Tax increment financing is a technique used by state and local governments to account for redevelopment projects. It works on the theory that a project carried out now will eventually be financed by the increased revenues that result from the project. Whether this is truly the case can be both unpredictable and difficult to measure.
To use tax increment financing, a state or local government must designate a particular geographic area as a TIF district. It will then carry out the improvement work in this district, using borrowed money. The idea is that the improvements will increase tax revenues, for example by making an area attractive and raising property prices, thus raising the total property tax take. Any increase in tax revenue from the district is then earmarked specifically for repaying the borrowing. This helps raise money while sticking within the common principle that a local government should only borrow money where it can show a credible plan for how it will be repaid.
As of 2011, the only state that does not have legislation allowing for tax increment financing is Arizona. Originally, the practice was limited to particular states, notably California and Illinois. Today, the practice is more popular as a result both of squeezes on public financing from federal sources, and restrictions on raising money through traditional municipal bonds.
The most obvious drawback of tax increment financing is that the increased tax revenue may not be enough to pay back the borrowed money, plus the related interest. To protect against this happening, most governments have a rule that says officials must estimate the increased tax revenue over the period of earmarking, which is usually 25 years. The government is then only allowed to borrow up to half of this figure. In the event that the tax revenue increases by more than is needed to repay the money, the excess goes to the general budget.
The other main arguments against tax increment financing are that it can be difficult to measure how much of any increase in tax is a direct result of the improvement works. In some cases, an element of the increase may simply be the result of inflation, rather than the area being more attractive. The arguments about the extent to which this will happen with a particular product are likely to involve both economic and political debate.
