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From The Encyclopedia of Taxation and Tax Policy
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A bond, issued by a state or local government, the interest on which is exempt from taxation.
State and local governments issue debt ($267 billion in 1997) in exchange for the use of the savings of individuals and corporations. This debt obligates state and local governments to make interest payments for the use of these savings and to repay, some time in the future, the amount borrowed (the bond proceeds).
The first income tax law in the United States, in 1913, excluded from taxable income the interest income earned by holders of the debt obligations of states and their political subdivisions. In 1988 the U.S. Supreme Court in South Carolina v. Baker (485 U.S. 505 ) rejected the assertion that any federal taxation of interest income derived from this debt is unconstitutional because the exemption is protected by the Tenth Amendment and the doctrine of intergovernmental tax immunity. The Court denied the claim of constitutional protection and found tax exemption to be dependent upon statute and regulation. In short, Congress has the right to tax this interest income if it chooseswhich it has not done.
Because the interest income on state and local debt is excluded from federal income taxation, the interest rate on this "tax-exempt" debt is lower than the interest rate on taxable debt. For this reason, taxexempt debt has its own "market" and is an important factor in several economic policy issues.
Characteristics of tax-exempt bonds
Short-term debt instruments are usually referred to as notes and carry maturities of 12 months or less ($46 billion in 1997). Notes usually are paid from specific taxes due in the near future or from anticipated intergovernmental revenue and are often referred to as tax and revenue anticipation notes (TRANS). These short-term notes are issued because governments are faced with the necessity of planning a budget for the year (or in some cases for two years). This requires a balancing of revenue forecasts (see Revenue forecasting, federal) against forecasts of the demand for services and spending. Not infrequently, the inevitable unforeseen circumstances that undermine any forecast cause a revenue shortfall that must be financed with short-term borrowing. In addition, even when the forecasts are met, the timing of expenditures may precede the arrival of revenues, creating the necessity to borrow within an otherwise balanced fiscal year. Finally, temporarily high interest rates that prevail at the time bonds are issued to finance a capital project may induce short-term borrowing in anticipation of a drop in rates.
New issue versus refunding
Such activity lies outside the purpose of tax exemption, and the federal tax law requires that taxexempt bond proceeds be used as quickly as possible to pay contractors for the construction of capital facilities. Because it is impossible for bonds to be issued on the day every contractor must be paid for expenses incurred in building public capital facilities, a two-year period is granted to spend an increasing share of the bond proceeds. Bond issues that have unspent proceeds in excess of the allowed amounts during this two-year spend-down schedule must rebate any arbitrage earnings to the U.S. Treasury. Bond issues are considered to be taxable arbitrage bonds if a governmental unit, in violation of the arbitrage restriction in the tax code, purposely invests a substantial portion of the proceeds in assets that earn interest rates that exceed the tax-exempt interest rate by more than one-eighth of a percentage point.
Public purpose versus private purpose
Most of the legislation pertaining to tax-exempt bonds over the 30 years from 1968 to 1998 represents an effort to reduce this "conduit" financing. The legislation restricted tax exemption to bonds issued for activities that satisfy some broadly defined "public" purpose, that is, for which federal taxpayers are likely to receive substantial benefits. Bonds are considered to satisfy a public purpose if they meet either of two criteria: No more than 10 percent of the proceeds is used directly or indirectly by a nongovernmental entity; and no more than 10 percent of the proceeds is secured directly or indirectly by property used in a trade or business. Bonds that satisfy either of these tests are termed "governmental" bonds and can be issued without limit. Bonds that fail both of these tests are considered to primarily benefit private individuals or businesses, are termed "private-activity" bonds, and are ineligible for tax-exempt financing.
Some activities that fail the two tests are considered to provide some public benefits in addition to private benefits. These activities, termed qualified private activities, can be financed with tax-exempt bonds. The annual volume of bonds issued within a state for all qualified private activities is restricted to the greater of $50 per state resident or $150 million. The majority of bonds issued for these qualified private activities finance mortgages for owneroccupied housing, student loans for postsecondary education, and loans for private manufacturing facilities. By 1990, legislative changes had succeeded in reducing private-activity bonds to 20 percent of total bond volume.
Tax-exempt bonds and economic issues
The lower interest rate of tax-exempt bonds relative to taxable bonds makes these bonds an important factor in four economic policy issues.
Intergovernmental fiscal relations
Federal budget deficit
All of these changes impose losses of national income on society, because the pretax rate of return on most of these subsidized investments is lower than the pretax rate of return on the unsubsidized investments that are displaced. The welfare of federal taxpayers is enhanced only if taxpayers value the social benefits produced by the subsidized investments more than the lost national income.
If one ignores or dismisses as of little value the social objectives of the interest income exclusion that is used to justify resource reallocation, one is left with the conclusion that tax-exempt bonds are, from the federal perspective, little more than a vehicle for investors to shelter a portion of their income from federal taxation. This is not, however, a balanced view. It is true that one can use tax-exempt bonds to reduce one's marginal tax rate to zero, but this is accompanied by an implicit tax in the form of a lower pretax rate of return that generates a positive marginal effective tax rate. Furthermore, society's vertical equity objectives are not expressed by the statutory rate structure, but by the effective rate structure that results from each income class's access to the numerous exemptions, deductions, exclusions, credits, deferrals, and so forth. This suggests that any effort to alter tax-exempt bonds on equity grounds is likely to be countered by adjustments in other tax preferences that leave the overall pattern of marginal effective tax rates by income class relatively unchanged.
Fortune, Peter. "The Municipal Bond Market, Part I: Politics, Taxes and Yields." New England Economic Review (September/ October 1991): 13-36.
Fortune, Peter. "The Municipal Bond Market, Part II: Problems and Policies." New England Economic Review (May/ June 1992): 47-64.
Hilhouse, Albert M. Municipal Bonds: A Century of Experience. New York: Prentice Hall, 1936.
Ott, David J., and Allan H. Meltzer. Federal Tax Treatment of State and Local Securities. Washington, D.C.: The Brookings Institution, 1963.
Petersen, John E., and Ronald Forbes. Innovative Capital Financing. Chicago: American Planning Association, 1985.
Public Securities Association. Fundamentals of Municipal Bonds. New York, 1989.
Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity. Washington, D.C.: The Urban Institute Press, 1991.
This report is available in its entirety in the Portable Document Format (PDF).