The Congress of the United States O Congressional Budget Office

CBO

Tax-Credit Bonds and the Federal Cost of 

Financing Public Expenditures

July 2004

A

PAPER

Preface

Tax-credit bonds—bonds on which the federal government pays “interest” in the form of 

credits against federal income tax liability—have been proposed as a mechanism for financing 

various expenditures at all levels of government. In instances in which the bonds would be 

used as an alternative to federal appropriations as a source of funding, the cost to the federal 

government would be greater than it would be with financing through conventional borrowing by the Department of the Treasury. But carefully designed tax-credit bonds could cost the 

federal government less per dollar of assistance provided to state and local governments than 

the federal tax exemption now accorded “municipal” bonds issued by those governments. This 

Congressional Budget Office (CBO) paper explains those conclusions; however, in accordance 

with CBO’s mandate to provide impartial analysis, the report makes no recommendations.

The paper was prepared by Elizabeth Pinkston of CBO’s Microeconomic and Financial Studies Division and Dennis Zimmerman of CBO’s Tax Analysis Division under the direction of 

Roger Hitchner, Roberton Williams, and Thomas Woodward. The authors benefited from 

comments by Kim Cawley, Robert Dennis, Peter Fontaine, Rachel Milberg, Marvin Phaup, 

Frank Russek, and Robert Sunshine.

Leah Mazade edited the report, and John Skeen proofread it. Maureen Costantino prepared 

the paper for publication, Lenny Skutnik produced the printed copies, and Annette Kalicki 

prepared the electronic versions for CBO’s Web site (www.cbo.gov).

Douglas Holtz-Eakin

Director

July 2004

What Are Tax-Credit Bonds? 1

Who Might Issue Tax-Credit Bonds? 2

Comparing Federal Financing Costs for Tax-Credit Bonds 

and Appropriations 3

Comparing Federal Costs for Alternative Approaches to

State and Local Government Borrowing 4

Tax-Exempt Bonds 4

The Taxable Bond Option 5

Redesigned Tax-Credit Bonds 6

Conclusion 6

Table

1. Comparing Annual Federal Costs for Different

Types of State and Local Bonds Under the

Assumption of a 7 Percent Interest Rate 5

CONTENTS

Tax-Credit Bonds and the Federal Cost of

Financing Public Expenditures

A relatively new debt instrument, the tax-credit 

bond, has gained some favor as a way to finance public 

expenditures for transportation, schools, and other programs. The bonds, whose use must be specifically authorized in the tax code, allow their purchasers to receive a 

nonrefundable credit against their federal income tax liability instead of the cash interest that is typically paid on 

the borrowing that bonds represent. With tax-credit 

bonds, the federal government bears virtually all of the 

cost of borrowing—in the form of forgone revenues—

even if the bonds are issued by a nonfederal entity such as 

a state or local government.

Advocates of tax-credit bonds are seeking authority to use 

the proceeds from the bonds’ sale to provide multiyear 

funding for transportation or other public programs that 

might otherwise be financed through annual appropriations. Supporters of programs for which such bonds have 

been proposed find the idea attractive, in part because the 

approach would eliminate the need for yearly legislative 

action. But that proposed use could make the federal 

budget a less comprehensive measure of the government’s 

costs. Unless the entity issuing the bonds was part of or 

controlled by the federal government, or was acting on 

the government’s behalf, the program’s spending (the actual outlays for a transportation project, for example) 

would not show up in the federal budget, nor would the 

borrowing be part of the federal debt. Thus, the spending 

and borrowing of state and local governments that issued 

such bonds would not appear in the federal budget. The 

cost of the tax-credit bonds for the federal government 

(the forgone revenues) would affect the federal deficit or 

surplus but would not appear as a line item in the budget.

Tax-credit bonds will always be a more expensive way of 

financing programs’ spending than the government’s conventional borrowing from the public will be. That borrowing is carried out by the Department of the Treasury, 

which issues bonds and other types of debt. Conventional 

Treasury securities are the “gold standard” of bonds because they are free of default risk and highly liquid. Any 

other means of raising funds can be expected to cost 

more.

Nevertheless, one use of tax-credit bonds that could 

prove advantageous for the federal government would be 

as a substitute for the exemption of interest income that 

federal tax law now accords traditional bonds—often referred to as municipal bonds—issued by state and local 

governments. (The federal assistance that the exemption 

effectively provides to those nonfederal entities allows 

them to borrow at a lower cost than they would otherwise 

have had to pay.) Such tax-credit bonds could be designed to provide the same amount of assistance that the 

exemption now offers but at a lower cost to the federal 

government. Thus, although tax-credit bonds issued in 

lieu of Treasury securities and those issued in lieu of traditional state and local bonds would have the tax-credit 

feature in common, they would differ in one important 

respect: the former would cost the federal government 

more than conventional financing, and the latter—if 

carefully structured—would cost the federal government 

less.

What Are Tax-Credit Bonds?

Bonds are a means of borrowing. In exchange for immediate cash from the purchaser of a bond, the bond’s issuer 

pledges payments in the future. Conventional bonds entail a promise to repay the amount borrowed (the principal) at the end of a stated period (often 10 or 20 years) 

and a promise to pay interest in cash (usually semiannu-
2 TAX-CREDIT BONDS AND THE FEDERAL COST OF FINANCING PUBLIC EXPENDITURES

ally) until the principal is repaid.1 In general, that interest 

is subject to federal income tax. A notable exception is 

the interest on bonds issued by state and local governments, which is tax-free.

In the case of tax-credit bonds, bondholders receive a 

credit against their federal income tax liability instead of 

cash interest.2 Bondholders must report the tax credit as 

income, but after calculating their tax liability as if they 

had received that compensation in cash, they can subtract 

the amount of the credit from the tax due. Although the 

federal government effectively pays the interest on the 

bonds by granting tax credits, the repayment of the principal at maturity is the responsibility of the entity that issues the bonds. 

The value of the tax credits that bondholders receive in 

lieu of interest on a long-term security is substantial. For 

example, consider a 20-year tax-credit bond with an interest rate of 5 percent. The present value of the principal 

repayment would be only 38 percent of the face value 

(the principal) of the bond.3 The remaining 62 percent 

would be the value of the tax credits from the federal

government.

If the authorizing legislation did not restrict the use of the 

proceeds, the bond-issuing entity might put aside some 

of the proceeds from the bond’s sale and invest them to 

fulfill its obligation to repay the principal at maturity, a 

process known as defeasement.4 Suppose that a state issued $100 million in tax-credit bonds for an infrastructure program. Using the defeasement mechanism, it 

would invest $38 million of the proceeds to repay the 

principal and would have $62 million—the value of the 

tax credits provided by the federal government—to spend 

on the program. One could view the transaction either as 

a joint federal/state financing of $100 million or as an entirely federal financing of $62 million for the benefit of 

the state.

The stream of tax credits that substitutes for interest over 

the term of a tax-credit bond is not contractual; in principle, the credits could be revoked before the bond matured, leaving the bondholders little legal recourse to recover their loss (the value of the credits that was 

substituting for interest). Practically speaking, however, a 

provision that authorizes tax credits offers much the same 

promise of future payments as that provided by federal 

borrowing.

Who Might Issue Tax-Credit Bonds?

The range of potential issuers of tax-credit bonds spans 

both governmental and nongovernmental entities. State 

and local governments could find them useful, as might a 

nongovernmental entity such as Amtrak. In principle, the 

federal government could issue tax-credit bonds to finance some of its activities, although the higher costs that 

the bonds entail make that unlikely.

State and local governments are candidates to use taxcredit bonds. Indeed, the only such bonds authorized to 

date—Qualified Zone Academy Bonds (QZABs)—are 

designated for their use. QZABs were authorized in the 

Taxpayer Relief Act of 1997 and its subsequent extensions; that legislation allowed state and local governments 

to issue up to $400 million of QZABs each year from 

1998 through 2003 to finance school renovation and 

construction projects that met a set of qualifying criteria. 

In addition, the Clinton Administration twice proposed 

other tax-credit bonds to be issued by state or local governments—specifically, $9.7 billion in 1999 and 2000 for 

school modernization bonds and $9.5 billion in 1999 

over a five-year period for Better America Bonds (a debt 

instrument for expenditures related to environmental 

protection, such as the acquisition of green spaces). 

Other potential issuers cited in recently proposed legislation are tribal authorities and at least one nongovernmental entity. The Senate passed a bill in May of this year that 

would allow Indian tribes to issue up to $200 million of 

“qualified tribal school modernization” tax-credit bonds 

1. Some bonds, such as short-term bills or long-term zero-coupon 

bonds, promise only a single payment at the bond’s maturity 

(when the principal comes due). Those bonds sell at a discount 

and therefore pay the interest implicitly by appreciating in value 

over time.

2. The description here, in accordance with proposals to date, is of a 

100 percent credit, exactly equal to the cash interest that otherwise 

would have been paid. As discussed later, the credit could be less 

than 100 percent, with some interest still paid in cash.

3. The present value is a single number that expresses a flow of current and future income (or payments) in terms of an equivalent 

lump sum received (or paid) today.

4. Federal tax law prohibits issuers of tax-exempt debt from using the 

proceeds for defeasement. That restriction is meant to prevent 

state and local governments from earning profits—at the federal 

government’s expense—by borrowing at a tax-exempt interest rate 

and lending the proceeds at a higher, taxable rate.
TAX-CREDIT BONDS AND THE FEDERAL COST OF FINANCING PUBLIC EXPENDITURES 3

in both 2005 and 2006.5 And a bill introduced in 2001 

proposed that the National Railroad Passenger Corporation (Amtrak) be authorized to issue $12 billion of taxcredit bonds over a 10-year period.6

 A common characteristic of the tax-credit bonds in all of the proposals 

noted here—including those for state and local governments—is that they would provide a federal subsidy to 

entities outside the purview of the federal budget. 

Some recent proposals would create a new institution to 

issue tax-credit bonds earmarked for specific activities. 

Those proposals envision that the new entity would be 

nonfederal. But it would be very difficult for such an entity to qualify as nonfederal for budgetary purposes. For 

that, the entity would have to be largely independent of 

the federal government, and the federal government 

could not maintain operational control over the way the 

entity spent the proceeds of the bond issues. Faced with 

the difficulties entailed in having such an entity deemed 

nonfederal, some proponents have suggested that the federal government issue tax-credit bonds directly. Whether 

the bonds were issued directly by the Treasury or through 

an entity that was deemed federal, the federal budget 

would show the program’s spending, and the tax credits 

would serve only to mask the interest costs.

Comparing Federal Financing Costs for 

Tax-Credit Bonds and Appropriations

Any spending financed with tax-credit bonds could be 

funded instead through the appropriation process, and 

any money raised by the sale of tax-credit bonds could 

also be raised through the Treasury’s conventional borrowing methods. Tax-credit bonds would cost the federal 

government more per dollar than would appropriations 

financed with Treasury bonds.7

If tax-credit bonds were issued by a nonfederal entity, 

such as a state or local government, the federal government would essentially be borrowing money jointly with 

that entity for the latter’s benefit. The present value of the 

tax credits would be the amount that the federal government “borrowed” and paid as a subsidy. But no other institution borrows at as low a rate as the federal government does when it borrows through its traditional 

instruments. Thus, if federal borrowing was coupled with 

borrowing by the nonfederal entity, the cost of financing 

(the return that investors would require to purchase the 

bonds) would tend to rise because of three factors: the 

bonds’ relative illiquidity, uncertainty about whether the 

tax credits might be revoked, and the risk that the principal might not be repaid.

Even if the Treasury issued the tax-credit bonds, the first 

two factors would raise the cost of financing. The nonstandard nature of the bonds would make them less liquid and cause investors to demand a yield premium—a 

larger return than they would require with standard riskfree Treasury securities.8

 The fact that the tax-credit 

promise was not contractual would add uncertainty, 

which would mean a further premium to account for 

risk. Investors might regard such bonds as similar to the 

instruments that finance the Resolution Funding Corporation, or REFCORP (the organization created by the 

Congress in 1989 to bail out the savings and loan industry).

For the REFCORP bonds, the Treasury pays the interest 

and guarantees the principal by requiring that a sufficient 

amount of the proceeds for repayment be invested in its 

zero-coupon bonds. Interest rates on REFCORP bonds 

have averaged about 10 to 16 basis points higher (a basis 

point is one-hundredth of a percentage point) than the 

rates on comparable Treasury bonds, according to a recent analysis.9 By way of illustration, if Treasury bonds 

yielded 5 percent, investors might demand that the yield 

on tax-credit bonds be 5.1 percent, making such financ5. The Jumpstart Our Business Strength (JOBS) Act, S. 1637, 

passed by the Senate on May 11, 2004.

6. For a discussion of the economic costs of the proposed spending, 

see Congressional Budget Office, A Financial Analysis of H.R. 

2329, The High-Speed Rail Investment Act of 2001 (September 

2001).

7. The Treasury explained the ways in which tax-credit bonds would 

be more expensive than its conventional securities in a letter from 

John W. Snow, Secretary of the Treasury, to Senator Don Nickles, 

Chairman, Senate Committee on the Budget, July 24, 2003.

8. Liquidity is important because to derive the benefit of nonrefundable tax credits, bond owners must have a tax liability at least as 

large as the credits. Bond owners who unexpectedly had a tax liability that was smaller than the credits and were thus unable to use 

all of them would presumably want to sell their bonds.

9. Francis A. Longstaff, The Flight-to-Liquidity Premium in U.S. 

Treasury Bond Prices (Los Angeles: University of California, Los 

Angeles, Anderson Graduate School of Management, May 2001), 

available at http://repositories.cdlib.org/anderson/fin/5-01.
4 TAX-CREDIT BONDS AND THE FEDERAL COST OF FINANCING PUBLIC EXPENDITURES

ing 2 percent more costly than regular Treasury financing. The Treasury’s costs for bond issuance and administration would rise as well, as would the compliance and 

enforcement costs of the Internal Revenue Service.

If a nonfederal entity was authorized to issue tax-credit 

bonds, the cost of financing could be higher still because 

of the risk premium demanded by bond buyers. If the entity was required to defease the debt using Treasury 

bonds, investors might view the debt as equivalent to 

REFCORP bonds and demand only a small premium. 

But if bond buyers were uncertain about whether the 

principal would be repaid and whether the proceeds 

would be used in ways that qualified for the tax credits, 

they would demand a higher risk premium. If, for example, investors demanded a yield of 5.5 percent when the 

interest rate on comparable Treasury bonds was 5 percent, then financing through the tax-credit bonds would 

be 10 percent more costly than financing through regular 

Treasury bonds.

Comparing Federal Costs for

Alternative Approaches to State and 

Local Government Borrowing

The federal government already bears part of the interest 

costs that state and local governments incur when they issue bonds whose interest income is exempt from federal 

income taxes. Because of the exemption, purchasers of 

such bonds are willing to accept a lower interest rate than 

they would require on taxable bonds of comparable risk 

and maturity—specifically, an interest rate on the taxexempt debt that equals or exceeds the after-tax interest 

rate on taxable debt.10 Consequently, the federal government effectively pays a share—about 25 percent to 30 

percent—of the taxable interest that state and local governments would have to pay if their debt were taxable. 

That contrasts with the interest subsidy of 100 percent 

that characterizes tax-credit bonds both as currently used 

and as proposed. Thus, tax-credit bonds deliver a bigger 

subsidy and cost the federal government more than the 

exemption of interest on state and local government 

bonds.

Yet they need not do so. The rate of the tax credit might 

be set at less than 100 percent to deliver an equivalent 

subsidy. Moreover, setting the tax-credit rate at a lower 

level could actually reduce the federal costs that are now 

incurred in paying a portion of state and local governments’ borrowing costs. A given subsidy could be delivered at a lower cost to the federal government; alternatively, a larger subsidy could be delivered at the same cost.

Tax-Exempt Bonds

Under the current tax exemption, each dollar of federal 

aid to state and local governments in the form of lower 

borrowing expenses costs the federal government considerably more than a dollar. As noted earlier, the return on a 

taxable bond is equal to the interest paid on the bond minus the federal income tax that the investor pays on that 

interest income. (For simplicity’s sake, that calculation ignores state income taxes.) A bond purchaser’s income tax 

and after-tax return depend on his or her marginal tax 

rate (the rate of tax paid on the last dollar of income).

Investors with a marginal tax rate of 30 percent would be 

willing to purchase either a $1,000 tax-exempt municipal 

bond with an interest rate of 4.9 percent (on which no 

federal taxes would be paid) or a $1,000 taxable bond 

paying 7.0 percent before taxes and 4.9 percent after taxes 

(30 percent of the 7.0 percent return, or 2.1 percent, is 

paid in taxes). For both bonds, the annual interest expenses are 7 percent, or $70. For the taxable bond, that 

expense is paid entirely by the issuer. For the tax-exempt 

bond, however, the interest costs are effectively shared between the state or local government (which pays the interest rate of 4.9 percent, or $49 in interest) and the federal government (which pays the remaining 2.1 percent, 

or $21, in the form of the tax revenue that would have 

been collected if the bond had been taxable; see Table 1). 

In effect, the share of the interest costs paid by the federal 

government is determined by the bond purchasers with 

the lowest marginal tax rate. Those buyers “clear the market”—that is, buy the last units of the bond issue. In this 

example, that marginal tax rate and thus the federal share 

of interest costs are both 30 percent. 

Because some bond purchasers’ marginal tax rates are 

higher than other buyers’, tax-exempt bonds usually end 

up costing the federal government more than the amount 

of benefits (that is, the reduced interest costs) received by 

the state and local governments that issue the bonds. To 

illustrate, suppose that most of the buyers of tax-exempt 

bonds were in a 35 percent tax bracket rather than the

10. As with tax-credit bonds, the exemption from federal income tax 

of the interest income on state and local debt could in principle be 

revoked before the bonds matured, leaving the bondholders with 

little legal recourse to recover the loss of the value of the interest 

for which the exemption was substituting.
TAX-CREDIT BONDS AND THE FEDERAL COST OF FINANCING PUBLIC EXPENDITURES 5

Table 1.

Comparing Annual Federal Costs for Different Types of State and Local Bonds 

Under the Assumption of a 7 Percent Interest Rate

(Dollars)

Source: Congressional Budget Office.

Note: Costs are figured on $1,000 worth of bonds, and the marginal tax rates are those of bond purchasers.

n.a. = not applicable.

a. As the text describes, the total return on the bonds under each of the alternatives in the table would be 7 percent, or a total of $70, with 

the state or local government paying $49 of the interest cost and the federal government $21. Those shares are the equivalent of the 

return on a taxable bond paying 7 percent before taxes and 4.9 percent after taxes.

30 percent bracket of the investors whose bond purchases 

clear the market. Each $1,000 bond sold to a buyer in the 

higher tax bracket would cost the federal government 

$24.50 in lost revenue each year ($70 of interest income 

not taxed at a 35 percent rate). Yet the reduction in the 

borrowing costs of state and local governments would be 

only $21—because the investors in the 30 percent tax 

bracket had bought the last bonds and set the tax-exempt 

interest rate at 4.9 percent. The federal government 

would thus incur a cost of $1.17 ($24.50/$21) for every 

dollar of assistance to the state or local government for 

bonds bought by people in the 35 percent tax bracket. 

Such a scenario is clearly an inefficient use of the federal 

government’s resources.

The Taxable Bond Option

In the past, analysts who wanted to eliminate the inefficiencies inherent in tax-exempt bonds have argued that 

the government should subsidize interest payments on 

municipal bonds not through the tax system but through 

the appropriation process. Under such a “taxable bond 

option” (TBO), state and local governments would issue 

taxable debt that carried an interest rate comparable with 

that on other taxable debt of equal risk and maturity (7 

percent in the above example). The federal government 

would compensate state and local governments by paying 

a share of the higher interest costs. That share, or subsidy 

rate, would be set to equal the market-clearing marginal 

tax rate that would have been expected if tax-exempt 

bonds had been issued (30 percent in the example). A 

subsidy of that size would allow state and local governments to pay the same interest rate (after receiving the 

federal payment) that they would have paid on taxexempt bonds, and their interest savings would be the 

same as the savings provided by those bonds—$21 on 

each $1,000 bond (see Table 1). The cost to the federal 

government would be limited to the appropriations made 

to state and local governments to finance a portion of 

their interest payments ($21 on each $1,000 bond). 

There would be no loss of tax revenue because the interest 

income on the bonds would be taxable rather than taxexempt. The federal government’s cost per $1 of interest 

savings for state and local governments would be $1, reTax-Exempt Bonds Taxable Bond Option

Redesigned

Tax-Credit Bonds

Marginal

Tax Rate of

30 Percent

Marginal

Tax Rate of

35 Percent

Marginal

Tax Rate of

30 Percent

Marginal

Tax Rate of

35 Percent

Marginal

Tax Rate of

30 Percent

Marginal

Tax Rate of

35 Percent

Federal Payment or Subsidy to State and 

Local Governmentsa 21 21 21 21 21 21

Cost to the Federal Government of 

Delivering the Subsidy to State and

Local Governments

Forgone revenue 21 24.50 n.a. n.a. n.a. n.a.

Appropriations n.a. n.a. 21 21 n.a. n.a.

Tax credit n.a. n.a. n.a. n.a. 21 21

Cost per Dollar of Subsidy 1 1.17 1 1 1 1
6 TAX-CREDIT BONDS AND THE FEDERAL COST OF FINANCING PUBLIC EXPENDITURES

gardless of the marginal tax rate of the investor who 

cleared the market.11

The Congress has considered a taxable bond option several times. The House Ways and Means Committee twice 

reported out legislation containing one, in 1969 and 

1976, and the Carter Administration included such a 

provision in its 1978 tax proposals. In none of those instances did a TBO become law. One of the issues that a 

TBO raises is related to bond volume. A TBO would 

change the subsidy from an open-ended program whose 

utilization was entirely determined by the issuers of 

bonds to one whose utilization was subject to an annual 

appropriation limit. As a result, state and local governments might lose control of the volume of bonds to be issued. (By contrast, tax-credit bonds, which are discussed 

below, would maintain the subsidy’s open-ended claim to 

federal revenues and leave decisions about bond volume 

in the hands of state and local issuers.) 

Redesigned Tax-Credit Bonds

Tax-credit bonds could be designed to replace tax-exempt 

bonds so that the federal government continued to pay 

the same share of state and local governments’ interest 

costs with the same level of efficiency as a TBO would offer. The kind of restructured tax-credit bond envisioned 

under that approach would divide its return into two 

components: a taxable interest payment from the state or 

local government issuing the debt and a taxable tax credit 

from the federal government. The federal government 

would set the rate of the tax credit to meet two conditions. First, the value to bond buyers of the sum of the interest paid by the state or local government and the tax 

credit would have to equal the interest income on a comparable taxable bond. Second, the total interest costs 

borne by the state or local government would have to be 

the same as they would have been if the bonds had been 

issued as tax-exempt debt. Those conditions yield a taxcredit rate that can be expressed as a percentage of those 

interest costs. For example, if the marginal tax rate that 

would have cleared the tax-exempt bond market was 30 

percent, the tax-credit rate would be 0.429.12

In that example, all purchasers of $1,000 bonds would receive a taxable interest payment of $49 (4.9 percent) from 

the bond’s issuer—the same interest that the issuer would 

have paid on a tax-exempt bond—and a tax credit of $21 

(which equals the credit rate of 0.429 times 4.9 percent, 

or $21). The $21 tax credit would substitute for the $21 

of interest costs that state and local governments would 

have had to pay on a taxable bond and equal the savings 

that they would have received on a tax-exempt bond. The 

federal government’s cost would equal the tax credit—

that is, the interest savings—regardless of whether the 

marginal tax rate of the bond purchaser was 30 percent or 

35 percent. The federal government would not suffer any 

loss of revenues in addition to the credit because both the 

state and local interest payment of $49 and the tax credit 

of $21 would be taxed at each bondholder’s marginal tax 

rate—as the $70 of interest income on an equivalent taxable bond would be. Thus, the tax-credit bond in this 

form would be efficient because it would cost the federal 

government $1 for each $1 of interest savings provided to 

state and local governments. 

Conclusion

Tax-credit bonds have been suggested as an alternative 

way of financing public expenditures, and advocates of 

their use claim a variety of advantages for that funding 

approach. However, using tax-credit bonds to fund programs that could be funded through federal appropriations would cost the federal government more per dollar 

than it would have to pay if it used its conventional financing method of issuing taxable bonds through the 

Treasury.

Tax-credit bonds could be designed to deliver the same 

federal subsidy to state and local governments that current tax-exempt bonds provide but at a lower cost. A tax 

credit would subsidize the interest on state and local government debt more efficiently than an exemption of interest income could because of the federal income tax’s 

progressive marginal tax rate structure. However, both 

tax-credit and tax-exempt bonds convey such assistance 

by forgoing income tax revenues, an approach whose 

costs are not readily visible in the federal budget.

11. If a TBO was enacted, the government would have to forecast 

bond demand and supply to estimate the market-clearing tax rate 

as well as the subsidy rate that would have prevailed with taxexempt bonds. If no forecasting bias skewed the results, the share 

of the interest costs paid by the federal government would vary 

around the share that would have been provided by tax-exempt 

bonds—and the federal government would save money.

12. The rate is equal to t/(1 - t), where t is the marginal tax rate of the 

taxpayer whose purchase would have cleared the tax-exempt bond 

market.