Order Code RL30638
CRS Report for Congress
Received through the CRS Web
Tax-Exempt Bonds: A Description of
State and Local Government Debt
Updated October 10, 2001
Steven Maguire
Analyst in Public Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Tax–Exempt Bonds: A Description of State and Local
Government Debt
Summary
This report provides basic information about state and local government debt.
State and local governments often issue debt instruments in exchange for the use of
individuals’ and businesses’ savings. This debt obligates state and local governments
to make interest payments for the use of these savings and to repay, at some time in
the future, the amount borrowed. State and local governments finance capital
facilities with debt rather than out of current tax revenue in order to match the time
pattern of benefits from these capital facilities with the time pattern of tax payments.
The federal government subsidizes the cost of state and local debt by excluding
the interest income from federal income taxation. This tax exemption of interest
income is granted because it is believed that state and local capital facilities will be
under provided if state and local taxpayers have to pay the full cost.
State and local debt is issued as bonds, to be repaid over a period of time greater
than one year and perhaps exceeding 20 years, and as notes, to be repaid within one
year. General obligation bonds are secured by the promise to repay with general tax
revenue, and revenue bonds are secured with the promise to use the stream of revenue
generated by the facility built with the bond proceeds. Most debt is issued to finance
new capital facilities, but some is issued to refund a prior bond issue (usually to take
advantage of lower interest rates). Tax-exempt bonds issued for some activities are
classified as governmental bonds and can be issued without federal constraint because
most of the benefits from the capital facilities are enjoyed by the general public. Many
tax-exempt revenue bonds are issued for activities Congress has classified as private
because most of the benefits from the activities appear to be enjoyed by private
individuals and businesses rather than the general public. The annual volume of these
tax-exempt private-activity bonds is capped.
Arbitrage bonds devote a substantial share of the proceeds to the purchase of
assets with higher interest rates than that being paid on the tax-exempt bonds. Such
arbitrage bonds are not tax exempt because Congress does not want state and local
governments to issue tax-exempt bonds and use the proceeds to earn arbitrage profits.
The arbitrage profits could substitute for state and local taxes.
The major policy issue in this area is the effort to use tax-exempt bonds to
increase federal financial support for a variety of public facilities. Another policy issue
is whether constraints should be relaxed on the types of activities for which state and
local governments can issue tax-exempt debt. This is illustrated by the debate about
whether governmental bonds should be used to finance sports facilities for
professional sports teams. The extent to which the current arbitrage bond rules
prohibit what some consider legitimate state and local financial behavior is a related
area of dispute. The list of activities that classify tax-exempt private-activity bonds
– and whether they should be included in the volume cap–is another area of
controversy.
A list of readings is provided for the reader who wants to know more about tax-
exempt bonds. This report will be updated as new data become available.

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Contents
What is Debt? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Why Do State and Local Governments Issue Debt? . . . . . . . . . . . . . . . . . . . . . . 1
What Makes State and Local Debt Special? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
What Does Tax Exemption Cost the Federal Government? . . . . . . . . . . . . . . . . 3
Why Does the Federal Government Subsidize State and Local Debt? . . . . . . . . . 4
Classifying State and Local Debt Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Maturity: Short-Term vs. Long-Term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Security: General Obligation, Revenue, and Lease Rental Bonds . . . . . . . . 6
Use of the Proceeds: New-issue vs. Refunding Bonds . . . . . . . . . . . . . . . . 8
Public Purpose vs. Private Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
What Are Arbitrage Bonds? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
What Are Tax Credit Bonds? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Legislative Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Suggested Readings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
List of Tables
Table 1. Yield on Tax-Exempt and Corporate Bonds of Equivalent Risk, the
Yield Spread, and the Yield Ratio: 1980 to 2000 . . . . . . . . . . . . . . . . . . . . 3
Table 2. Federal Revenue Loss on the Outstanding Stock of
Tax-exempt Bonds: 1990 to 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Table 3. Volume of State and Local Tax-Exempt Debt: 1980 to 2000 . . . . . . . . 6
Table 4. Volume of Long-term Tax-exempt Debt: General Obligation (GO),
Revenue, and Refunding Bonds, 1980 to 2000 . . . . . . . . . . . . . . . . . . . . . . 7
Table 5. Private-Activity Bond Volume by Type of Activity in 2000 . . . . . . . . . 9
Table 6. Long-Term Private Activity Bond Volume as Percent of Total
Bond Volume, 1976 to 1995 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Table 7. Comparison of Three Types of Bonds with a 6% After-Tax Yield . . . 12

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Tax-Exempt Bonds: A Description of State
and Local Government Debt
What is Debt?
Individuals and businesses lend their accumulated savings to borrowers. In
exchange, borrowers give lenders a debt instrument. These debt instruments, typically
called bonds, represent a promise by borrowers to pay interest income to lenders on
the principal (the amount of money borrowed) until the principal is repaid to the
lenders. This principal, sometimes called the proceeds, generally is used to finance
the construction of capital facilities.
Why Do State and Local Governments Issue Debt?
Since public capital facilities provide services over a long period of time, it
makes financial and economic sense to pay for the facilities over a similarly long
period of time. This is particularly true for state and local governments. Their
taxpayers lay claim to the benefits from these facilities by dint of residency and
relinquish their claim to benefits when they move. Given the demands a market-
oriented society places on labor mobility, taxpayers are reluctant to pay today for
state and local capital services to be received in the future. The rational response of
the state or local official concerned with satisfying the preferences of constituents is
to match the timing of the payments to the flow of services, precisely the function
served by long-term bond financing. An attempt to pay for capital facilities “up front”
is likely to result in a less than optimal rate of public capital formation.
State and local governments are also faced with the necessity of planning their
budget for the year (or in some cases for 2 years). This requires a balancing of
revenue forecasts against forecasts of the demand for services and spending. Not
infrequently, the inevitable unforeseen circumstances that undermine any forecast
cause a revenue shortfall, which must be financed with short-term borrowing, or
“notes.” 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.
Thus, state and local governments have valid reasons to borrow funds. In fact,
these reasons are so universally accepted that both taxpayers and the courts have
ignored the nineteenth century legacy of unrealistically restrictive constitutional and
statutory limitations on state and local borrowing.1
1 Dennis Zimmerman, “History of Municipal Bonds,” in his The Private Use of Tax-Exempt Bonds:
(continued...)

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CRS-2
What Makes State and Local Debt Special?
The federal government has chosen to intervene in the public capital market by
granting the debt instruments of state and local governments a unique privilege–the
exemption of interest income earned on these bonds from federal income tax. The tax
exemption lowers the cost of capital for state and local governments, which should
then induce an increase in state and local capital formation. The lower cost of capital
arises because investors would be indifferent between taxable bonds (e.g., corporate
bonds) that yield a 10% rate of return before taxes and tax-exempt bonds of
equivalent risk that yield a 6.5% return. The taxable bond interest earnings carry a
tax liability (35% of the interest income in most cases) making the after tax return on
the two bonds identical at 6.5%. Thus, state and local governments could raise
capital from investors at an interest cost 3.5 percentage points lower than a borrower
issuing taxable debt.
Generally, the degree to which tax-exempt debt is favored is measured in two
ways. The yield spread is the difference between interest rate on corporate bonds and
the interest rate on municipal bonds of equivalent risk. Table 1 lists the average yield
on high-grade municipal bonds and AAA-rated corporate bonds from 1980 to 2000,
and the corresponding yield spread. The spread grew to a high of 3.43% in 1980 and
dropped to a low of 1.41% in 1998. The greater the yield spread, the greater is the
nominal savings to state and local governments as measured by the interest rates they
would have to pay if they financed with taxable debt. As the spread approaches zero,
state and local borrowing costs approach the level of taxable bond interest rates.
Another measure, the yield ratio (which is an average rate on tax-exempt bonds
divided by an average rate on a corporate bond of like term and risk), adjusts the
spread for the level of interest rates. The lower the ratio, the greater the savings to
state and local governments relative to taxable debt. As the ratio approaches one, the
cost of tax-exempt state and local borrowing approaches that of taxable borrowing.
As shown in Table 1, the ratio was lowest in 1980 at 0.71 and reached a peak of 0.84
in 1982. For the last decade the ratio has been relatively stable, though drifting lower
at the end of the period.
These variations in the cost of state and local borrowing relative to the cost of
taxable borrowing depend upon the demand for and supply of both tax-exempt and
taxable bonds. Demand for tax-exempt bonds depends upon the number of investors,
their wealth, and alternative investment opportunities. Supply depends upon the
desire of the state and local sector for capital facilities and their ability to engage in
conduit financing (issuing state or local government bonds and passing the proceeds
through to businesses or individuals for their private use). Almost all of the factors
which influence demand and supply are affected by federal tax policy.
1 (...continued)
Controlling the Public Subsidy of Private Activity (Washington, The Urban Institute Press, 1991),
pp. 17-27.

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CRS-3
Table 1. Yield on Tax-Exempt and Corporate Bonds of
Equivalent Risk, the Yield Spread, and the Yield Ratio: 1980 to
2000
High Grade Tax- AAA Corporate
Yield Ratio
Yield Spread
Year
exempt Yield
Yield
(tax-exempt/
(in percent)
(in percent)
(in percent)
corporate)
1980
8.51
11.94
3.43
0.71
1981
11.23
14.17
2.94
0.79
1982
11.57
13.79
2.22
0.84
1983
9.47
12.04
2.57
0.79
1984
10.15
12.71
2.56
0.80
1985
9.18
11.37
2.19
0.81
1986
7.38
9.02
1.64
0.82
1987
7.73
9.38
1.65
0.82
1988
7.76
9.71
1.95
0.80
1989
7.24
9.26
2.02
0.78
1990
7.25
9.32
2.07
0.78
1991
6.89
8.77
1.88
0.79
1992
6.41
8.14
1.73
0.79
1993
5.63
7.22
1.59
0.78
1994
6.19
7.96
1.77
0.78
1995
5.95
7.59
1.64
0.78
1996
5.75
7.37
1.62
0.78
1997
5.55
7.26
1.71
0.76
1998
5.12
6.53
1.41
0.78
1999
5.43
7.04
1.61
0.77
2000
5.71
7.62
1.91
0.75
Source: Council of Economic Advisors, Economic Report of the President, February 2000, Table
B-71; The Federal Reserve, “Table H. 15: Selected Interest Rates,” Federal Reserve Statistical
Release, http://www.federalreserve.gov/releases/H15/data.htm, visited September 24, 2001.
What Does Tax Exemption Cost the Federal
Government?
The direct cost to the federal government of this interest exclusion is the
individual and corporate income tax revenue forgone. Consider a 35% marginal tax
rate corporate investor who purchases a 6.5% tax-exempt bond with principal of
$1,000 that is to be repaid after 20 years. Each year for 20 years this taxpayer
receives $65 in tax-exempt interest income. Each year the federal government
forgoes collecting $35 of revenue because the revenue loss is based upon the yield the
taxpayer forgoes. For example, if the investor had purchased a taxable bond carrying
a 10% interest rate, he would have received $100 in interest income and paid $35 in
income taxes on that income.2
2 The decision about preferred alternatives is critical to estimates of the revenue loss from tax-exempt
bonds. An entire range of financial and real assets exists with different yields, risk, and degree of
preferential taxation. It is not true that the municipal bond purchaser’s preferred alternative is always
a taxable bond.

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CRS-4
The loss of federal revenue on the outstanding stock of tax-exempt bonds is
estimated separately by the Treasury Department’s Office of Tax Analysis and the
Joint Committee on Taxation. The Treasury Department’s estimates for the last 11
years are displayed in Table 2.3 Because they are based upon the outstanding stock
of tax-exempt bonds, it takes time for some legislative changes to show up in these
data. The amount of forgone tax revenue from the exclusion of interest income on
tax-exempt bonds is substantial, almost $23 billion in 2000.
Table 2. Federal Revenue Loss on the Outstanding Stock of
Tax-exempt Bonds: 1990 to 2000
($ in billions)
Year
Revenue Loss
Year
Revenue Loss
1990
26.0
1996
24.6
1991
27.0
1997
24.9
1992
20.7
1998
24.6
1993
20.8
1999
24.8
1994
19.6
2000
22.6
1995
19.9
Source: Office of Management and Budget. Special Analyses: Budget of the United States
Government, various years; and Analytical Perspectives: Budget of the United States
Government, various years.
Why Does the Federal Government Subsidize State
and Local Debt?
When first introduced in 1913, the federal income tax excluded the interest
income earned by holders of the debt obligations of states and their political
subdivisions from taxable income. It was asserted by many that any taxation of this
interest income would be unconstitutional because the exemption was protected by
the Tenth Amendment and the doctrine of intergovernmental tax immunity. The U.S.
Supreme Court rejected this claim of constitutional protection in 1988 in South
Carolina v. Baker (485 U.S. 505, [1988]).
Although the legal basis for the subsidy is statutory rather than constitutional,
the policy reason for the subsidy is economic. Economic theory suggests that certain
types of goods and services will not be provided in the correct or “optimal” amounts
by the private sector because some of the benefits are consumed collectively, a street
light for example. The Nation’s welfare can be increased by public provision of these
goods and services, and some of these public goods and services are best provided by
state or local governments. However, some of the goods and services provided by
state or local governments benefit both residents, who pay taxes, and nonresidents,
who pay minimal if any taxes. Since state and local taxpayers are likely to be
unwilling to provide these services to nonresidents without compensation, it is
3 These estimates are derived by summing the revenue loss estimates for each activity listed in the tax
expenditures budget. Technically, this is incorrect because each activity’s revenue loss is calculated
in isolation, and there are interactive effects. Nonetheless, without an estimate of the interactive
effects’ impact on revenue loss, the summing employed here provides the best available order of
magnitude.

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CRS-5
probable that state and local services will be under provided. In theory, the cost
reduction provided by the exemption of interest income compensates state and local
taxpayers for benefits provided to nonresidents and encourages these governments to
provide the optimal amount of public services.
Classifying State and Local Debt Instruments
State and local debt can be classified based on 1) the maturity (or term), which
is the length of time before the principal is repaid; 2) the type of security, which is the
financial backing for the debt; 3) the use of the proceeds for either new facilities or
to refinance previously-issued bonds; and 4) whether the type of activity being
financed has a public or a private purpose. Another important factor is the level risk.
Just about every bond issued by a state or local government is rated based on the
probability of default. The privately managed rating agencies incorporate all of the
above factors as well as the financial health of the entity issuing the bonds when
arriving upon a bond rating. The higher the default risk, the lower the rating.
Maturity: Short-Term vs. Long-Term
State and local governments must borrow money for long periods of time and
for short periods of time. Long-term debt instruments are usually referred to as
bonds, and carry maturities in excess of one year. Short-term debt instruments are
usually referred to as notes, and carry maturities of 12 months or less. If the notes are
to be paid from specific taxes due in the near future, they usually are called tax
anticipation notes (TANs); if from anticipated intergovernmental revenue, they are
called revenue anticipation notes (RANs). If the notes are to be paid from long-term
borrowing (e.g., bonds), they are called bond anticipation notes (BANs). Tax
anticipation notes and revenue anticipation notes are often grouped together and
referred to as tax and revenue anticipation notes (TRANs). Table 3 displays the
volume of long-term and short-term borrowing since 1980. Long-term borrowing
dominates state and local debt activity in most years, with the long-term share peaking
in 1985 at over 90% of this market.

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CRS-6
Table 3. Volume of State and Local Tax-Exempt Debt: 1980 to
2000
Short-term
Long-term
Long-term
Year
($ millions)
($ millions)
Share of Total
1980
$26,485
$47,133
64.0%
1981
34,443
46,134
57.3%
1982
43,390
77,179
64.0%
1983
35,849
83,348
69.9%
1984
31,068
101,882
76.6%
1985
20,809
206,991
90.9%
1986
22,046
150,638
87.2%
1987
20,518
105,027
83.7%
1988
23,666
117,316
83.2%
1989
29,596
125,005
80.9%
1990
34,804
127,828
78.6%
1991
44,800
172,443
79.4%
1992
42,894
234,667
84.5%
1993
47,354
292,249
86.1%
1994
40,293
165,034
80.4%
1995
38,346
159,983
80.7%
1996
41,695
185,014
81.6%
1997
46,271
220,622
82.7%
1998
34,784
286,183
89.2%
1999
36,647
227,348
86.1%
2000
40,214
200,113
83.3%
Source: The Bond Buyer Yearbook, 2001 and earlier editions.
Security: General Obligation, Revenue, and Lease Rental
Bonds
Another important characteristic of tax-exempt bonds is the security provided
to the bondholder. General obligation (GO) bonds pledge the full faith and credit of
the issuing government. The issuing government makes an unconditional pledge to
use its powers of taxation to honor its liability for interest and principal repayment.
Revenue bonds, or nonguaranteed debt, pledge only the earnings from revenue-
producing activities, most often the earnings from the facilities being financed with the
revenue bonds. Should these earnings prove to be inadequate to honor these
commitments, the issuing government is under no obligation to use its taxing powers
to finance the shortfall. Some revenue bonds are issued with credit enhancements
provided by insurance or bank letters of credit that guarantee payment upon such a
revenue shortfall.
The first two columns of Table 4 display the breakdown between long-term GO
and revenue bonds since 1980. The long-term market has been and continues to be
dominated by revenue bonds, which are nonguaranteed debt instruments. During the
1960s (not shown in this table), revenue bonds constituted less than 40% of long-term
bond volume; during the 1970s (also not shown) the revenue bond share crept into
the 50% to 65% range; and beginning in 1979 this share settled into the high 60s and
low 70s, achieving a high of 73.1% in 1988. The revenue bond share has remained
below 70% from 1989 through 2000.

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CRS-7
Table 4. Volume of Long-term Tax-exempt Debt: General
Obligation (GO), Revenue, and Refunding Bonds, 1980 to 2000
($ in millions)
Long-term Bond Volume
Refunding Bonds
General
Revenue
Refunding
Year
Revenue
Amount
Obligation
Share
Share
1980
$16,347
$30,786
65.3%
$1,649
3.5%
1981
13,988
32,146
69.7%
1,192
2.6%
1982
23,276
53,903
69.8%
4,044
5.2%
1983
22,584
60,764
72.9%
13,048
15.7%
1984
27,508
74,374
73.0%
11,390
11.2%
1985
55,287
148,994
72.9%
57,867
28.3%
1986
45,555
105,417
69.8%
56,063
37.1%
1987
30,867
74,656
70.7%
38,490
36.5%
1988
31,502
85,509
73.1%
36,591
31.3%
1989
38,501
86,504
69.2%
28,842
23.1%
1990
40,303
87,526
68.5%
19,881
15.6%
1991
57,110
115,334
66.9%
41,444
24.0%
1992
80,479
154,188
65.7%
92,446
39.4%
1993
91,555
200,694
68.7%
150,152
51.4%
1994
55,767
109,267
66.2%
38,601
23.4%
1995
60,367
99,615
62.3%
33,850
21.2%
1996
64,355
120,685
65.2%
45,944
24.8%
1997
72,301
148,340
67.2%
60,153
27.3%
1998
93,531
192,652
67.3%
81,957
28.6%
1999
70,207
156,418
69.0%
37,800
16.7%
2000
64,584
135,529
67.7%
19,380
9.7%
Source: The Bond Buyer Yearbook, 2001 and earlier editions.
All tax-exempt interest income attributable to state and local governments does
not appear in the form of bonds. Governments may engage in installment purchase
contracts and finance leases for which the portion of the installment or lease payment
to a vendor is tax exempt. For example, computer equipment or road building
equipment could be leased from a vendor using a rental agreement or an installment
sales contract. Under this type of agreement, the monthly payments to the vendor are
large enough to cover the vendor’s interest expense on the funds borrowed to
purchase the equipment which was leased to the government. This portion that is
attributable to interest income is not included in the vendors taxable income. Such
transactions are often referred to as municipal leasing.
Lease rental revenue bonds and certificates are variations on revenue bonds. An
authority or nonprofit corporation issues bonds, builds a facility with the proceeds,
and leases the facility to a municipality. Security for the bonds or certificates is based
on the lease payments. When the bonds are retired, the facility belongs to the lessee
(the municipality). An advantage to this type of arrangement is that many states’
constitutional and statutory definitions do not consider this type of financing to be
debt because the lease payments are annual operating expenses based upon
appropriated monies.
The leasing technique has also been used to provide tax-exempt funds to
nonprofit organizations. A municipality issues the bonds for the construction of a

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CRS-8
facility that is leased to a nonprofit hospital or university. Again, security for the
bonds is based on the lease payments.
Use of the Proceeds: New-issue vs. Refunding Bonds
Long-term tax-exempt bond issues also can be characterized by their status as
new issues or refunding issues. New issues represent bonds issued to finance new
capital facilities. Refundings usually are made to replace outstanding bonds with
bonds that carry lower interest rates or other favorable terms. As such, the refunding
bonds usually do not add to the stock of outstanding bonds or the capital stock. The
proceeds of the refunding bonds are used to pay off the remaining principal of the
original bond issue, which is retired. Advance refunding bonds, however, do add to
the outstanding stock of bonds without adding to the stock of capital. Advance
refunding bonds are issued prior to the date on which the original bonds are refunded,
so that for a period of time there are two bond issues outstanding to finance the same
capital facilities.
The last two columns of Table 4 show the dollar value of refunding issues and
their share of total long-term bond volume. The share varies widely, depending to a
great extent on changes in the relative magnitudes of taxable and tax-exempt interest
rates. Since 1985 the refunding share has usually been in excess of 25%. Note that
the 1993 increase in the top marginal individual income tax rates apparently increased
the demand for tax-exempt bonds. Higher tax rates make tax-exempt bonds more
attractive relative to taxable bonds, all other things being equal. The increased
demand and accompanying lower interest rates may have prompted state and local
governments to replace outstanding issues with refunding bonds that carried lower
interest rates. In contrast, refundings dropped considerably in 1999 and 2000. The
decline could have been in response to higher interest rates or to strong economic
conditions in most states which minimized the need for debt finance generally.
Public Purpose vs. Private Purpose
An important characteristic of tax-exempt bonds is the purpose or activity for
which the bonds are issued. Most of the tax legislation pertaining to tax-exempt
bonds over the last 30 years reflects an effort to restrict 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
be for a public purpose if they satisfy either of two criteria: less than 10% of the
proceeds is used directly or indirectly by a non-governmental entity; or less than 10%
of the bond 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 federal limit. Bonds that fail both of these tests are termed
“private-activity” bonds because they provide significant benefits to private individuals
or businesses. These projects are ineligible for tax-exempt financing.
Activities which fail the two tests but are considered to provide both public and
private benefits have been termed eligible or qualified private-activity bonds. These
selected activities can be financed with tax-exempt bonds. Table 5 provides the
dollar value of new issues of tax-exempt private-activity bonds and their share of total
private-activity volume capacity for 2000. Table 6 provides historical data on the
portion of private-activity bond volume to total bond volume.

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CRS-9
Table 5. Private-Activity Bond Volume by Type of Activity in
2000
Portion of Total Volume
Issued in 2000
Private Activity
Capacity Available in
($ millions)
2000
Total Volume Capacity Available
$19,142.2
100.0%
2000 New Volume Capacity
15,375.7
80.3%
Carryforward from Previous Years
3,766.5
19.7%
Single-family Mortgage Revenue
3,636.0
19.0%
Multi-family Housing
3,041.1
15.9%
Industrial Development
3,008.3
15.7%
Housing not Classified
1,594.0
8.3%
Student Loans
1,562.4
8.2%
Exempt Facilities
1,427.7
7.5%
Other Activities
715.3
3.7%
Mortgage Credit Certificates
436.2
2.3%
Abandon Capacity
106.6
0.6%
Carry Forward (unused capacity)
3,615.0
18.9%
Source: “State Allocation of Private-Activity Bonds in 2000,” The Bond Buyer, July 9, 2001, p. 34.
Table 6. Long-Term Private Activity Bond Volume as Percent of
Total Bond Volume, 1976 to 1995
Private
Percent
Private
Percent
Year
Activity ($
of
Year
Activity ($
of
billions)
Volume
billions)
Volume
1976
$8.4
24.0%
1986
$17.2
20.0%
1977
13.1
27.9
1987
16.7
28.2
1978
15.8
32.2
1988
29.4
25.1
1979
24.6
51.1
1989
27.7
22.3
1980
29.4
53.6
1990
31.4
24.6
1981
27.4
48.5
1991
27.8
16.1
1982
44.0
51.7
1992
26.9
11.5
1983
49.9
71.0
1993
21.2
7.3
1984
65.8
72.7
1994
25.0
15.1
1985
99.4
67.9
1995
27.9
17.4
Source: Private activity data, 1976-82 from Joint Committee on Taxation, Trends in the Use of Tax-
Exempt Bonds to Finance Private Activities, Including a Description of H.R. 1176 and H.R.
1635. June 13,1983. Joint Committee Print; for 1983 to 1995, Internal Revenue Service Data.
Long Term bond volume from various issues of the Bond Buyer Yearbook.
Private Activities Eligible for Tax Exemption
All tax-exempt private-activity bonds are subject to restrictions that do not apply
to governmental bonds, chief among them being no advance refundings and the
inclusion of the interest income in the alternative minimum income tax base. In
addition, the annual dollar value of all bonds issued for most of these activities by all
governmental units within a state is limited to the greater of $62.50 per resident or
$187.5 million in 2001. Beginning in 2002, the cap will be increased to the greater
of $75 per resident or $225 million. The annual volume cap applies to the total of

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bonds issued primarily for but not limited to: multi and single-family housing,
industrial development, exempt facilities4, student loans, and bond-financed takeovers
of investor owned utilities (usually electric utilities).
Bonds issued for several activities classified as private are not subject to the
volume cap if the facilities are governmentally owned.5 These activities are airports,
docks, and wharves; nonprofit organization facilities; high-speed inter-urban rail
facilities; and solid waste disposal facilities that produce electric energy.
As part of the Economic Growth and Tax Relief Reconciliation Act of 2001
(EGTRRA), a new type of tax-exempt private activity bond was created beginning on
January 1, 2002.6 The Act expanded the definition of “an exempt facility bond” to
include bonds issued for qualified public educational facilities. Bonds issued for
qualified educational facilities are not counted against a state’s private-activity volume
cap. However, the qualified public educational facility bonds have their own volume
capacity limit equal to the greater of $10 multiplied by the State population or $5
million. Since nearly all states would be better off with the $10 per capita limit, the
potential new debt would have been approximately $2.8 billion in 2001 if the bonds
were available in 2001.
What Are Arbitrage Bonds?
Many individuals and businesses make money by engaging in arbitrage,
borrowing money at one interest rate and lending that borrowed money to others at
a higher interest rate. The difference between the rate at which one borrows and the
rate at which one lends produces arbitrage earnings. At its most basic level, it is the
primary activity of commercial banks — pay depositors an interest rate of “x” and use
the deposits to make commercial, automobile, and home loans at “x + y” interest rate.
In this context, arbitrage is a time-honored and appropriate financial market activity.
That is not the case in the tax-exempt bond market. State and local governments
do not pay federal income tax, and absent federal constraint, have unlimited capacity
to issue debt at low interest rates and reinvest the bond proceeds in higher-yielding
taxable debt instruments, thereby earning arbitrage profits. Unchecked, state and
local governments could substitute arbitrage earnings for a substantial portion of their
own citizens’ tax effort.
4 Exempt facilities subject to the volume cap are the following: mass commuting facilities, water
furnishing, sewage treatment, solid waste disposal, residential rental projects, electric energy or gas
furnishing, local district heating or cooling provision, and hazardous waste disposal and 75% of high-
speed rail facility bonds. 26 I.R.C. Section 141(e) and Section 142(a).
5 This does not mean governmental ownership in the conventional sense. It simply means that lease
arrangements for private management and operation of bond-financed facilities must be structured to
deny accelerated depreciation benefits to the private operator, lease length must conform to the
facility’s expected service life, and any sale of the facility to the private operator must be made at fair
market value. 26 I.R.C. Section 146(g).
6 For a more extensive explanation of the tax exempt bond provisions in EGTRRA, see CRS Report
RS20932 Tax-Exempt Bond Provisions in the “Economic Growth and Tax Relief Reconciliation Act
of 2001,” by Steven Maguire.

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Congress has decided that such arbitrage should be limited, and that tax-exempt
bond proceeds must be used as quickly as possible to pay contractors for the
construction of the capital facilities for which the bonds were issued. Since it is
impossible for bonds to be issued precisely when contractors must be paid for their
expenses incurred in building public capital facilities, the tax law provides a 3-year
period to spend an increasing share of the bond proceeds. Bond issues that have
unspent proceeds in excess of the allowed amounts during this three-year spend-down
schedule must rebate any arbitrage earnings to the Department of the Treasury. Bond
issues are considered to be taxable arbitrage bonds if a governmental unit, in violation
of the arbitrage restriction in the tax code, invested a substantial portion of the
proceeds “to acquire higher yielding investments, or to replace funds which were used
directly or indirectly to acquire higher yielding investments.”7
What Are Tax Credit Bonds?
The 1997 Taxpayer Relief Act created a new category of tax preferred state and
local bonds, the qualified zone academy bond (QZAB) for renovating public school
facilities. Congress authorized QZAB debt of $400 million a year for 1998 through
2001 or $1.6 billion over the four years. The annual limit is allocated among the
states in proportion to their share of all individuals below the poverty line.8
The subsidy for these bonds is not provided in the form of the exemption of
interest income from federal income tax, as is true for tax-exempt bonds, including
bonds issued for public elementary and secondary education facilities. Rather, the
subsidy for a QZAB is a credit taken by eligible financial institutions against the
federal taxes they owe. The credit rate is calculated by the Treasury Department such
that the bonds can be issued without discount and without any interest cost to the
issuer.
One way to think of this alternative subsidy is that financial institutions can be
induced to purchase these bonds if they receive the same after-tax return from the
credit that they would from the tax exemption. The value of the credit must be
included in taxable income, but is then used to reduce regular or alternative minimum
tax liability. Assuming the taxpayer is subject to the regular corporate income tax, the
credit rate should equal the ratio of the purchaser’s forgone market interest rate on
tax-exempt bonds divided by one minus the corporate tax rate. For example, if the
tax-exempt interest rate is 6% and the corporate tax rate is 35%, the credit rate would
be equal to 0.06/(1-0.35), or about 9.2%. Thus, a financial institution purchasing a
$1,000 zone academy bond would receive a $92 tax credit for each year it holds the
bond.
The implicit subsidy is much greater for zone academy bonds than for tax-
exempt bonds. All of the interest costs for zone academy bonds are paid by the
federal taxpayer. For tax-exempt bonds, the federal taxpayer absorbs only the
difference between the taxable and tax-exempt interest rates. For example, if the
taxable rate is 9.2% and the tax-exempt rate is 6%, the non-zone bond receives a
7 26 I.R.C. Section 148(a).
8 For a more detailed explanation of tax credit bonds or QZABs, see CRS Report RS20606, Qualified
Zone Academy Bonds: A Description of Tax Credit Bonds, by Steven Maguire.

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CRS-12
subsidy equal to 3.2 percentage points, the difference between 9.2% and 6%. The
QZAB receives a subsidy equal to all 9.2 percentage points.
The relationship between three types of bonds, all with the same after-tax yield
of 6%, is presented in Table 7. The most important column is the last, titled “Implicit
Subsidy to Borrower,” which is synonymous with the federal revenue loss presented
in Table 2 for all outstanding tax-exempt debt. The implicit subsidy is the amount the
borrower saves because of favorable federal tax treatment. In the case of zone
academy bonds, the subsidy is considerably greater than with traditional tax-exempt
bonds.
Table 7. Comparison of Three Types of Bonds with a 6% After-
Tax Yield
Numbers are in Percentage of Bond Proceeds Assuming a Corporate Taxpayer is in the 35%
Marginal Tax Bracket
Federal Tax
Implicit
Borrower
Lender
Taxes Paid
Type of Bond
Revenue
Subsidy to
Pays
Receives
by Lender
from Bond
Borrower
Taxable
9.2
9.2
3.2
+3.2
0.0
Tax-exempt
6.0
6.0
0.0
0.0
3.2
Tax Credit
0.0
9.2a
3.2b
-6.0b
9.2
Notes:
a. The lender is allowed to reduce its tax liability by the amount of the credit.
b. The federal government receives some additional tax revenue because the credit is included in
taxable income. However, the loss in revenue from the credit exceeds the revenue gain
producing the negative revenue effect.
Legislative Issues
Current legislative interest focuses on altering the tax treatment of state and local
debt to provide even greater financial support for a variety of public projects such as
education infrastructure, healthcare facilities, and rapid transit. There are several
ways the federal government can increase the federal subsidy to state and local
governments that issue tax-exempt bonds for these targeted purposes. One, arbitrage
rules could be loosened to allow the state or local government to earn more
investment income on unused bond proceeds. Less stringent arbitrage rules may also
reduce the compliance burden of some smaller government entities freeing more funds
for the project. Two, the federal government can change the rules for private
activities that qualify for tax-exempt financing. If more activities qualified to use tax-
exempt debt finance by virtue of any proposed rules changes, previous congressional
efforts to limit the use of tax-exempt debt for non-governmental projects would be
mitigated. Third, Congress could introduce a new type of tax favored instrument,
such as tax credit bonds, for a broader range of activities. Currently, the only tax
credit bonds are those issued for school renovation and repair, the QZABs described
earlier in this report.

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In addition to the three options highlighted above, many other methods can be
employed to enhance the federal subsidy for state and local government capital
formation. The desire to subsidize state and local capital formation, which in many
cases may be justified, must be weighed against the federal revenue loss and the
potential for misallocation of federal tax revenue.
Suggested Readings
Ballard, Frederic L., Jr., ABCs of Arbitrage: Tax Rules for Investment of Bond
Proceeds by Municipalities, (Chicago: Urban, State, and Local Government
Law Section, American Bar Association, 1992).
Describes and explains arbitrage and the arbitrage tax rules that control state and
local investment practices.
Congressional Budget Office, The Tax-Exempt Financing of Student Loans,
(Washington: GPO, August 1986).
Provides a legislative history of student loan bonds, describes the operation of
student loan authorities, estimates the costs of student loan bonds, and discusses
policy alternatives.
Congressional Budget Office, Small Issue Industrial Development Bonds,
(Washington: GPO, September 1981).
Describes the growth, uses, and effects of small-issue IDBs, and discusses policy
alternatives.
CRS Report 96-698, Tax-Exempt Bond Legislation, 1968-1996: An Economic
Perspective, by Dennis Zimmerman.
Provides a history of tax-exempt bond law changes from 1968 through 1996.
Places these legislative changes in the context of the economic incentives being
created to affect the demand and supply of tax-exempt bonds.
CRS Report 96-460, Tax-Exempt Bonds and the Economics of Professional Sports
Stadiums, by Dennis Zimmerman.
Discusses the history and economic rationale for tax-exempt bond financing of
private investments, calculates the value of tax-exempt bond subsidies for 21
publicly owned stadiums used by professional sports teams, evaluates the
economic benefits of these stadiums for state and federal taxpayers, and
evaluates options for limiting the federal revenue loss from these subsidies.
U.S. General Accounting Office, Home Ownership: Mortgage Bonds Are Costly and
Provide Little Assistance to Those in Need, GAO Report RCED-88-111, March
1988.
Discusses the structure and operation of mortgage revenue bonds and analyzes
whether the bonds are successful in increasing home ownership for the target
population of lower-income households.

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Hilhouse, Albert M., Municipal Bonds: A Century of Experience, (New York:
Prentice-Hall, 1936).
The classic history of the use and development of municipal bonds from their
introduction in the 19th century.
Petersen, John E., and Ronald Forbes, Innovative Capital Financing, (Chicago:
American Planning Association, 1985).
Provides discussion of the numerous variations on tax-exempt bonds that have
been developed to raise capital for the state and local sector, such as sale-
leasebacks, installment purchase contracts, etc.
Public Securities Association, Fundamentals of Municipal Bonds, (New York:
Public Securities Association, 1987).
Describes the structure and functioning of the state and local debt markets.
U.S. Senate, Committee on the Budget, Tax Expenditures: Compendium of
Background Material on Individual Provisions. S.Prt. 106-65, 106th Congress,
2d session, December 2000.
Provides description, revenue loss estimate, and economic analysis of the effects
of governmental bonds and each major category of private-activity bond.
Zimmerman, Dennis, The Private Use of Tax-Exempt Bonds: Controlling Public
Subsidy of Private Activity, (Washington: The Urban Institute Press. 1991).
Provides institutional background: history, legal framework, and industry
characteristics. Provides discussion of tax-exempt bonds as an economic policy
tool affecting: intergovernmental fiscal relations, the federal budget deficit,
efficient resource allocation, and tax equity. Provides a history and economic
analysis of tax-exempt bond legislation from 1968 to 1989.

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