Eliminate the Tax Exemption 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.
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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 are used to 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. Such bonds—known as qualified private activity bonds—may be used 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) entities after the section of the tax code that authorizes them.)
In 2015, a total of approximately $102 billion in qualified private activity bonds was issued by the 50 states, and slightly less than half (45 percent) of the proceeds were used for new investment. The remaining proceeds were used to issue new bonds that replaced existing bonds. At that time, Standard and Poor's reported that the yield on high-grade municipal bonds—a reasonable proxy for qualified private activity bonds—was 3.5 percent, well below the yield on corporate bonds of comparable creditworthiness (3.9 percent).
This option would eliminate the tax exemption for new qualified private activity bonds beginning in 2019.
Effects on the Budget
The option would increase revenues by $32 billion from 2019 through 2028, according to estimates by the staff of the Joint Committee on Taxation. Federal revenues raised by this option would initially be small but would grow over time. That is because the interest income from any type of bond depends on the bond's outstanding principal amount and the rate of interest it pays. As the volume of debt rises, interest income increases as well (barring a drop in interest rates, which could lead existing debt to be refinanced at lower rates). And interest rates are projected to rise over the 2019-2028 period, which would cause the interest income that would become subject to tax under the option to grow even more rapidly. Hence, the effect on federal revenues is expected to increase.
Estimates of the federal revenues that would be raised through this option are uncertain. The estimates rely on the Congressional Budget Office's projections of interest rates over the next decade, which are inherently uncertain. The estimates also depend on several types of behavioral responses to this option—specifically, taxpayers' willingness to purchase bonds of state and local governments that no longer offer tax-free interest income, and those governments' willingness to incur such debt.
One argument 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 the investments is inefficient because the exemption shifts resources from taxpayers to private investors without generating any additional public benefits. As another example, some private-sector projects funded through qualified private activity bonds might provide public benefits that are small relative to the existing tax exemption. In such cases, the subsidy could lead to investment in projects whose total value (counting private as well as public benefits) is 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 taxes 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 greater 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 projects financed through sales of 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. As a consequence, however, nonprofits with few assets that they could liquidate to cover an increase in the cost of financing might be forced to curtail or even cease operations.
A disadvantage of this option is that some projects that would not be undertaken without a tax exemption might provide sufficient public benefits to warrant a subsidy. For example, although some privately funded roads specifically benefit the owners and operators (who can collect tolls from users), they also have broad social benefits (because they are part of a larger transportation network). 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.
However, if lawmakers wished to continue to support investments in infrastructure and other projects undertaken by the private sector, they could do so more efficiently by subsidizing those investments directly rather than through the tax system. Tax-exempt financing is inefficient for two reasons. First, the reduction in borrowing costs for issuers of tax-exempt bonds is less than the amount of federal revenues forgone through the tax exemption. (The interest rate on tax-exempt debt is determined by the market-clearing tax-exempt bond buyer, whose bond purchase establishes the price at which the amount of debt purchased by investors just matches the volume brought to market by tax-exempt borrowers. The market-clearing tax-exempt bond buyer is typically in a lower marginal income tax bracket—and hence willing to accept a lower tax-free rate of return—than the average tax-exempt bond buyer, who determines the amount of federal revenues forgone as a result of the tax exemption.) Second, the amount of the subsidy is determined by the tax code and does not vary among projects according to federal priorities. Lawmakers could, instead, provide a direct subsidy by guaranteeing loans or making loans available for certain private-sector projects at below-market rates of interest. By offering a direct subsidy rather than providing one through the tax system, the federal government could both select the types of projects receiving support and determine the amount of the subsidy.