(Archived Content)
JS-4121
Before The Subcommittee On Select Revenue Measures Of The Committee On Ways And Means
Chairman Camp, Mr. McNulty and distinguished members of the Subcommittee:
I appreciate the opportunity to discuss with you today some of the Federal tax issues surrounding the use of tax-preferred bond financing. There are two general types of tax-preferred bonds: tax-exempt bonds (including governmental bonds and qualified private activity bonds) and tax credit bonds. Tax-preferred bonds have long been an important tool for State and local governments to finance public infrastructure and other projects to carry out public purposes. The Federal government provides important subsidies for tax-preferred bond financing that significantly reduce borrowing costs for State and local governments, most notably through the Federal income tax exemption afforded to interest paid on tax-exempt bonds. While steady growth in the volume of tax-preferred bonds and Congressional proposals to expand them reflect their importance as incentives in addressing public infrastructure and other needs, it is appropriate to review these programs to ensure that they are properly targeted and to ensure that the Federal subsidy is justified.
The first part of my testimony today will provide an overview of existing types of tax-preferred bonds and summarize the current market for these bonds. The second part of my testimony will give a basic explanation of the Federal subsidy that is provided for each type of tax-preferred bond. The third part of my testimony will describe various technical rules in the tax law that ensure that the Federal subsidy for tax-preferred bonds is used properly. The fourth part of my testimony will summarize the recent growth in special purpose tax-exempt bonds and tax credit bonds. The fifth and final part of my testimony will highlight administrative and tax policy concerns that are raised by the recent growth in special purpose bond financing.
Overview of Tax-Preferred Bonds
Governmental Bonds
State and local governments issue tax-exempt bonds to finance a wide range of public infrastructure, including schools, hospitals, roads, libraries, public parks, and water treatment facilities. The interest paid on debt incurred by State and local governments on these bonds is generally excluded from gross income for Federal income tax purposes if the bonds meet certain eligibility requirements. There are two basic kinds of tax-exempt bonds: governmental bonds and qualified private activity bonds. Bonds generally are treated as governmental bonds if the proceeds of the borrowing are used to carry out governmental functions and the debt is repaid with governmental funds.
Under the general tax-exempt bond provisions of the Internal Revenue Code (Code), bonds are classified as governmental bonds under a definition that limits private business use and private business sources of payment for the bonds and also limits financing of private loans. Bonds that have excessive private involvement under this definition are classified as "private activity bonds," the interest on which is tax-exempt only in limited circumstances.
In order for interest on tax-exempt bonds, including governmental bonds, to be excluded from income, a number of specific requirements must be met. Requirements generally applicable to all tax-exempt bonds include arbitrage limitations, registration and information reporting requirements, a general prohibition on any Federal guarantee, advance refunding limitations, restrictions on unduly long spending periods, and pooled bond limitations.
The total volume of new, long-term governmental bonds has grown steadily since 1991, as shown in Figure 1. The Federal tax expenditures associated with the income exclusion for interest on governmental bonds has also grown over the years, as shown in Figure 3.
Private Activity Bonds.
Bonds are classified as "private activity bonds" if more than 10% of the bond proceeds are both: (1) used for private business use (the "private business use test"); and (2) payable or secured from private sources (the "private payments test"). Bonds also are treated as private activity bonds if more than the lesser of $5 million or 5% of the bond proceeds are used to finance private loans, including business and consumer loans. The permitted private business thresholds are reduced from 10% to 5% for certain unrelated or disproportionate private business uses.
Private activity bonds may be issued on a tax-exempt basis only if they meet the requirements for "qualified private activity bonds," including targeting requirements that limit such financing to specifically defined facilities and programs. For example, qualified private activity bonds can be used to finance eligible activities of educational and other charitable organizations described in section 501(c)(3). Tax-exempt private activity bond financing is also available for certain qualified facilities such as airports, docks, wharves, transportation infrastructure, utility and sanitation infrastructure, low-income residential housing projects, and small manufacturing facilities. Qualified private activity bonds may also be used to finance home mortgages for veterans and to facilitate single-family home purchases for first-time home buyers who satisfy income, purchase price, and other qualifications.
Qualified private activity bonds are subject to the same general rules applicable to governmental bonds, including the arbitrage investment limitations, registration and information reporting requirements, the Federal guarantee prohibition, restrictions on unduly long spending periods, and pooled bond limitations. Most qualified private activity bonds are also subject to a number of additional rules and limitations, in particular the volume cap limitation under section 146 of the Code.
Unlike the tax exemption for governmental bonds, the tax exemption for interest on most qualified private activity bonds is generally treated as an alternative minimum tax (AMT) preference item, meaning that the tax preference for these bonds is often taken away by the AMT.
The current private activity bond regime was enacted as part of the Tax Reform Act of 1986 and was designed to limit the ability of State and local governments to act as conduit issuers in financing projects for the use and benefit of private businesses and other private borrowers. Prior to enactment of this regime, States and municipalities were subject to more liberal rules governing tax-exempt "industrial development bonds," the proceeds of which could be used for the benefit of private parties. The dramatic impact that enactment of the private activity bond regime in 1986 had on the volume of tax-exempt bonds benefiting private parties is reflected in Figure 4.
The total volume of new, long-term qualified private activity bonds issued since 1991 is shown in Figure 1. In 2003, the most recent year for which the Internal Revenue Service Statistics of Income (SOI) division data are available, approximately $200 billion in tax-exempt bonds were issued, 22 percent of which were private activity bonds. Between 1991 and 2003, private activity bonds accounted for an average of 27 percent of total annual tax-exempt bond issuances.
Figure 2 shows the allocation of private-activity bonds among various qualified projects and activities. As can be seen, the largest issuance category in 2003 was tax-exempt hospitals, followed by non-profit education, rental housing, airports and docks, mortgages, and student loans. Tax expenditure estimates for tax-exempt bond issues between 1996 and 2005 are shown in Figure 3.
Tax Credit Bonds
Tax credit bonds are a relatively new type of tax-preferred bond that differ from governmental or qualified private activity bonds in that the economic equivalent of "interest" is paid through a taxable credit against the bond holder's Federal income tax liability. Tax credit bonds are designed to be "zero coupon" bonds that pay no interest. Recent programs for tax credit bonds encompass less than $5 billion in total authorized or outstanding issues. By comparison, the tax-exempt bond market (including governmental and qualified private activity bonds) encompassed over $2 trillion in outstanding issuances as of the end of 2005.
In general, the Federal subsidy provided to tax credit bonds is "deeper" than that provided to tax-exempt bonds. In simplified terms, the Federal subsidy to State and local governments on tax credit bonds is equivalent to the Federal government's payment of interest on those bonds at a taxable rate. By comparison, the Federal subsidy on tax-exempt bonds is equivalent to the Federal government's payment of the interest differential between taxable and lower tax-exempt interest rates as a result of the exclusion of the interest from income for most Federal income tax purposes.
Existing law provides for three types of tax credit bonds, Qualified Zone Academy Bonds ("QZABs"), Clean Renewable Energy Bonds ("CREBs") and Gulf Opportunity Zone Tax Credit Bonds ("GO Zone Tax Credit Bonds"), each of which is described in more detail below.
Federal Subsidy for Tax-Exempt Bonds and Tax Credit Bonds
A rationale for Federal subsidization of local public projects and activities exists when they serve some broader public purpose. The most straightforward means of delivering this subsidy is through direct Federal appropriations for grants to State and local governments. The tax exemption for interest paid on tax-exempt bonds, and the interest equivalent paid on tax credit bonds, are alternative means of delivering a Federal subsidy. The policy justification for delivering these subsidies, whether through direct appropriations, a tax exemption, or a tax credit, is weakened, however, as use of the proceeds gets further away from traditional governmental purposes.
Subsidy for Tax-Exempt Bonds
The Federal government's exemption of the interest on certain bonds from income tax lowers the rate of interest that investors are willing to accept in order to hold these bonds as compared to taxable bonds, thereby lowering State and local governmental borrowing costs. Governmental bonds also often have tax exemptions for various State tax purposes. The amount of the Federal subsidy enjoyed by State and local governments depends on the overall supply and demand for tax-exempt bonds and on the marginal tax bracket of the investor holding the bonds. For example, if taxable bonds yield 10 percent and equivalent tax-exempt bonds yield 7.5 percent, then investors whose marginal income tax rates exceed 25 percent will prefer to invest in tax-exempt bonds. On an after-tax basis, these investors will be better off giving up the extra 2.5 percent yield on a taxable bond in exchange for a greater than 25 percent reduction in their income tax liability for each dollar in tax-exempt interest they receive. At the same time, the State or local government issuing the bond will enjoy a 25 percent reduction in its borrowing costs.
This "tax wedge" between the tax-exempt and taxable bond interest rates highlights the inefficiency of the Federal subsidy provided by tax-exempt bond financing. Investors whose marginal tax brackets exceed the prevailing tax wedge (25 percent in the example above) reap a windfall from investing in tax-exempt bonds, because they would have been willing to accept a lower interest rate to hold tax-exempt debt. Therefore, although tax-exempt issuers spend less on interest than they would if they had to issue taxable debt, they nonetheless spend more on interest than they would if they were able to pay each investor just enough to make him hold tax-exempt debt. The size of the windfall to high-bracket investors can be large: since 1986, the average tax wedge between long-term tax-exempt bonds and high-quality corporate bonds has been about 21 percent, well below the top marginal personal income tax rates of 28 to 39.6 percent during that period. The Federal government pays this premium through a tax exemption.
Subsidy for Tax Credit Bonds
Tax credit bonds provide a Federal tax credit that is intended to replace a taxable interest coupon on the Bonds. Existing tax credit bond programs provide that the credit rate is based on a taxable AA corporate bond rate at the time of pricing. In theory, an investor who has sufficient Federal tax liability to use the credit will have a demand for a tax credit bond. Tax credit bonds are more efficient than tax-exempt bonds, although unlike tax-exempt bonds they shift the entire interest cost to the Federal government.
Instead of having cash coupons, tax credit bonds provide tax credits (at a taxable bond rate), which are added to the investor's taxable income and then subtracted from the investor's income tax liability. For example, if the taxable rate is 10 percent, a $1,000 bond would yield $100 in tax credits. If the investor were in the 35 percent tax bracket, he would include $100 in income and pay an extra $35 in tax (before the credit). He would then take the $100 credit against this total tax bill, for a net reduction in tax liability of $65. For investors with sufficient positive tax liabilities to utilize the full value of the credit, tax credit bonds are equivalent to Federal payment of interest at a taxable interest rate. Thus, an investor who received $100 in taxable interest and paid $35 in tax would have $65 in hand after taxes. Similarly, the holder of a tax credit bond who receives $100 in credits would, after paying $35 in tax on those credits, end up with $65 more in hand after taxes.
From an economic perspective, the Federal subsidy for tax credit bonds may be viewed as more efficient than the subsidy for tax-exempt bonds. This is because the Federal subsidy for tax credit bonds is based on taxable interest rates and an investor may have a demand for tax credit bonds so long as the investor has sufficient Federal tax liability to use them. By comparison, the Federal subsidy for tax-exempt bonds may be viewed as inefficient in the sense that the tax-exempt bond market does not pass the full Federal revenue cost to State and local governments through correspondingly lower tax-exempt bond rates. As discussed in more detail below, however, tax credit bonds have a number of practical inefficiencies that may outweigh any economic advantage they have in delivering a Federal subsidy.
Rules Governing Tax-Preferred Bonds
Federal tax law contains a number of detailed rules governing tax-exempt bonds that reflect a longstanding, well developed regulatory structure. Additional rules provide detailed targeting and other restrictions for qualified private activity bonds. In contrast, the three existing tax credit bond programs provide disparate statutory rules with varying incorporation of the general tax-exempt bond rules.
Rules of General Applicability to Tax-Exempt Bonds .
Arbitrage Yield Restrictions and Arbitrage Rebate. In order to properly target the Federal subsidy for projects financed with tax-exempt bonds, the Code contains arbitrage rules that prevent State and local governments from issuing more bonds than necessary for a particular project, or from issuing bonds earlier or keeping bonds outstanding longer than necessary to finance a project. Subject to certain exceptions, these "arbitrage yield restrictions" limit the ability of State and local governments to issue tax-exempt bonds, any portion of which is reasonably expected to be invested in higher-yielding investments. The arbitrage rules also require that certain excess earnings be paid to the Federal government (the "arbitrage rebate" requirement).
Advance Refunding Limitations. The Code contains detailed "advance refunding" limitations designed to limit the circumstances in which more than one tax-exempt bond issuance is outstanding at the same time for the same project or activity. Refunding bonds are often issued to retire outstanding debt in an environment of declining interest rates. Limitations on the ability to "call" outstanding debt often lead to circumstances in which issuers seek to do advance refundings. In an advance refunding, the issuer uses proceeds from refunding bonds to defease its obligation on the original "refunded bonds," but does not pay off the refunded bonds until more than 90 days after the refunding bonds are issued.
Advance refundings are inefficient and costly to the Federal government because they result in more than one Federal subsidy being provided for the same project at the same time. In 2002 and 2003, when interest rates were falling, current refundings and advance refundings accounted for 40 percent and 36 percent of total governmental bond issuances, respectively. By contrast, in 2000, a year of relatively high interest rates, advance refundings accounted for 20 percent of total governmental bond issuances.
Prior to the Tax Reform Act of 1986, advance refundings were a greater concern because issuers could advance refund governmental bonds an unlimited number of times. The Code now generally permits only one advance refunding for governmental bonds and prohibits advance refundings entirely for qualified private activity bonds other than qualified 501(c)(3) bonds. Less restrictive rules apply to "current refundings" in which the refunded bonds are fully retired within 90 days after the issuance of the refunding bonds.
Prohibition Against Federal Guarantees. Under the Code, interest paid on bonds that carry a direct or indirect Federal guarantee is generally not excluded from income. The broad prohibition against Federal guarantees of tax-exempt bonds is designed to avoid creating a tax-exempt security that is more attractive to investors than Treasury securities because it has both the credit quality of a Treasury security and a Federal tax exemption. There are a limited number of exceptions to the prohibition on a Federal guarantee, most of which date back to enactment of the Federal guarantee prohibition in 1984.
Registration Requirement and Information Reporting. In order to ensure the liquidity of tax-preferred bonds in the financial markets and to prevent abuse through use of bearer bonds, most tax-exempt bonds are subject to registration requirements. In addition, issuers of these bonds must file certain information returns with the IRS at the time of issuance of the bonds in order for the interest to be tax exempt or for the holder of a tax credit bond to claim the credit.
Hedge Bond Restrictions. "Hedge bond" provisions generally prohibit the issuance of tax-exempt bonds in circumstances involving unduly long spending periods in which issuers cannot show reasonable expectations to spend most of the bond proceeds within a five-year period.
Pooled Bond Financing Limitations. "Pooled bond" financing limitations generally impose restrictions on the use of tax-exempt bonds in pooled bond financings involving loans of bond proceeds to two or more borrowers. These restrictions are designed to encourage prompt use of the bond proceeds to make loans to carry out ultimate governmental purposes.
Additional Rules Applicable to Qualified Private Activity Bonds
Qualified private activity bonds are generally subject to the rules described above and to additional limitations. Most significantly, with some exceptions, the amount of tax-exempt qualified private activity bonds that can be issued by each State (or its political subdivisions) is subject to a unified annual State volume cap based on population. Presently, the annual State volume cap is equal to the greater of $75 per resident or $225 million (increased for inflation for every year after 2002). In general, the unified State volume cap on qualified private activity bonds has provided a fair, flexible, and effective constraint on the volume of tax-exempt private activity bonds.
The Code also places limitations on the types of projects and activities that can be financed by qualified private activity bonds. For example, the proceeds from qualified private activity bond cannot be used to finance sky boxes, health clubs owned by an entity other than a Section 501(c)(3) entity, gambling facilities, or liquor stores. In addition, there are a number of more technical rules that apply to qualified private activity bonds, including limits on the tax exemption for bonds held by persons who are users of projects financed by the bonds. There are also limits on the maturity date of the bonds, which unlike governmental bonds is statutorily linked to the economic life of the financed property. Furthermore, conduit borrowers who use the proceeds of qualified private activity bonds are subject to penalties if they use the bond proceeds in an inappropriate manner.
Application of the Operating Rules to Tax Credit Bonds
The general operating rules for tax-exempt bonds are established in the Code and Treasury Department regulations. In theory, similar rules should apply to tax credit bonds in order to ensure that the proceeds from these bonds are being properly utilized, and to ensure that the Federal subsidy is properly targeted. The three existing tax credit bond programs, however, provide disparate statutory rules with inconsistent incorporation of the general tax-exempt bond rules. For example, the Code provides that the arbitrage rules and information reporting requirements apply to certain tax credit bonds but not to others. Similarly, remedial action rules are applied inconsistently to tax credit bonds. In addition, due to the novelty and limited scope and application of tax credit bonds, the rules otherwise applicable to tax-exempt bonds cannot be applied without statutory authorization or appropriate modification of existing regulations. Tax credit bonds also raise new issues and challenges, including those highlighted below:
- Eligible Uses. The projects and activities for which qualified private activity bonds can be used are articulated in the Code and defined in regulations that have been developed over time. While the statutory provisions authorizing tax credit bonds similarly describe eligible uses for the proceeds of these bonds, there is little guidance on the specific types of projects or activities that qualify. Moreover, because the permitted uses are often highly technical and differ from the uses authorized for qualified private activity bonds, entirely new sets of rules may need to be published.
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Application to Pass-Through Entities. The complex nature of tax credit bonds raises significant issues when those bonds are held by pass-through entities or mutual funds. Accordingly, new rules need to be developed to describe how the tax credit is both included in income for members of a pass-though holder of a tax credit bond, and to describe how the credit is ultimately used by the members or partners.
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Credit Rate. For tax-exempt bonds, the markets set the applicable interest rate. While there are some market inefficiencies that arise from the limited size of some issuances, the market can generally take them into consideration. In contrast, the Treasury Department sets the rates for tax credit bonds. While the credit rate-setting mechanism is designed to result in rates that permit the bonds to be sold at par, that objective has not always been achieved in practice and the Treasury Department may be less suited than the market in determining the appropriate rate.
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Maturities. For qualified private activity bonds, the Code generally requires that the weighted average maturity of the bonds be based on the economic lives of the financed projects or activities. In contrast, the Treasury Department is charged with determining the maturity date for all existing tax credit bonds at a level at which the present value at issuance of the obligation to repay the principal of the bonds is equal to 50% of the face amount of the bond. This rate-setting methodology does not involve the typical consideration of the economic life of the financed projects.
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Volume Cap. The authorizing statutes for the three existing types of tax credit bonds each limit the aggregate amount of bonds that can be issued. Under the volume cap rules that apply to most qualified private activity bonds, the IRS is only required to determine the total amount of volume cap a State may allocate and States are given the discretion to allocate their volume caps among permitted types of projects in accordance with their specific needs. In contrast, for some tax credit bonds the IRS is required to make allocations to specific projects. This raises complex questions about how to allocate bond authority when demand exceeds supply and how to determine the technical merits of an application for bond authority. Although the Treasury Department and IRS are responsible for answering these questions, they often lack the non-tax expertise needed to do so and must make judgment calls on which projects will be allocated bond authority. Moreover, allocations of tax credits by the Federal government outside of State volume caps weighs against the flexibility and efficiency associated with allowing States to allocate limited volume cap in accordance with State and local needs and priorities.
Special Purpose Tax-Preferred Bonds
In recent years, a number of new types of qualified private activity bond programs have been created outside of the general volume cap rules for specific targeted projects or activities. In addition, three tax credit bond programs have been enacted for specific targeted projects or activities that would not otherwise be covered by the qualified private activity bond rules. A number of proposals for additional types of private activity bonds and tax credit bonds have been proposed, including recent proposals for high-speed rail infrastructure bonds, transit bonds and Better America Bonds.
Special Purpose Private Activity Bonds
Recently enacted special purpose qualified private activity bonds include those described below.
New York Liberty Zone Bond Provisions. The Job Creation and Worker Assistance Act of 2002 provided tax incentives for the area of New York City (the "New York Liberty Zone") damaged or affected by the terrorist attack on September 11, 2001. New York Liberty Zone tax incentives include two provisions relating to tax-exempt bonds: (1) $8 billion of tax-exempt private activity bonds that are excluded from the general volume cap rules and that are allocated by the Governor of New York and they Mayor of New York City in a prescribed manner; and (2) $9 billion of additional tax-exempt, advance refunding bonds. The dates originally established for issuing bonds under the New York Liberty Zone authority were extended by the Working Families Tax Relief Act of 2004. New York City has not used all of its allocated bond authority.
GO Zone Act Bond Provisions. The Gulf Opportunity Zone Act of 2005 (GO Zone Act) increased the otherwise applicable volume cap for qualified private activity bonds issued by Louisiana, Mississippi and Alabama. For each of these States, the GO Zone Act provided additional volume cap through the year 2009. The GO Zone Act also provided that interest paid on additional private activity bonds issued by under this provision would be exempt from AMT. The additional volume cap authority is estimated to be $7.9 billion, $4.8 billion, and $2.1 billion for Louisiana, Mississippi, and Alabama, respectively. These States collectively had over $1.8 billion in unused, carryover volume cap at the end of 2004, raising some question as to whether, as happened with the New York Liberty Zone bond authority, the additional volume cap authority will be used.
Green Bonds. As part of the American Jobs Creation Act of 2004, Congress authorized up to $2 billion of tax-exempt private activity bonds to be issued by State or local governments for qualified green building and sustainable design projects. "Qualified green building and sustainable design projects" are defined to mean any project that is designated by the Treasury Secretary, after consultation with the Administrator of the Environmental Protection Agency, to be a qualified green building and sustainable design project and that meets certain other requirements. The Treasury Secretary is responsible for allocating the dollar limit among qualified projects. Only four qualified applicants submitted applications for green bond authority. The IRS has made allocations among those qualified applicants. Because the demand for an allocation of the limit was greater than the limit, the allocation was made using a pro rata method.
Qualified Highway and Surface Freight Transfer Facility Bonds. The Safe, Accountable, Flexible, Efficient Transportation Equity Act of 2005 authorizes the Secretary of Transportation to allocate a $15 billion national limitation to States and local governments to issue bonds to finance surface transportation projects, international bridges or tunnels or transfer of freight from truck to rail or rail to truck facilities, if those projects receive Federal assistance. Bonds issued pursuant to such allocation do not need to receive volume cap under the normal bond rules. The statute generally requires proceeds to be spent within 5 years from the date the bonds were issued.
Special Purpose Tax Credit Bonds
The three existing special purpose tax credit bond programs are described below:
Qualified Zone Academy Bonds. Qualified Zone Academy Bonds (QZABs) were first introduced as part of the Taxpayer Relief Act of 1997. State and local governments can issue QZABs to fund the improvement of certain eligible public schools. Eligible holders are banks, insurance companies, and corporations actively engaged in the business of lending money. QZABs are not interest-bearing obligations. Rather, a taxpayer holding QZABs on an annual credit allowance date is entitled to receive a Federal income tax credit. The credit rate for a QZAB is set on its day of sale by reference to credit rates established by the Treasury Department and is a rate that is intended to permit the issuance of the QZABs without discount and without interest cost to the issuer. The credit accrues annually and is includible in gross income (as if it were an interest payment on a taxable bond) and can be claimed against regular income tax liability. The maximum term of a QZAB issued during any month is determined by reference to the adjusted applicable Federal rate (AFR) published by the IRS for the month in which the bond is issued. The arbitrage investment restrictions and information reporting requirements that generally apply to tax-exempt bonds are not applicable to QZABs.
Because issuers of QZABs are not currently required to file Form 8038 information returns, there is no reliable data on the volume of QZABs that have been issued. Total QZAB issuances of $400 million per year have been authorized since 1998, so the maximum aggregate volume would be $3.2 billion. Although data is not generally available, it is likely that a significant portion of this volume remains unused, since many States did not use their full allocation in the early years of the program, when the instruments were new to both issuers and investors.
Clean Renewable Energy Bonds. The Energy Tax Incentives Act of 2005 introduced a new tax credit bond for clean renewable energy projects. This provision provides for up to $800 million in aggregate issuance of clean renewable energy bonds ("CREBs") through December 31, 2007. CREBs are similar, but not identical, to QZABs in how they work. Like QZABs, CREBs are not interest-bearing obligations. Rather, a taxpayer holding CREBs on a quarterly credit allowance date (versus annual credit allowance dates for QZABs) is entitled to a Federal income tax credit. Unlike QZABs, there are no limits on who may hold these bonds. The amount of the credit is determined by multiplying the bond's credit rate by the face amount on the holder's bond. The credit rate on the bonds is determined by the Treasury Department and is a rate that is intended to permit issuance of CREBs without discount and interest cost to the qualified issuer. The credit accrues quarterly and is includible in gross income (as if it were an interest payment on the bond), and can be claimed against regular income tax liability and alternative minimum tax liability. Unlike QZABs, CREBs are subject to arbitrage rules and information reporting requirements.
Gulf Opportunity Zone Tax Credit Bonds. The Gulf Opportunity Zone Act of 2005 (GO Zone Act), authorized a third type of tax credit bond referred to as "GO Zone Tax Credit Bonds." These tax credit bonds can be issued by Louisiana, Mississippi and Alabama in order to provide assistance to communities unable to meet their debt service requirements as a result of the Hurricane Katrina. Gulf Tax Credit Bonds operate in much the same way as QZABs and CREBS, with the economic equivalent of interest being delivered through a Federal income tax credit that the holder can claim on its tax return. GO Zone Tax Credit Bonds must be issued by December 31, 2006, and must mature before January 1, 2008.
There have been other recent proposals for tax credit bonds as to which the Administration has expressed strong reservations.
Tax Policy and Administrative Concerns Highlighted by Tax-Preferred Bonds
Applying Generally Applicable Bond Rules to Special Purpose Bonds
In general, it would be preferable to subject any new or expanded programs for tax-preferred bond financing to the existing regulatory framework for tax-exempt bonds or to impose comparable general restrictions and targeting restrictions. The general tax-exempt bond provisions have well developed general restrictions. To take one illustrative example, the tax-exempt bond provisions have extensive arbitrage investment restrictions that limit the investment of tax-exempt bond proceeds at yields above the bond yield and which require that excess earnings be rebated to the Federal government, subject to certain prompt spending and other exceptions. Similarly, the general tax-exempt bond provisions have an information reporting requirement to the IRS which assists Treasury and the IRS in analyzing use of tax-exempt bonds. The tax credit bond program for QZABs, however, does not impose arbitrage investment restrictions or information reporting requirements, raising targeting and administrability concerns. In this regard, various special other tax-exempt bond programs and tax credit bond programs outside the general tax-exempt bond framework present many administrability issues for Treasury and the IRS in assessing how or to what extent to impose comparable rules by analogy.
Liquidity Concerns
The tax-exempt bond market generally caters to tax-sensitive investors. Even in this large market, liquidity is low due to the small size of individual issues and the limited attractiveness of the Federal tax exemption. Low liquidity creates a number of problems that are magnified in the context of special purpose bonds, all of which have very small relative volume. Most notably, low liquidity requires the issuer to offer a higher tax-exempt interest rate in order to ensure a market for the bonds. This problem is magnified as the volume of tax-exempt and tax credit bonds increases, forcing issuers to offer higher rates in order to appeal to the same limited universe of holders. An increased interest rate, in turn, increases the Federal subsidy for the bonds.
Tax Credit Bond Considerations
For the three existing tax credit bond programs, the credit rate is set at a rate equivalent to an AA corporate bond rate with the intention that this pricing allow the bonds to be sold at par. In practice, however, this has proven to be difficult. Investors in tax credit bonds generally demand a discounted purchase price in comparison to similar interest-bearing bonds in order to account for a number of additional risks, including the possibility of not having sufficient tax liability in the future to use the credit and liquidity concerns.
While more efficient from a broader economic perspective in delivering a Federal subsidy, tax credit bonds have a number of practical inefficiencies. The tax-exempt bond market is a longstanding, established market with over $2 trillion in outstanding bond issues. The market generally operates independently to set appropriate interest rates. In addition, the general tax-exempt bond provisions under the Code reflect a well developed set of rules and targeting restrictions aimed at ensuring that the tax-exempt bonds carry out public purposes. By comparison, the existing tax credit bond market is limited and illiquid, and requires some inefficient, less market driven involvement by the Treasury Department in setting the credit rates. These rates are designed to allow zero interest tax credit bonds to price at par, although this often does not happen in practice. In addition, tax credit bonds introduce a number of new complexities, including issues involving the timing of ownership relative to eligibility for using the tax credits in the case of pass-through entities and other holders, the inflexibility of tax credit bond maturity rules that are not tied to project economic life considerations, and the inconsistent application of general restrictions (e.g., arbitrage investment limitations) and other restrictions comparable to those under the general tax-exempt bond provisions.
In general, tax-exempt bonds and tax credit bonds have the same fundamental purpose of providing a Federal subsidy as an incentive to promote financing of public infrastructure and other public purposes for State and local governments. That said, absent completely replacing the tax-exempt bond subsidy with a broad-based tax credit bond subsidy having carefully developed program parameters, the complexity and awkwardness associated with parallel regulatory regimes for the large tax-exempt bond program and the various limited tax credit bond programs raises concerns.
Targeting of the Federal Subsidy
Statutes authorizing special purpose bonds typically carry specific dollar amount authority, either as an exception to the normal volume cap rules or as a targeted amount for tax credit bond issuances. With bond financing, however, it is often difficult to predict the market for the issuance, raising questions as to whether the authorization can and will be utilized for its intended purpose. For example, the New York Liberty Bond provision overestimated demand for private activity bonds as a tool in rebuilding lower Manhattan after September 11 th. Accordingly, the full intended Federal subsidy was not delivered. New York Liberty Bonds were seen as a model for delivering relief in the GO Zone Act through authorizations of additional private activity bond authority. The original New York Liberty Bond authority was carefully targeted to a very small geographic area in lower Manhattan and, for this reason, could be targeted to the economic character of that area. Expanding the concept to such a large and economically diverse area as the Gulf coast region damaged by Hurricane Katrina may raise additional targeting concerns.
The experience with QZABs is also illustrative. While no statistics are available (because QZABs are not subject to the normal information reporting rules), we understand that many States do not use their allocated QZAB tax credit bond authority while others would, if able, use more. Thus, the incentive that was intended to be provided by QZABs appears to have been both over-inclusive (for those States that do not use the full amounts of their allocations) and under-inclusive (for those States that could use more bond authority). In both scenarios, targeting of the Federal subsidy has missed its mark.
Related to the problem of targeting the Federal subsidy is competition between tax-preferred financing and other forms of financing. This problem is exacerbated the further a bond-financed project is from traditional governmental activities. When tax-preferred bonds are used to finance necessary projects that would not be built without a Federal incentive, the justification for the subsidy is apparent. Where projects would have been built even without the subsidy, or where the broader public justification for a project is absent, the Federal incentive can result in a misallocation of capital.
Volume Cap Considerations
In general, the classification system for governmental bonds and private activity bonds effectively targets the use of tax-exempt qualified private activity bonds to specified exempt purposes with extensive program requirements and effectively constrains those bonds with the unified annual State volume cap. One structural weakness of this general classification system is that, under the definition of a private activity bond, a State or local government remains eligible to use governmental bonds in circumstances involving substantial private business use, provided that it secures the bonds predominantly from governmental sources. While political constraints generally deter State and local governments from pledging governmental sources of payment to bonds used for private business use, this is nonetheless a structural weakness of the definition of a private activity bond. A classic example is financing for a stadium in which a professional sports team uses more than 10% of the bond proceeds, but the State or local government is willing to subsidize the project with generally applicable governmental taxes and thus the stadium remains eligible for governmental bond financing.
The unified annual State volume cap on qualified private activity bonds generally has provided a fair, flexible, and effective constraint on the volume of tax-exempt private activity bonds. The unified State volume cap is fair in that it appropriately provides for allocation of bond volume based on population, with some additional accommodation for small States. In addition, the unified State volume cap is flexible in that it accommodates diverse allocations of volume cap within States to different kinds of eligible projects tailored to State and local needs. In general, the unified State volume cap has been an effective way to control private activity bond volume and Federal revenue costs. In this regard, it is important to recall that, in the early 1980s before the enactment of any volume caps, private activity bond volume grew at an unchecked, accelerated pace. Between 1979 and 1985, private activity bond volume grew from about $8.9 billion to $116.4 billion. While the unified State volume cap has been somewhat less of a constraint in the last several years since the volume cap was raised effective in 2002 (from the greater of $50 per resident or $150 million to the greater of $75 per resident or $225 million, with annual inflation adjustments thereafter), the unified State volume cap basically has been effective and is preferable to alternatives.
While the case appropriately can be made for separate volume caps for particular activities (e.g., New York Liberty Bonds) or for Federal involvement in allocations (e.g., the new private qualified highway and surface freight transfer facility bond program), as a general structural and tax policy matter, the private activity bond volume caps work best when imposed within the framework of the unified State volume cap under section 146.
Allocations
Under the general private activity bond volume cap rules, each State is required to allocate volume cap to the projects it deems most worthy of a Federal subsidy. Some recent special purpose bonds diverge from this historical State-based allocation system and require the IRS or other Federal agencies to allocate new bond authority. For example, the IRS has recently allocated the Green Bond national limit and the Department of Transportation is responsible for allocating the volume cap on the new exempt facility category for highway and surface freight transfer facility projects
Requiring the IRS to make allocations raises a number of concerns. Historically, allocations have been made by the States on the theory that they are in a better position to understand local demands for Federally-subsidized financing. In addition, because allocations have historically been done by the States, there is no mechanism in place for the IRS to perform bond allocations among proposed projects. More significantly, with highly technical provisions such as Green Bonds and CREBs, the IRS is not in the best position to determine how to allocate a Federal subsidy to renewable energy projects or energy-efficient projects. Thus, tax administrators are placed in the difficult position of selecting between qualified applicants, without necessarily having the technical knowledge needed to make informed allocation decisions. While the Treasury Department and IRS do consult regularly with other agencies having technical expertise, coordination can be time-consuming and difficult. For example, tax administrators need to learn the intricacies of energy policy while energy administrators need to learn the nuances of tax-exempt bond law. It is questionable whether this approach represents the most efficient use of limited government resources.
Allocation problems also arise when a special purpose bond provision is over or under-subscribed. If over-subscribed, the Treasury Department and the IRS may have to pick among largely indistinguishable qualified applicants or reduce all allocations pro-rata, which may have consequences for the feasibility of a project. If under-subscribed, unless the volume cap goes unused, the Treasury Department and the IRS may need to reopen the application process for further submissions. Given the limited time frame over which special purpose bonds are generally authorized, additional rounds of applications are often precluded.
Illustrative of other problems that can arise with allocations is the American Jobs Creation Act provision authorizing Green Bonds as a new category of qualified private activity bonds subject to an exception to the normal volume cap rules. In providing an exception to the volume cap, the statute also mandated that at least one qualified applicant from a "rural state" be awarded an allocation of Green Bond authority. The Treasury Department and IRS published a notice specifically soliciting rural State applicants for Green Bonds, but no applications were received.
Administrative Resource Considerations
The Treasury Department and the IRS are increasingly charged with regulatory responsibility for writing rules for allocating and auditing unique special purpose bond issuances. Because these special bond programs are often created as independent programs outside the well-developed structure of tax-exempt bonds rules (including established volume cap rules), they present unique challenges in trying to ensure that the myriad technical rules governing tax-preferred bonds correctly apply. Uncertainty in the application of these rules can lead to delay in implementing guidance (and, in turn, delay in issuing the bonds) and can create uncertainty in the market, limiting the number of investors and the effectiveness of the special purpose bond program.
Special purpose bond provisions require the Treasury Department and the IRS to evaluate whether special rules are needed in order to implement them. Because these provisions have such limited scope and are highly complex, they require a disproportionate allocation of administrative resources. Further, to help issuers comply with interest arbitrage rules, the Treasury Department provides State and local government issuers with the option to purchase non-marketable Treasury securities known as State and Local Government Securities, or "SLGS." Administration of this $200 billion program adds to the cost to the Federal government in facilitating tax-exempt bond financing.
Examination Concerns
Special purpose bond provisions often contain unique rules defining the projects or activities for which their proceeds can be used. For example, with respect to CREBs, qualified projects are linked to the technical eligibility requirements for the renewable energy credit. Failure of a bond issuance to comply with eligibility requirements results in disallowance of the credit to a third-party holder who had nothing to do with operation of the bond-financed facility. The technical nature of many special purpose bond provisions, combined with the absence of historical rules and practices interpreting these provisions, compounds an existing problem for tax-exempt bonds. For tax-exempt bonds generally, the tax consequences of failure to comply fall on the holder, who generally is without the information necessary to determine whether the bonds comply.
Conclusion
The Administration recognizes the important role that tax-preferred bond financing plays in providing a source of financing for critical public infrastructure projects and other significant public purpose activities. The Tax Reform Act of 1986 enacted a number of important provisions such as the volume cap limitation that help to ensure that the Federal subsidy being delivered is properly targeted and used for its intended purpose. Over the past 20 years, a carefully structured set of general statutory and regulatory rules have been developed under the general tax-exempt bond provisions to further this goal. On balance, tax-preferred bond financing works most effectively to target uses to needed public infrastructure projects and other public purpose activities when it is provided for within the existing general framework of the tax-exempt bond rules, rather than within small independent special regimes.
The cost to the Federal government of tax-preferred financing is significant and is growing. Unlike direct appropriations, however, the cost often goes unnoticed because it is not tracked annually through the appropriations process. In addition to the cost to the Federal government that results from providing a tax exemption or credit, there are indirect costs, such as administrative burdens on issuers and the IRS, imposed by the complex rules. These more indirect costs are magnified in the context of special purpose tax-preferred financing.
When considering further expansions of tax-preferred bond financing, it is necessary to ensure that the Federal subsidy is properly targeted and used for its intended purposes, and that the direct and indirect costs of the subsidy are carefully considered.
REPORTS