Tax Arbitrage by Colleges and Universities

April 30, 2010

Colleges and universities enjoy a variety of federal tax preferences that are designed to support a broader public purpose—the advancement of higher education and research. Not only are institutions of higher learning exempt from paying federal income taxes, they also are eligible to receive tax-deductible charitable contributions and allowed to use tax-exempt debt to finance capital expenditures. According to the staff of the Joint Committee on Taxation, the cost of allowing institutions of higher learning to borrow using such debt—measured in terms of the revenues that could have been collected if those institutions had borrowed using taxable debt—will be about $5.5 billion in 2010.

The use of proceeds from lower-cost tax-exempt bonds to directly finance the purchase of higher-yield securities—a practice known as tax arbitrage—is prohibited by law. Nevertheless, as discussed in a CBO study released today, the law as currently implemented allows many colleges and universities to use tax-exempt debt to finance investments in operating assets (buildings and equipment) while, at the same time, they hold investment assets that earn a higher return. (Investment assets are publicly traded and privately held securities, as well as land or buildings held for investment purposes.) To the extent that colleges and universities can earn untaxed returns on investments that are higher than the interest they pay on tax-exempt debt, they are benefiting from a form of “indirect” tax arbitrage.

Using data from information returns filed with the Internal Revenue Service by institutions of higher learning and by issuers of tax-exempt debt, CBO developed measures of tax arbitrage under a broader definition of the term that encompasses both direct and indirect tax arbitrage. Under one such definition, nearly all of the tax-exempt bonds that 251 colleges and universities issued in 2003 would be classified as earning profits from tax arbitrage. If some investment assets were set aside in a reserve, which would be excluded from the arbitrage measure under an alternative expanded definition, the amount of debt earning returns from arbitrage would be lower; even so, about 75 percent of bonds issued in 2003 would still be classified as earning arbitrage profits under that expanded definition.

By either measure, the amount of debt issued by colleges and universities that earns arbitrage profit would be considerably larger than that issued by nonprofit hospitals (which was the subject of a previous CBO study). Over time, if legislators were to expand the definition of tax arbitrage and thereby eliminate some of the benefits of tax-exempt financing, nonprofit institutions would probably respond by reducing the issuance of tax-exempt debt. That response, in turn, would decrease the cost to the federal government of the tax preference.

This study was prepared by Kristy Piccinini of CBO’s Tax Analysis Division.