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Federal Authority for
and Types of
For almost 80 years, since the 1913 federal income tax law was passed,
interest earned from state and local government bonds generally has been
tax exempt. Congress intended that the federal subsidy resulting from this
tax exemption would allow state and local governments to finance
public-purpose projects at less cost because investors would be willing to
accept lower interest rates to obtain tax-exempt income. Since the 1960s,
however, issuers increasingly have used tax-exempt bonds to finance
activities that also have benefited private parties and organizations.
Concerned about the growth in tax-exempt bonds used to finance private activities, forgone tax revenues associated with such financings, and incidents of abusive transactions, Congress began adding restrictions in the late 1960s to redirect and target the use of tax-exempt bonds to better serve the public good. As restrictions were added, tax-exempt bond provisions became more numerous and complex. Similarly, the bond financings became more complex.
The Internal Revenue Code (IRC) allows state and local governments to
issue bonds that provide investors with interest income that is exempt
from federal income tax. State and local governments can then finance
public-purpose projects (e.g., schools, roads, and water and sewer
facilities) at lower interest rates, because investors are willing to accept
these rates to obtain tax-exempt income. State and local governments also
may issue tax-exempt bonds on behalf of certain nonprofit organizations
(i.e., charitable organizations specified under IRC section 501(c)(3)) and
private for-profit persons or organizations if the bonds are used for certain
activities that are specified in the IRC. In addition, state or local law may
establish special authorities and districts to issue tax-exempt bonds.
Depending on the source of revenue that backs the issue, tax-exempt bonds can be classified as either general obligation bonds or revenue bonds. General obligation bonds are guaranteed by the full faith, credit, and taxing power of the issuing government. Revenue bonds are backed by a source of revenue, such as proceeds from a particular tax or from the project being financed.
Tax-exempt bonds also can be classified by the type of entity using the proceeds as either governmental or private activity bonds. In general, governmental bonds are those bonds in which 90 percent or more of the
'Much of the background information contained in this chapter is based on information included in Tax Policy: Internal Revenue Code Provisions Related to Tax-Exempt Bonds (GAO/GGD-91-124FS, Sept. 27, 1991).
proceeds are used by governmental entities. In general, private activity
bonds are bonds in which (1) more than 10 percent of the proceeds are
used by a nongovernmental private entity and more than 10 percent of the
principal or interest is paid directly or indirectly from, or secured by,
revenues from a private trade or business or (2) the lesser of more than
5 percent of the proceeds or $5 million is used for loans to private persons.
The IRC restricts the type and, in some cases, the size of activity that can be
financed with tax-exempt private activity bonds. In addition, the amount
of private activity bonds that can be issued in a state during any calendar
year cannot exceed that state's volume cap.
Issuing tax-exempt bonds can be a complex process. Specialized services generally are needed to help issuers plan the bond issue and sell the bonds. Although some of these services can be obtained in-house, the less in-house expertise that is available to an issuer, the more the issuer has to rely on private firms to handle tax-exempt bond issuances.
Planning a tax-exempt bond issue requires legal and financial services. Generally, bond counsels prepare pertinent legal documents and ensure that the proposed sale is consistent with local, state, and federal laws and regulations. Financial advisors may help issuers determine such details as the size of the issue, the bonds' maturity, and the security pledged for payment of the debt. These advisors also may help issuers determine the best method to sell the bonds to underwriting firms, which in turn sell the bonds to investors.
Issuers may use other specialists, such as rating agencies, bond insurers, trustees, accountants, consultants for feasibility studies, and printing and advertising firms. Rating agencies evaluate the creditworthiness of the bonds. Bond ratings provide information on the creditworthiness of the offering to potential investors. Bond insurance protects the investor against default. A trustee is the custodian of a bond's funds and the official representative of bondholders in their contract with the issuer.
Changes in the
Market and Increased
Since 1968, state and local government use of tax-exempt bond financing
has increased substantially. The Federal Reserve Board of Governors' data
showed that in 1968 the volume of outstanding long-term tax-exempt
bonds was about $114 billion,2 whereas at the end of 1990, the volume of
these bonds had increased to about $796 billion. As the use of tax-exempt
bonds grew, estimated federal tax expenditures for the activities funded
by the bonds also grew.3 Figure 1.1 shows the changes in estimated tax
expenditures related to outstanding tax-exempt bonds from 1975 through
1990 in 1990 dollars.
"Using the gross national product price deflator, $114 billion in outstanding tax-exempt bonds is equivalent to about $398 billion in 1990 dollars.
The Congressional Budget Act of 1974 identifies tax expenditures as "revenue losses attributable to
provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from
gross income or which provide a special credit, a preferential rate of tax, or a deferral of liability."
However, as explained in the United States Budget, tax expenditure estimates, including those for
tax-exempt bonds, do not exactly reflect the increase in federal receipts that would accompany the
repeal of the special provisions. For example, if tax-exempt provisions related to municipal bonds
were eliminated, some investors might use other methods to make their income tax exempt;
consequently, the net increase in federal receipts would be smaller. Additionally, excluding the interest
received from tax-exempt bonds lowers a taxpayer's taxable income, which can reduce the value of
other tax expenditures, such as the deduction for charitable contributions. If the interest exclusion
alone were repealed, some taxpayers could be thrust into higher tax brackets, which would
automatically increase the value of charitable contributions and their budget cost, even if taxpayers
did not make larger contributions. However, if both the interest exclusion and the deduction for
charitable contributions were repealed simultaneously, the increase in tax liability, and thus federal
receipts, would be greater than the sum of the two separate tax expenditures because each is
estimated assuming that the other remains in force.