Key Issues in Tax Reform: Federal Subsidies for Interest Income Generated from Municipal Bonds

Key Issues in Tax Reform: Federal Subsidies for Interest Income Generated from Municipal Bonds

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Updated November 15, 2017
Key Issues in Tax Reform: Federal Subsidies for Interest
Income Generated from Municipal Bonds
Changes to tax expenditures have been a core component of
governmental entity; or (2) less than 10% of the bond
several recent tax reform proposals. Tax expenditures are
proceeds are secured directly or indirectly by property used
special provisions that move the tax code away from a
in a trade or business. Bonds that satisfy either test are
“theoretically normal” tax system. In most cases, these
termed “governmental” bonds and can be issued without
special tax provisions result in a revenue loss for the federal
federal restriction. The federal government subsidizes the
government. Among the tax expenditures modified by tax
cost of governmental bonds by excluding interest income
reform proposals in the 115th Congress are the exclusions
earned by investors on those bonds from federal income
for interest income generated from certain state and local
taxation. The exclusion lowers the cost of debt for state and
bonds. State and local (municipal) governments issue bonds
local governments by allowing them to borrow at lower
to investors to finance investments in exchange for interest
interest rates than would otherwise apply if the interest
payments and the eventual repayment of the principal
income were taxable.
(amount borrowed).
The lower cost of capital arises because in most cases
Current Law
investors will be indifferent between taxable and tax-
The federal government subsidizes state and local debt
exempt bonds of equivalent risk if their after-tax return is
through three policies: (1) all interest income earned from
identical. For example, consider a taxpayer in the 35% tax
public purpose bonds is excluded from federal income
bracket who is considering investing in a taxable bond with
taxation; (2) a tax credit may be claimed on interest income
a 10% interest rate and a tax-exempt bond with a 6.5%
in lieu of the exclusion in some cases; and (3) interest
interest rate. The taxability of the bond with the 10%
income earned from qualified private activity bonds (PABs)
interest rate makes the investor’s after-tax income identical
is excluded from federal regular income taxation.
to that of the tax-exempt bond with a 6.5% interest rate.
Thus, state and local governments could raise capital from
Table 1. Estimated Combined Expenditures on
investors at an interest cost 3.5 percentage points (350 basis
Federal Bond Subsidies, FY2016-FY2020
points) lower than a borrower issuing taxable debt.
(billions of dollars)
The direct cost to the federal government of tax-exempt
Reduced
Increased
bonds is the individual and corporate income tax revenue

Revenues
Outlays
Total
forgone. In the example above, the taxable bond with a 10%
interest rate would have generated federal tax liability equal
Tax-Exempt
194.7
-
194.7
to 3.5% (or 35% x 10%) of the bond’s principal value each
Bonds
year.
Tax Credit
1.8
24.0
25.8
Bonds
Tax Credit Bonds
Tax credit bonds (TCBs) are an alternative to tax-exempt
Qualified
60.8
-
60.8
bonds. TCBs provide a tax credit or direct payment
PABs
proportional to the bond’s face value in lieu of the tax
Source: JCT, Estimates of Federal Tax Expenditures for Fiscal Years
exemption. Unlike tax-exempt bonds, the value of the credit
2016-2020, December 2016.
(and subsequent cost to the federal government) is not
dependent on the investor’s marginal income tax rate.
Table 1 shows Joint Committee on Taxation (JCT)
estimates of the budgetary effects of federal bond subsidies
Most TCBs are designated for a specific purpose. For
from FY2016-FY2020. The federal bond subsidies are
example, TCBs have been used by issuers for financing
projected to provide a total of $281.3 billion in benefits
public school construction and renovation, clean renewable
over five years. That annual subsidy represents roughly 2%
energy projects, refinancing of outstanding government
of the current municipal debt stock: the Federal Reserve
debt in regions affected by natural disasters, conservation of
estimated that state and local governments had $3.05
forest land, investment in energy conservation, and
trillion in debt issuances outstanding in the first quarter of
economic development purposes.
2017.
All of the TCBs currently in circulation were established as
Tax-Exempt Bonds
temporary tax provisions. Many recent TCBs are not
Bonds are considered to be for a public purpose if they
eligible for new issuances, due either to the expiration of
satisfy either of two criteria: (1) less than 10% of the
issuing authority or to full subscription of the TCB issuing
proceeds are used directly or indirectly by a non-
limit. Bonds that are no longer issued may still be held by
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Key Issues in Tax Reform: Federal Subsidies for Interest Income Generated from Municipal Bonds
the public. The relative appeal of TCBs and tax-exempt
Policy Issues
bonds varies with bond interest rates, tax status of the
Certain goods and services provided by state or local
investor, and underlying economic conditions.
governments benefit both residents, who pay municipal
taxes, and nonresidents, who pay minimal if any municipal
Qualified Private Activity Bonds
taxes. State and local taxpayers may be unwilling to provide
Bonds that fail both public purpose tests are termed private-
these services to nonresidents without compensation, which
activity bonds (PABs) because they provide significant
could cause the services to be underprovided relative to
benefits to private individuals or businesses. These projects
their public benefits. In theory, the cost reduction provided
are generally ineligible for tax-exempt financing. Activities
by the exemption of interest income compensates state and
that fail each test but that Congress considers to provide
local taxpayers for benefits provided to nonresidents.
both public and private benefits are categorized as qualified
and can be financed with qualified PABs, which are tax
It may be appealing to finance public capital facilities over
exempt. Only qualified activities included in the federal
a long period of time to match the period over which those
code can be financed with tax-exempt PABs.
facilities provide services. This is particularly true for state
and local governments, whose taxpayers lay claim to the
Qualified PABs are subject to restrictions that do not apply
benefits from these facilities through residency and
to governmental bonds, such as being required to include
relinquish benefit claim when they move. State or local
subsequent interest income in the alternative minimum
officials may therefore elect to match the timing of the
income tax (AMT) base. Some qualified PABs are also
payments to the flow of services, precisely the function
subjected to an annual, state-specific issuance cap intended
served by long-term bond financing. Federal subsidies for
to limit the benefits provided through the subsidy. The
municipal debt encourage state and local governments to
value of bonds issued for some of these activities by all
engage in more debt financing.
governmental units within a state was limited to the greater
of $100 per resident or $305.3 million in 2017. Qualified
State and local governments are also faced with the
PABs issued for several activities are not subject to the cap,
necessity of planning their budget one to two years in
including for all bonds issued for government-owned
advance, and often are required to balance some or all of
facilities.
their incoming and outgoing payments. Unforeseen
circumstances can undermine such plans and cause a
Recent Reform Proposals
revenue shortfall, which must be financed with short-term
Tax reform proposals in the 115th Congress have included
borrowing. Even when forecasts are met, timing issues may
several modifications to the exclusion for bond interest
create the necessity to borrow within an otherwise balanced
income. H.R. 1, as reported by the Committee on Ways and
fiscal year. Finally, temporarily high interest rates that
Means, would eliminate the ability to issue TCBs and
prevail at the time bonds are issued may induce short-term
qualified PABs beginning in 2018. H.R. 1 would also repeal
borrowing in anticipation of a drop in rates. Federal
the exclusion of interest income earned on advance
subsidies reduce the costs of these activities, though the
refunding bonds from federal income taxation. Refunding
economic rationale behind the transfer of such costs from
bonds are bonds that are typically issued to replace
municipal taxpayers to federal taxpayers is less clear.
outstanding bonds with bonds that carry more favorable
terms; advance refunding bonds are refunding bonds that
Critics of the subsidies for municipal debt believe that they
are issued in such a way that both the original and
represent a suboptimal allocation of federal resources.
refunding bonds are outstanding for a period of time.
Spending incurred for one program directly reduces
Finally, H.R. 1 would amend the definition of tax-exempt
amounts available for others, and some observers believe
bonds so that issuances for the construction of professional
that the subsidies for municipal debt could be better used on
sports stadiums do not qualify for the exemption. The JCT
some combination of direct federal investment in municipal
estimated that those proposals would increase revenues by a
infrastructure, other federal programs, or deficit reduction.
combined $56.9 billion over the FY2018-FY2027 window.
Moreover, since the amount of capital investors are willing
to loan is limited, offering subsidies for municipal debt may
The Senate Finance Committee chairman’s mark to the
increase the interest costs for other types of debt issuances,
“Tax Cuts and Jobs Act” as scheduled for markup the week
including for federal borrowing and private financing.
of November 13, 2017, would repeal the income exclusion
for advance refunding bonds but would make no other
The bond subsidies also affect the distribution of the federal
changes to federal bond subsidies, including to TCBs and
tax system. Benefits from tax-exempt bonds and qualified
qualified PABs. The JCT estimated that the proposal would
PABs are directly proportional to the investor’s marginal
increase revenues by $16.8 billion over the FY2018-
tax rate, meaning that higher-income taxpayers benefit
FY2027 period.
more than lower-income taxpayers using the program.
Higher-income taxpayers also tend to have more disposable
The Congressional Budget Office published an option
capital to loan to municipal governments, making them
modifying the bond exclusion in its December 2016
more likely to receive such benefits even without the
Options for Reducing the Deficit report. That option
incremental marginal tax benefits described above.
restricts the tax exemption for future municipal debt
issuances to governmental bonds only. The JCT estimated
Grant A. Driessen, Analyst in Public Finance
that proposal would increase revenues by $27.5 billion over
the FY2017-FY2026 period.
IF10712
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Key Issues in Tax Reform: Federal Subsidies for Interest Income Generated from Municipal Bonds

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