A Benchmark Modelling for Participation Based Tax Increment Financing

Tax increment financing (TIF) is one of public financing practices in which future tax revenues of the designated district or any license is sold or assigned to a third party, in exchange for a cash payment. TIF is mostly used by local governments/municipalities to combat fiscal constraints and upgrade urban settings and local infrastructures. Various TIF methods have been used around the world, particularly in the USA for over 60 years. Similar but different version of alternative instruments have been employed as a traditional public financing/banking method, namely esham and iltizam systems, by the Ottoman Empire. In this study, we develop a benchmark model for P-TIF model by combining TIF and participation based financing method. This model offers a participative contract between lender and borrower. In return for reduced interest rate, P-TIF promises lenders to a part of excess payoff from tax earnings. P- TIF can also be applied within the Islamic finance thanks to the model it is based on. Finally, implications and fields of application are explored with a discussion of challenges.


Introduction
In current world, particularly after the modern era started, the transformations leaded by industrialization have had some significant effects on various phenomena of economies. One of the most prominent of these phenomena has been on urbanization. The urbanization worldwide is reported at around 54 percent, this share is expected to increase to 70 percent by 20501. Because of increasing urbanization, today the municipalities have to manage a complex and competitive urban setup. They manage their development and consumption expenditure from their limited local government revenue share. Due to fiscal constraints, municipalities face trade-off between the consumption and development expenditure. To augment public infrastructure development or to upgrade the decaying infrastructure municipalities have to look for alternative financing mechanisms. Tax increment financing (TIF) is one such mechanism used by local governments to combat fiscal constraints and upgrade local infrastructure.
TIF is an important public finance tool for economic development used by local governments and municipalities to finance new development and renovation projects in Tax Increment District (TID). A traditional TIF works on the principal that infrastructure development in a TID stimulates economic activity by means of attracting private investment i.e. business setups and employment opportunities, hence result in an increase in property value and property taxes.
This financing tool allows to capture the incremental tax value from the increased property value within a TID that can be then used to finance the capital costs of development plan (Carroll, 2008).
TIF has been used particularly in the USA for over 60 years (McIntosh et al., 2015) where it has generally been used within the scope of fixed income financing such as project-specific Tax Increment District Bond (TID Bond) and some other public sector finance methods for urban infrastructure developments and urban renovation projects. TIF began in 1952 with a creation of legal framework in the USA California and has been spread to other states in time.
Outside of USA, most distinct usage of TIF can be seen in Canada. While UK, New Zealand and Australia have been attempting pilot applications or trials TIFs, it can be seen that similar instruments aiming to finance urban renewal and infrastructure projects have been considered in European region (Squires and Hutchison, 2014).
Although the origin of TIF traces back in 1950, when state government California passed TIF legislation as an urban renewal strategy (Man and Rosentraub, 1998;Runde, 1999). the different version of it has been used as a traditional borrowing method by the Ottoman Empire and in many European countries also. This long-term domestic borrowing was called as an esham system in the Ottoman Empire (Pamuk, 2009). While the modern practice of the TIF includes redevelopment project that is financed by future tax revenue, the esham system in the Ottoman Empire was the sale of tax revenue of the specific region to large number of buyers.
Buyers were using the right of collecting tax throughout his life.
The TIF process starts when a municipality initiates a development plan by designating an area as TID. At the time of designation of an area as TID, the property taxes rates are made frozen at base assessment value (Smith, 2009). During the life of TID, the taxes authorities continue to collect taxes at base rate. Meanwhile municipality issues revenue rights or bonds to fund developments or redevelopments in TID. As developments occur in TID, the assessed value of land and properties increases that leads to incremental increase in property taxes over and above the base tax rate. These incremental taxes revenues are used by municipality to repay the bonds that were issued to fund developments (Merriman, Skidmore, and Kashian, 2011).
At the expiration of TIF, all debts are paid off and the new higher-level property taxes (base plus incremental) are collected by tax authorities (Byrne, 2010).
The rapid increase in population and urbanization in Muslim countries give rise to concerns about public infrastructure development and financing. P-TIF by local municipalities can be a viable solution to cater the needs of community development in emerging countries as well.
This kind of financing might be popular when the local authorities such as municipalities face a fall in central government tax collections and grant transfer or lack of sufficient financial sources. Compared to other income generating model such as sale of municipal land or service, TIF provides a long-term solution to shortage of municipal budget.
The remainder of the paper is as follows: the next section provides a literature review; Section 3 introduces a benchmark modelling for P-TIF; Section 4 indicates possible implications and discusses challenges for the use of P-TIF, finally, Section 5 summarizes the findings and concludes.

Literature Review
The literature generally discusses tax increment financing as an economic development tool and its relation with property values. Practically, TIF has been largely adopted by municipalities. In his study, Anderson (1990) uses a structural probit model to analyze how some USA cities adopt TIF plans and its impact on property values. Author finds that cities adopting TIF plans experience greater property value compared to non-TIF adopting ones. This positive association between TIF adoption and property value does not directly imply that TIF causes growth in property value. Similarly, in their study Man and Resontraub (1998) analyze the impact of TIF plan on property value by utilizing a panel data of Indiana Cities. Using firstdifference model, they find that TIF plan increased median housing value by 11 %.
In contrast to the previous two studies, Dye and Merriman (2000) provides a different result in their paper. Based on data for the Chicago metropolitan, they show that cities adopt TIF grow more slowly than those do not. They also examine why local governments offer EDI (economic development incentive). Market failure, blighted areas, bidding wars and intergovernmental revenue shifting are four reasons why local authorities might offer EDI.
TIF program helps municipalities which use it. TIF plans aim to support urban redevelopment programs, widely focusing on the areas that are unlighted and it needs no outside money or financial sources. Briffault (2010) evaluates TIF plans as a potential source of conflict between private and public sector since the expenditure of taxes should legally require public purpose. How the public authorities support private activities or how the public-private partnership is established is a legally sensitive issue. Another potential problem related to TIF is tax restrictions based on the fact that tax rates and assessments should be uniform throughout the taxing jurisdiction. Briffault (2010) claims that TIF practices violate uniformity since the income generated within TIF district is used for the developments within the district, whereas income generated in the whole city is returned to the city including the TIF district. Briffault (2010) also emphasizes the cost-benefit analysis of TIF plans. He asks which municipalities choose it and does the economic benefits of TIF compensate its costs. Decentralization, interlocal conflict, municipals' debt limits have been another issues related to TIF that the author discusses. Despite its potential problems, TIF looks like to be a significant alternative financing method for public and local authorities. Local and public authorities are able to modify TIF programme and define new rules and criteria to develop this alternative financing method.
Although the modern tax increment financing practices have been widely observed in developed countries like USA and Canada, the different version of it has been used as a traditional borrowing method by the Ottoman Empire and in many European countries also. This long-term domestic borrowing was called as an esham system in the Ottoman Empire (Pamuk, 2009). While the modern practice of the TIF includes redevelopment project that is financed by future tax revenue, the esham system in the Ottoman Empire was the sale of tax revenue of the specific region to large number of buyers. Buyers were using the right of collecting tax throughout his life. The esham value (the amount that buyers of the esham pay) was being sold for six to seven times the annual tax revenue of the government (Pamuk, 2009). The main motivation of the esham system was to broaden the government's borrowing.
In the iltizam system, empire or states would had organized a public auction and the sources of public revenue were farmed out to applicants in the auction. The buyer of the iltizam right had his own agents for collecting taxes or would had sold its right to the third party. The average duration of the iltizam collecting tax was three years. In contrast to the iltizam, the malikane system had the life-long practice and created more cash for empire or states. (Masters, 2010).
The iltizam and malikane system were often abused by the holders or buyers and the esham system was introduced to eliminate the problems of the previous two old method.
In relation to alternative financing methods to local redevelopment projects, Hummel and Goud (2017) investigate the esham-ijara structure, type of Islamic borrowing product, in USA.
Unlike the TIF, traditional approach to local redevelopment investment, authors find that when incorporating a crowdsourced option along with an ijara and esham approach, the returns on investment are higher than for a conventional approach. They also add that ijara and esham approach includes higher risk but the returns of this alternative approach are also higher. The higher returns might increase the incentive of the lenders and borrowers to invest in this option.
Our benchmark model for P-TIF, the participatory tax increment financing, should be seen as a modified TIF that includes a version of Shariah compliant product based on risk share principal and offers new opportunities for public-private partnership agreements.

Model
The studies mentioned in previous section have not adequately focused on the technical aspects. To the best of our knowledge, it is observed in the literature that technical models such as stochastic processes have not been used before at the point of TIF. In this study, while we include participation of both sides in a given TIF contract and name it as P-TIF, we also introduce a benchmark model for P-TIF by incorporating stochastic modelling. In this direction, we establish a financing model with benefit of various stochastic processes.
Initially, to define the values of real estate properties in a given redeveloping district, first we assume for simplicity that the properties in the district are identical. Then, following Varli and Yildirim (2015) and Ebrahim et al. (2011), we define a real estate property value, , is generated from the following stochastic process: where is the expected return (i.e. risk adjusted yield) and δ H is referred as rental rate and represents the stream of rental income that the property provides, which can be viewed as a percentage of the value of the property. Kau et al. (1992) denotes δ H as a service flow from using the real estate over time. The volatility in the process indicates how the property value deviates from its mean. is donated as standard risk neutral Brownian motion for the process.
We assume the cost of redevelopment for a given property is a constant proportion of initial value of the property 0 and all properties are same so the initial loan 0 required for the redevelopment of district equals to sum of redevelopment costs of all properties in a given district i.e., 0 = 0 , where n is the total number of properties. The loan includes continuous payments for all ∈ [0, ] where is the maturity of the loan and the terminal payment (i.e. balloon payment, sometimes also called the bullet payment) at maturity. The outstanding loan balance (i.e. OLB), , at any time ∈ [0, ]; is equal to sum of discounted expected value of future periodic payments and terminal balance such that where ( ) is the term structure of risk adjusted yield. For simplicity, the structure of nonamortizing loan, also called interest-only loan, is employed in which there is a balloon payment consisting of the entire principal amount of the loan at maturity. Therefore, the outstanding loan balance for each period equals to the initial loan payment, implying where is participation rate for tax increment, π is tax rate and is the number of properties in the district.
We include the term structure of short term rates into the model to construct a discount process for future payments (see Bakshi et al. (1997) and Deng (1997)). The risk-free short term rate process that is used to discount the borrower's future payments, following Vasicek (1977) process as where denotes the speed of mean reversion, µ is the long-run mean rate and denotes volatility. The correlation between the property value mentioned above and the short rate is Then the outstanding loan balance (OLB), , at time as For simplicity, assuming non-amortizing loans such that = 0 = , the OLB becomes where ( , 0 , , ( )) represents the pricing formula for European call option. The valuation of call option is derived in the Appendix.

Interest Rate Calculation
where the part in brackets on the right-hand side reflects the reduction in interest rate in the case of a participating TIF in comparison to conventional TIF. An increase in participation rate lowers the interest rate. Table 1 shows the parameters used for calculating the base case interest rate in P-TIF. While the interest rate in conventional TIF (i.e. = 0%) is calculated as 8.26%, the rate is reduced to zero in P-TIF case with 50% participation of tax increment (i.e. = 50%).

Possible Implications and Challenges
The participation based Tax Increment Financing is easily applicable to urban transformation projects to create a new urban settlement areas. Old cities where illegal housing or unpermitted buildings had been tolerated and then were recorded as legal, host risky building stocks in some specific districts or towns. Current owner of housings and buildings pay regular property tax to municipals but the annual total amount of property tax that local authorities collect is insufficient to compensate for rehabilitation and regeneration of areas. Instead, local municipals (borrower in our model) and construction companies (lender in our model) can make an agreement based on our suggested model. It is significant to note that, property tax of buildings in any district tend to increase after urban transformation since there emerge positive externalities in new urban settlement in many respects such as new and broad green areas, social reinforcement areas, planned infrastructure, earthquake resistant design et. al. The expected higher future property tax influence the participation rate for tax increment in our model. Besides urban transformation, P-TIF is also used for funding infrastructure development project of commercial or industrial districts where some portion of the future income of these districts are transferred to lenders that will be responsible for the infrastructure development.
In addition to urban transformation and infrastructure development, P-TIF is also applicable to any local authorities to finance their public services such as inner-city or inner-district transportation. Local authorities like municipalities might create a license that includes the right for providing public transportation. Some portion of the expected future income of this public transportation right (license) is sold to lender in an auction so that lender invest in transportation for stronger and quality infrastructure and service. The possible application areas of the TIF and P-TIF can be extended to any public authorities that provide any service or commercial product via license. P-TIF provides alternative financing instruments to almost all public authorities which aim to solve their long-term borrowing problem for various projects.
As an alternative instrument in Islamic finance, P-TIF might function a kind of capital partnership (known as musharakah) that does not permit interest in any joint partnership or enterprise. In our baseline model, the higher participation rates in tax increment would reduce the interest rate to zero which attracts the applicability of our alternative instrument in Islamic finance. Compared to classical musharakah instrument that includes losses and profits based on partnership ratio and investment risk, our P-TIF model is more sensitive to tax increment and participation rate. By adding some properties, our model can be transformed into various P-TIF instrument types such as diminishing in the participation rate over the term. As the tax revenue increases over the term, the parties might set new participation rate to share the extra tax revenue. P-TIF model also provides an alternative instrument in muzara'ah (agriculture) and mudharabah (capital/labor) types risk-sharing agreement in Islamic finance. Borrowers, municipalities, local authorities or public bodies, could directly provide labor or machinery support to lenders to increase their participation rate since they have enough workforce and physical capital. This kind of support also makes the lenders better off as they undertake less fixed and variable investment cost. Therefore, besides the tax increment and participation rate, there are other financial incentives for both lenders and borrowers that are available in P-TIF type instrument in Islamic Finance.
Additionally, P-TIF model might gain an important place, as an alternative, in non-banking financial system since it eliminates brokerage between the lenders and the borrowers. The elimination of brokerage would directly reduce fees, transaction costs et al. associated with P-TIF financing. With required standardization and audit, public authorities should develop and disseminate this instrument through its local bodies. Compared to other instrument or partnership agreement in Islamic Finance, P-TIF includes less risk. Assuming all economic and financial variables are constant, participation rate and tax increment level are influencing the P-TIF models and public authorities such as municipals will make a guarantee tax payment to lenders. There might appear other risks related to quality of construction or infrastructure projects or end time of projects. The strict inspection and monetary penalties would reduce the other risks and increase the applicability of the P-TIF model.
There might potentially emerge some challenges/troubles to the implication of the P-TIF instrument as an alternative finance tool. One of the significant part of the P-TIF model is that which mechanism will be used to sell this alternative financial instrument. In practice or more generally, an auction mechanism is considered that might involve at least two stage to adjust the participation rate, tax sharing, maturity. Therefore, design of the auction mechanism takes on the most critical issues facing the applicability of the P-TIF model. The designed auction should take into account some risky aspects such as valuation, maturity, tax increment level, participation rate, audit et al. Moreover, public authorities should attract more lenders to participate in P-TIF auctions to create maximum welfare for the well-being of the district and local economy.
Another challenge related to the P-TIF instrument is that real valuation of the planned project directly affect the parameters of the model. Therefore, the question of which institutions will calculate the real value of the project gains critical importance in this alternative system. Last but not least, our P-TIF instrument includes complex mathematical calculation and stochastic modelling that makes it difficult for lenders and borrowers to understand. Instead, a more simple version of the reduced model helps the market players about how the P-TIF instrument works.

Concluding Remarks
Tax increment financing is a public finance instrument in which future tax revenues of the renovated district sold or assigned to a third party, in exchange for a cash payment to cover the cost of designation. This type of financing method might to come forefront particularly when the local authorities such as municipalities lack of sufficient funding sources. Compared to other income generating model such as sale of municipal land or service, tax increment financing provides a long-term solution to shortage of municipal budget. Although various modern implications of TIF practices have been widely observed in developed countries such as USA and Canada, the different version of it has been used as a traditional borrowing method by the Ottoman Empire and in many European countries as well.
In this paper, we introduce and develop a P-TIF model by combining TIF and participation based traditional public financing method. We establish a benchmark model for P-TIF by incorporating various stochastic processes. We mainly show that a rise in participation rate lowers the interest rate. Under the base case scenario we have in this paper, the interest rate is reduced to zero when the participation rate of the tax increment is set as 50%. With this feature, we argue that P-TIF can also be implied within the Shariah compliance framework thanks to the model it is based on. Therefore, P-TIF can be seen as an alternative financing instrument to almost all public authorities which aim to solve their long-term borrowing problem for various projects.