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Tax-exempt bonds have always been something of a two-edged sword. On one hand, they reduce borrowing costs for state and local governments. On the other, they suffer from both built-in inefficiencies and the potential for serious abuse.
The newly enacted stimulus bill didn’t do much to prevent the abuses—indeed it includes eight separate provisions that would expand the use of bonds for a wide-range of purposes from housing to alternative energy. But it did add one provision that promises to make municipal bonds a far more efficient way for states and localities to raise money.
The provision creates a new bond, where a tax credit could replace the old-style tax-free interest payment. The new law would give states and municipalities the option of issuing a bond where the borrower would get a federal credit equal to a percentage of the interest the issuer pays. Both the credit and the interest would be taxable. Since investors who have enough tax liability to use the credit would not care whether they bought these bonds or ordinary taxable bonds, the potential market for munis should expand.
Because muni bond interest is tax exempt, issuers can borrow at below market rates. The problem is that the rate is often still too high. Here’s why: A tax-exempt bond paying 6.5% interest is equivalent to a taxable bond paying 10% for an investor in the 35 percent bracket. However, since many potential buyers are in lower brackets, they demand a higher rate to make their investment return equivalent to, say, a taxable corporate bond. As a result, the state must pay a higher rate to attract the widest possible market. If the bond pays 8 percent, the issuer only saves 2 percent in interest and the rest of the revenue loss from the tax exemption becomes a windfall to high bracket taxpayers who retain 8% after-tax compared to 6.5% on a taxable bond.
Perhaps recognizing this problem, the Taxpayer Relief Act of 1997 created a limited class of taxable bonds which give investors tax credits in place of interest payments. Thus, if the appropriate interest rate on taxable bonds were 10%, the holder of a tax credit $1000 bond would, instead of a cash interest payment of $100, be entitled to a credit which would reduce tax liability by $100. Like the interest payment, the credit increases taxable income by $100. The stimulus act expands on this idea but under the new provision part of the interest comes in cash and part by way of the credit.
Since the credit can be the equivalent of cash, ideally it should enable the issuer to reduce interest payable by the full amount of the credit. In contrast to tax exempt bonds, the cost to the federal government would be fully reflected in cost savings to the states and there would be no windfall for investors. However, the credit might not be fully reflected in reduced interest payments by the issuer. Since the credit is not refundable, many potential investors who already have little or no tax liability or who fear that they won’t owe tax as a result of the bad economy would remain on the sidelines, driving up rates. In addition, such an unfamiliar product may not be completely understood by the market, also driving up rates.
In an effort to fix this, the new stimulus would allow state and local governments, for bonds issued in 2009 and 2010, to choose to take cash in lieu of the credit and pay fully taxable interest. The federal grant would be fixed as a percentage of the interest rate. Tax-exempt investors might also buy these bonds since the interest is paid in cash and not through a tax credit. The revenue loss to the federal government lowers the issuer’s cost dollar for dollar.
This provision of the stimulus may be obscure, but it has the potential to completely change the way state and local governments borrow. Ideally, in a few years, tax-free bonds may go the way of the Hummer.
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