Eliminate the Tax Exemptions for New Qualified Private Activity Bonds

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

Billions of Dollars 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues * 0.4 0.8 1.4 2.1 2.9 3.7 4.6 5.4 6.2 4.7 27.5

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

* = between zero and $50 million.

The U.S. tax code permits state and local governments to finance certain projects by issuing bonds whose interest payments are exempt from federal income taxes. As a result, those bonds pay lower rates of interest than they would if the interest payments were taxable. For the most part, proceeds from tax-exempt bonds finance public projects, such as the construction of highways and schools. In some cases, however, state and local governments issue tax-exempt bonds to finance private-sector projects. The issuance of such bonds—which are known as qualified private activity bonds—is authorized by the tax code to fund private projects that provide at least some public benefits. Eligible projects include the construction or repair of infrastructure and certain activities, such as building schools and hospitals, undertaken by nonprofit organizations. (Those organizations are sometimes called 501(c)(3)s after the section of the tax code that authorizes them.)

This option would eliminate the tax exemption for new qualified private activity bonds beginning in 2017. The option would increase revenues by $28 billion through 2026, according to estimates by the staff of the Joint Committee on Taxation.

One rationale for this option is that eliminating the tax exemption for new qualified private activity bonds would improve economic efficiency in some cases. For example, the owners of some of the infrastructure facilities that benefit from the tax exemption can capture—through fees and other charges—much of the value of the services they provide. Therefore, such investments probably would take place without a subsidy. In those instances, providing a tax exemption for such investments would be inefficient because the tax exemption would shift resources from taxpayers to private investors without generating any additional public benefits. As another example, in cases in which the public benefits from a private-sector facility would be small relative to the existing tax exemption, the subsidy sometimes would lead to investment in projects whose total value (counting private as well as public benefits) was less than their costs.

Another argument in favor of this option is that it would encourage nonprofit organizations to be more selective when choosing projects and, in general, to operate more efficiently. Nonprofit organizations do not pay federal income tax on their investment income. Many nonprofit universities, hospitals, and other institutions use tax-exempt debt to finance projects that they could fund by selling their own assets. By holding on to those assets, they can earn an untaxed return that is higher than the interest they pay on their tax-exempt debt. Eliminating the tax exemption for the debt-financed projects of nonprofit organizations would put those projects on an even footing with the projects financed by selling assets. Further, the tightening of nonprofit organizations' financial constraints that would result from eliminating the tax exemption would encourage those organizations to operate more cost-effectively, although some nonprofits with small asset bases, or endowments, could be forced to cut back or even cease operations.

A disadvantage of this option is that some projects that would not be undertaken without a tax exemption would provide sufficient public benefits to warrant a subsidy. For example, some roads can have broad social benefits (because they are part of a larger transportation network) and, at the same time, be appealing to private owners (because those owners and operators could collect tolls from users). State and local governments are increasingly looking to the private sector to undertake projects of that sort, and supporters of qualified private activity bonds argue that eliminating the tax exemption would remove an important source of funding for them.

If lawmakers wished to continue to support infrastructure investment and other projects undertaken by the private sector, they could do so more efficiently by subsidizing them directly rather than doing so through the tax system. Tax-exempt financing is inefficient for two reasons: First, the reduction in borrowing costs for issuers of those bonds is less than the federal revenues forgone through the tax exemption. (The interest rate on tax-exempt debt is determined by the market-clearing tax-exempt bond buyer, who will typically be in a lower marginal income tax bracket—and hence be willing to accept a lower tax-free rate of return—than the average tax-exempt bond buyer, who determines the amount of federal revenue forgone as a result of the tax exemption.) Second, the amount of the subsidy delivered is determined by the tax code and so does not vary across projects according to federal priorities. Lawmakers could, instead, provide a direct subsidy for certain projects by guaranteeing loans or making loans available to the private sector at below-market rates of interest. By offering a direct subsidy rather than one provided through the tax system, the federal government would be better able both to select the types of projects receiving support and to determine the amount of the subsidy.