taxexempt bonds).

Housing projects qualify for the credit only if one of two lowincome tenant occupancy requirements is continuously satisfied for a period of 30 years (a 15-year compliance period followed by a 15year extended use period). These restrictions require that (1) at least 20 percent of the housing units be occupied by individuals having incomes of 50 percent or less of the area median gross income or (2) at least 40 percent of the units be occupied by individuals having incomes of 60 percent or less of the area median gross income.

The basis on which the tax credit is claimed is equal to the "qualified basis" in the project, defined as the basis of the housing units actually occupied by low-income tenants plus an allocable share of the basis of common elements. No credit is allowed for the basis of (1) housing units occupied by nonqualifying tenants, (2) common elements allocable to such units, or (3) other facilities.5

Expensing of certain investments

There is no provision under present law that allows the amount of an investment to be expensed (i.e., deducted for the year in which the investment occurs) based on the location of the investment. Present law, however, provides that in lieu of depreciation deductions, a taxpayer (other than an estate or trust) may elect to deduct all or a portion of the cost of qualifying property for the taxable year in which the property is placed in service. The maximum amount that may be expensed under this provision for any taxable year is $10,000. In general, qualifying property is any tangible personal property that is predominantly used in the active conduct of a trade or business.

Depreciation deductions

The depreciation deduction for any tangible property used in a trade or business or for the production of income is determined under the accelerated cost recovery system as modified by the Tax Reform Act of 1986. Under this system, the depreciation deduction for nonresidential real property generally is determined by using the straight line method and a recovery period of 31.5 years and the depreciation deduction for residential real property generally is determined by using the straight line method and a recovery period of 27.5 years. The depreciation deduction for tangible personal property generally is determined by using a recovery period that is based on the class life of the property and the 200-percent (or 150-percent) declining balance method (with a switch to the straight line method for the taxable year that the straight line method yields a higher depreciation deduction).

Nonrecognition provisions

A sale or exchange of an asset generally is a taxable event. In a number of instances, however, gain or loss realized by a taxpayer upon the sale or exchange of an asset is not recognized for Federal income tax purposes. For example, no gain or loss is recognized if property held for productive use in a taxpayer's trade or business, or property held for investment purposes, is exchanged solely for property of a like-kind that also is to be held for productive use in a trade or business or for investment. As another example, a taxpayer generally may defer recognition of gain on the sale of a principal residence if the sales price of the old residence is reinvested in a new principal residence within a specified period of time. Present law does not provide for nonrecognition of gain or loss in the case of the sale or exchange of an asset solely because the asset is located within a particular economically distressed area.

Capital gains

Net capital gains are taxed as ordinary income under present law, subject to a maximum marginal rate of 28 percent in the case of individuals. In general, a capital asset is any property held by the taxpayer except certain specified types of property, such as inventory or property held primarily for sale to customers in the taxpayer's trade or business. Before 1987, net capital gains were taxed at a reduced rate. All taxpayers other than corporations could reduce net capital gains by 60 percent, and the remainder was taxed as ordinary income-effectively establishing a maximum 20percent tax rate on this income (40 percent of the gain included in income multiplied by a 50-percent maximum marginal income tax rate). The maximum tax rate for net capital gains of corporations was 28 percent. This reduction in tax was treated as a preference item for purposes of the minimum tax.

Private activity bonds

Although interest on State or local government bonds used to finance trade or business activity generally is taxable, various exceрtions are provided. For example, interest on State or local government bonds generally is tax-exempt if the bonds are qualified small-issue bonds (used to finance manufacturing facilities or property acquired by first-time farmers) 6 or qualified redevelopment bonds. Tax-exempt private activity bonds issued by State and local governments generally are subject to State volume limitations. In addition, the depreciation deduction for property financed with taxexempt bonds generally is determined by using the straight line method over the class life of the property.

Losses with respect to certain securities

The loss resulting from the worthlessness of a stock, bond, or other evidence of indebtedness issued by a corporation is generally treated as a loss from the sale or exchange of a capital asset. Consequently, the loss is subject to the general rules that limit the

• Under present law, the authority to issue qualified small-issue bonds is scheduled to expire after June 30, 1992. The President's fiscal year 1993 budget proposal would extend the authority to issue first-time farmer bonds for 18 months (i.e., through December 31, 1993).