Chamber Supports the Proposed Economic Development Plan – Here’s why.

(Warning:  Reading why the Chamber supports this proposal may turn members against the entire idea as too boring to be good law).

The ancient Greeks struggled over the question “What is justice?”  The ancient Greeks had it easy compared to the 2013 legislative session, which has struggled with a more delicate issue:

“What is Economic Development?”

• Is it the same as community development?
• Does it always involve things that are “new”?
• Is it helping small businesses in small communities?
• Is it getting businesses to move to South Dakota?
• Is it housing?
• Do highways, streets, or sewer systems count?  (They sure count when they don’t work.)
• How about workforce development or even helping schools teach English as a second language?

Perhaps more important than “what is” economic development, one should ask “How does a community measure economic development?”

• Jobs?
• Wage levels and benefits like health insurance, vacation, free massages?
• Growing tax base – tax revenue?
• New and different kinds of jobs to diversify the economic base?

SB 235 – An omnibus bill for the next step in economic development

In a process that was completed last Friday, right before the final week of this legislative session, a group of legislative leaders worked to develop an exhaustive approach to economic development that represents ideas from both the House and Senate and both Republicans and Democrats.  Here is an attempt to summarize what SB 235 does and how it will accomplish the all-encompassing mission. 

Ever drop a raw egg onto a wood floor?  Cleaning it up is complicated and involves the contradiction of soaking up a dozen paper towels only to still find yourself chasing most of the egg around in circles on the floor.  It’s the same trying to explain SB 235 in a few pages.  This will be a review of the major concepts rather than a detailed analysis of application.   The essence of the bill is outlined below.

First – What is a “project”?  South Dakota has a long history of pursuing “large projects” such as ethanol plants, expansion of manufacturing, expansion of value added agriculture and wind energy.  In these pursuits there has been an obstacle that has resulted from how the state applies sales/use taxes and then adds a Contractor’s Excise Tax (CET) to the entire project, including the materials that have already paid the sales and use tax.  In the past, a series of refund formulas were used to mitigate the impact of the taxes on these large projects.

Now a Change in Approach - The threshold for being considered as a “qualifying project” has been increased from $10 million under the previous refund law to $20 million dollars under SB 235.  The term “project” has been defined as “a new building or structure or the expansion of an existing building or structure, the construction of which is subject to the CET.”

There continue to be exclusions in the new law.  The following types of buildings cannot be qualified for reinvestment payments:

• Building used for sale of products as retail
• Buildings used predominantly for residential housing or transient lodging
• Builds used predominantly to provide health care services
• Structures used for the transportation of natural gas, oil, or crude oil by means of pipeline
• Structures constructed for raising or feeding of livestock
• Building that is not subject to ad valorem real property taxes

One significant change is that reinvestment funds will be granted to businesses ordering new equipment or even replacing equipment.  For equipment to be considered as a qualifying project, the expenditure must be more than $2 million dollars.  The term equipment includes “laboratory and testing facilities, manufacturing facilities, data centers, power generation facilities, power transmission facilities, agricultural processing facilities and wind energy facilities.”

More Details on How SB 235 is Designed to Work

Follow the money – There are virtually no public underground parking facilities in Pierre but this advice from the Watergate days is still valid.  The first pile of money to understand is the “Build South Dakota Fund”; the second is “Reinvestment Money”.   

Build South Dakota Fund - The money for this fund will come from two sources, Contractor’s Excise Tax (yep, that one) and money transferred from the Unclaimed Property Fund (it’s a grown up version of finders keepers, losers weepers). 

• Contractor's Excise Tax – There will be no refunds for Contractor’s Excise Tax (CET).  All projects will pay the CET.  The funds from the CET that are applied to officially approved projects will be placed in the Build South Dakota Fund.  To be an official project, a proposal must have expenditures of more than $20 million dollars (and not be on the list of exclusions) OR be an equipment replacement or expansion of more than $2 million.  More on this later.
• Unclaimed Property Fund – This is a fund that is kept by the State Treasurer’s Office and is money that has been sent there after being in banks or other financial institutions for more than three years.  The State Treasurer keeps track of who the money belongs to (assuming the banks even know) and will assist anyone in getting money that is legally theirs.  How does money become unclaimed property?  People either forget about it through time, death, divorce, or hiding it like a squirrel and then not being able to find it.  This money is in South Dakota because the state has strong banking laws and is host to a number of significant financial institutions that operate on a national scale.  The fund has a history of gathering about $8 million a year.  This amount is expected to increase significantly in 2015 and 2016 and perhaps beyond as national laws change how banks must deal with unclaimed property.  The fund may increase to $25-30 million or more.   

Example – Seeing this money flow by using a hypothetical example can help at times.  For the purposes of trying to explain the impact of SB 235 consider a project that is a power plant owned by a private utility known as Ever-Dark Electric Power and Low-Light.  Ever-Dark is planning to build a gas-fired power peaking plant that will cost $250 million dollars.  Ever-Dark’s plant will have 70% ($175 million) spent on capital purchases (steel, lumber, elevators, toilets, and those little bumper thingies that keep the doors from banging against the wall). 

Back to the Build South Dakota Fund.  This project would produce approximately $5 million in Contractor’s Excise Tax ($250 million x 2%).  The CET is applied to all taxable project costs, including the materials purchased and taxed by the sales/use tax.  The actual application of the tax will result in a slightly lower amount as not all project costs are subject to CET but the labor and material are taxed.  These CET funds would be deposited into the Build South Dakota Fund and used for many programs listed in the next section.

The Reinvestment Funds - The state sales/use tax on this project would be $7 million ($175 million x 4%).  This would be the maximum “reinvestment” money available.

Money Summary – Ever-Dark Electric Power and Low-Light Company’s $250 million dollar power plant will produce $12 million in tax revenue for the construction phase (this does not include ongoing property taxes or the taxes paid by 35 employees with salaries of $35,000).  Of this $12 million, $5 million will be placed in the Build South Dakota Fund along with a portion of the Unclaimed Property funds.  The other $7 million is available to the Board of Economic Development for a reinvestment payment to Ever-Dark as a way to reduce the rather high taxes that result from the way South Dakota combines sales/use tax with CET.

 What do the funds  . . . . fund?

The Reinvestment Fund is rather straight forward.  It is a holding account for the 4% sales/use taxes on an approved project (those over $20 million and/or spending $2 million on new or upgraded equipment).  The tax money is held in this account until the reinvestment payments are made to the owners of the project.  The amount of the reinvestment payment is set by the Board of Economic Development and can be for a portion of the tax paid or for an amount equal to the entire tax payment.

The Build South Dakota Fund – This fund will collect the Contractor's Excise Tax from ALL approved projects, plus receive funds from the Unclaimed Property Fund.  These funds are set to take on a wide array of economic development concepts including:

• Housing - 25%.  These funds will be administered by the South Dakota Housing Authority and will be used for the purpose of expanding sustainable, affordable and safe housing.  The bill sets up an oversight committee, defines low and moderate income and outlines various ways to address housing issues. 
• Local Infrastructure Improvement Grant Fund – 25%.  Grants will be awarded by the Board of Economic Development.  Grants can be awarded to a political subdivision or a non-profit development group.  The mandate is very broad and allows funds to be used to construct or reconstruct infrastructure for the purpose of serving economic development.  The funds will not be given to a county that does not collect the wheel tax.       
• Local Economic Development Efforts – 15%.  This fund will be placed into the Governor’s Office of Economic Development and will be used for helping local economic development offices hire staff or expand from part-time staff to full-time.  These funds can be used to replenish a local revolving development fund.  Funds can also be used for emphasizing high quality employment, support of entrepreneurship, repopulation, housing development and expansion or retention of local businesses.  These funds are available for matching funds and require local matching dollars which will need to cover an increasing percentage of the match over four years.
• Recapitalizing REDI Loan Fund – 5%.  The REDI Fund revolving loan fund was established nearly 30 years ago.  It has been well managed and has grown but will be even more effective with a small injection of funds on a regular basis. 
• Workforce Education 30% - This fund will support technical education, including the purchase of equipment and financial support of school districts that need support for English as a second language programs. 

Bottom Line - How much money will these funds have to accomplish all that is envisioned?

The Reinvestment Fund will have the funds collected by applying the sales/use tax on a given project.  Projects that are very equipment and capital intensive, such as wind farms, will put more money in this fund than a project that builds a structure to house research.

The Build South Dakota Fund will have funds from the Contractor’s Excise Tax on the projects approved by the Board of Economic Development (the ones paying sales/use tax into the reinvestment fund above).  Taking an educated guess (okay, a wild stab in the dark), for a hypothetical year that has $400 million dollars in construction by approved projects, simply applying the 2% CET to 90% of the total costs (there are non-taxable expenses on every project such as land purchases), the Build South Dakota Fund will receive approximately $7,200,000.  Assuming the Unclaimed Property Fund has the anticipated increase to $30 million and the hypothetical year is 2016, the Build South Dakota Fund will get $15 million from the Unclaimed Property Fund.  So for 2016, and perhaps beyond, the Build South Dakota Fund might get over $22 million dollars.

In this case the plethora of sub-funds would receive:

• Workforce/Education - $6.6 million (30%)
• Housing - $5.5 million (25%)
• Infrastructure - $5.5 million (25%)
• Local Development Partnerships - $3.3 million (15%)
• REDI Reinvestment – $1.1 million (5%) 

Consider the Build South Dakota Fund using less joyful scenarios and it could look much different.  In a year with only $50 million in “approved project” construction and Unclaimed Property of $18 million (halfway between the past average of $8 million and the increase expected), this would provide $900,000 from CET and $9 million from Unclaimed Property for an annual fund of $9.9 million.  Rounding to $10 million here is how much each fund would receive:      

• Workforce/Education - $3 million (30%)
• Housing - $.2.5 million (25%)
• Infrastructure - $2.5 million (25%)
• Local Development Partnerships - $1.5 million (15%)
• REDI Reinvestment – $500 thousand (5%)

For those wanting to contemplate a compete meltdown, should a year transpire that has no “approved projects” and a return to historic averages for the Unclaimed Property Fund, the Build South Dakota Fund would be reduced to $4 million.  This would allow only $1.2 million for workforce; $1 million for housing and infrastructure each; $600,000 for local development and $200,000 for REDI reinvestment.

How does SB 235 compare to the previous Large Project Refund programs?

The basic answer to this question is to simply say "pretty well . . . if".  The new approach to large projects will provide relief from the unique application of the CET and Sales/Use taxes, just as the refunds accomplished.  Hopefully, they will accomplish that goal with a program that is easier to comply with and to administer.  For the reinvestment payments to provide an equivalent level of incentive, the Board of Economic Development will have to award payments that equal more than 90% of the sales/use taxes collected.

Here is a basic comparison.  Note:  There is nothing straight forward about these taxes and so there is plenty of room for nit-pickers to say these numbers are not 100% accurate.  They will be right.  Suffice it to say that the Chamber is expert enough to render an accurate application of these policies and the comparison will be essentially correct.  In other words, don’t use these methods to attempt a landing on Mars, but know that they can guide you across town and through tax policy very well.

The Project.  Here now is the return of Ever-Dark Electric Power and Low-Light Company.  They are building a $250 million dollar power plant that will use natural gas and, whenever possible, will burn used Popsicle sticks found in state parks.  The project will spend 70% of project costs on capital expenditures (meaning on stuff that is subject to the sales/use tax).  These notes will assume that the taxable costs for the entire project that are subject to the Contractor's Excise Tax (CET) are 90%.  This plant will have a CET taxable value of $225 million dollars.

Under the old refund policy – the Ever-Dark project would pay all taxes on the first $10 million dollars.  This amount would be approximately $500 thousand.

The total taxes paid by Ever-Dark’s plant would be:

• $5.4 million dollars in sales/use tax on 70% of the $215 million dollars (after taxes paid on first $10 million)
• $3.8 million of CET on the $215 million dollars of project costs (after taxes paid on first $10 million)
• $500 thousand of taxes on the first $10 million
• Total taxes paid by the project would be approximately $9.8 million dollars.

Calculating the refund.  The refund policy would have refunded 45% of the taxes on costs above the $10 million threshold up to $40 million in project costs; and then refunded 55% of the taxes paid on project costs above $40 million up to $500 million.   Any project with costs exceeding $500 million would resume paying full taxes (and hiring lobbyists for the very next legislative session).  This return to full taxes did not apply to wind projects and they continued to receive refunds at 55% for all remaining project costs.

For project costs above the $10 million dollar level and up to $40 million; the taxes would be an estimated $1.3 million with a refund of 45% that would return to the project owners something around $650,000.

The higher level refunds would be for costs above $40 million, which stop at $185 million dollars of project costs for Ever-Dark.  The $185 million is the project costs remaining after the refund paid on the first $10 million AND the refunds for the next $30 million (total of $40 million already used up).  The taxes on the $185 million of project costs would be around $8 million; with a refund of 55% or about $4.4 million dollars that would be returned to the owners.

This would be a total net refund of approximately 51% which is higher than the actual refunds that members shared with the Chamber.  Most of the actual refunds were in the 40 – 45% range which means the percent of actual taxable costs is too high in the example.

Now a look at the taxes under the proposed Reinvestment system using the same assumptions.

Ever-Dark’s proposal is still a $250 million project, well exceeding the requisite level of $20 million.  Using a 90% taxable costs assumption (yep, consistency has value here, it’s faster than doing all the calculations again).  The taxable value for this project will again be $225 million.

Under the new proposal, the project will pay all of the CET for a tax of $4.5 million.  These funds will be placed in the Build South Dakota Fund and combined with 25% or 50% of the annual money placed into the Unclaimed Property Fund for use as outlined above.

With 70% of the expenditures being on taxable purchases, the sales/use tax should be around $6.3 million dollars.  These funds will be placed into an account marked as the Reinvestment Fund.  The Board of Economic Development can award a portion, or all, of the funds to the project as a way of reducing the impact of the taxes discussed way back at the start of this explanation.  If you can’t remember those details don’t call a neurologist – your mind isn’t shorting out, it is trying to protect you from long-term damage that these issues can cause.  In order to achieve an equivalent cost reduction under the provisions of SB 235, the reinvestment payment will need to be $5.1 million dollars, which is 80%.    

Bottom line – SB 235 will be equivalent to prior refund policies only if the Board of Economic Development is willing to use a high percent of the taxes (in this example at least 80%) of a project’s sales/use tax as a Reinvestment award.  Anything less and the value of the cost reduction will be diminished.  Remember, there is no refund of the CET so all cost reductions must come from the sales/use tax portion of the costs.