Paying for Enterprise Zones

Use the tax code to reroute mutual-fund investments

ALTHOUGH the Senate has dropped the long-awaited enterprise-zone legislation from the budget bill, its future still rests in the deliberations of the House-Senate Conference Committee.

Enterprise zones provide a new and real opportunity to regenerate cities from the core as well as to demonstrate the potential of the capitalist system to address one of the most serious, complex problems of our society.

Hopefully, the legislation will survive, but a critical element is still missing from the debate. Without vigorous investment, enterprise zones may lack the catalyst to make things happen in poverty-stricken urban and rural areas. Small and medium-sized businesses have historically created the vast majority of new jobs in this country. But given the weak economy and restrictive bank lending practices, especially in the inner cities, such businesses will have great difficulty in obtaining debt or equity t o finance development or expansion in the zones.

A preferred solution is to tap the enormous pool of private investment capital now flowing into mutual funds and closed-end investment funds. The question is how to direct a portion of fund investments into businesses located in or expanding into "empowerment zones and enterprise communities," the phrase used in the current bill.

One answer is to encourage the creation of "enterprise-zone development funds" whose purpose would be to invest exclusively in enterprise zones. To attract capital, investors would be permitted to defer taxes on gains realized from sales of securities and other capital assets to the extent that they used the proceeds to acquire shares of these funds.

Investors also would enjoy the prospect of appreciation in value of the funds' shares, in part because the special tax incentives available to zone businesses will improve their chances of becoming profitable by lowering their costs. Investors also would have the benefit of diversification and professional management, which will reduce their risk.

Like other regulated investment companies, the enterprise-zone funds would enjoy two major pass-through tax benefits: First, to the extent that they annually distribute all realized income and gains to their shareholders, there would be no tax at the fund level; and second, amounts distributed to the shareholders would retain their character as ordinary income and capital gains.

The funds would be closed-end and traded on stock exchanges. By avoiding the redemption requirements of open-end mutual funds, the enterprise-zone funds could concentrate on long-term investments and less-liquid enterprises. The funds would be restricted to investing in qualified zone businesses and property (as defined in the statute) and, initially, in Treasury securities. Investment in Treasury securities would be permitted initially because new zones may not offer enough opportunities for investment.

The percentage of fund assets invested in Treasury securities would be reduced each year as the zones develop and more investments in businesses and properties become available.

This plan offers five dramatic benefits:

* It would encourage thousands of Americans to invest in the rebuilding of the nation's inner cities and other impoverished areas.

* It would enhance the legislative initiative by adding nongovernment funds to the modest grants proposed, thereby benefiting the 100 enterprise communities as well as the 10 empowerment zones. Indeed, if the enterprise zone funds attract sufficient capital, Congress might designate additional zones.

* Although investors would get a tax deferral, if the funds succeed the Treasury will recoup the deferred tax when the fund shares are ultimately sold because the tax basis of the shares will reflect any prior untaxed gain. Congress could choose to limit the amount of deferred tax either by a per-capita cap, such as with IRAs, or by a total cap on the tax benefits offered with respect to these investments.

* The market would allocate capital among and within the various zones. Investment decisions would be made by professional fund managers seeking to maximize returns for shareholders.

* The funds would provide needed technical assistance to zone entrepreneurs. To protect their investments, investment bankers and venture capitalists managing enterprise-zone funds can be expected to play a management or advisory role, thereby helping to train a generation of entrepreneurs.

The concept of capital-gains tax deferral for investing in zone businesses could be extended to limited partnerships and other private investment vehicles. Traditionally, such entities are highly suited to invest in high-risk ventures for the sake of higher returns.

Economically, this proposal is in keeping with the basic concept of enterprise zones: using tax incentives to accomplish a societal goal. Politically, the modification could easily be seen as an appropriate and enlightened application of the capitalist system that would give thousands of investors a stake in the rebuilding of America's inner cities and impoverished rural areas. Finally, Wall Street would not only have a new product to sell, but an opportunity to make an important social and economic cont ribution to the nation.

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