APRIL 2010

Tax Arbitrage by

Colleges and

Universities

CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

S T U D Y

CBO
Pub. No. 4015
The Congress of the United States O Congressional Budget Office

A

STUDY

CBO

Tax Arbitrage by 

Colleges and Universities

April 2010

Preface

CBO

Because colleges and universities serve a public purpose—advancing higher education 

and promoting myriad forms of research—they enjoy a variety of tax preferences. In addition 

to being exempt from paying federal income taxes, institutions of higher learning can accept 

taxdeductible charitable contributions and use taxexempt debt to finance capital expendi

tures. It is the latter preference that the Congressional Budget Office (CBO) focuses on in 

this study, which was prepared at the request of the Ranking Member of the Senate Finance 

Committee. The law explicitly prohibits the use of taxexemptbond proceeds for the pur

chase of investment assets, a practice known as tax arbitrage; however, issuers of taxexempt 

bonds may use the proceeds for the purchase of operating assets while they simultaneously 

hold investment assets that provide a higher rate of return. To the extent that colleges and 

universities earn an untaxed return on investments that exceeds 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 taxexempt debt, CBO created several measures of tax 

arbitrage under a broader definition of the term that includes indirect tax arbitrage. Over 

time, if legislators were to expand the definition of tax arbitrage, nonprofit institutions 

would most likely respond by reducing their issues of taxexempt debt. That response, in 

turn, could decrease the cost to the federal government of granting such tax preferences. In 

accordance with CBO’s mandate to provide objective, nonpartisan analysis, the paper makes 

no recommendations. 

Kristy Piccinini of CBO’s Tax Analysis Division wrote the study, under the supervision of 

Frank Sammartino and G. Thomas Woodward (formerly of CBO). Nabeel Alsalam, 

Robert Dennis, Mark Hadley, and Deborah Lucas provided helpful comments. In addition, 

Thomas Pollack of the National Center for Charitable Statistics provided assistance with the 

data, and William Gentry of Williams College, Thomas Holtmann of the Joint Committee 

on Taxation, Kim Reuben of the Urban Institute, and Dennis Zimmerman of the American 

Tax Policy Center commented on earlier drafts. (The assistance of external reviewers implies 

no responsibility for the final product, which rests solely with CBO). 

Loretta Lettner edited the study, and Kate Kelly proofread it. Maureen Costantino designed 

the cover, and Jeanine Rees prepared the report for publication. Lenny Skutnik printed the 

initial copies, Linda Schimmel coordinated the print distribution, and Simone Thomas 

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

Douglas W. Elmendorf

Director

April 2010

Contents

CBO

Summary and Introduction 1

Tax Preferences for Higher Education 2

Tax-Exempt Bonds and Tax Arbitrage 3

The Use of TaxExempt Bonds 3

Advantages and Disadvantages of TaxExempt Bonds 5

Direct and Indirect Tax Arbitrage 6

Approaches to Measuring the Extent of Indirect Tax Arbitrage 7

Investment Assets and TaxExempt Debt 7

Possible Approaches to Expanding the Definition of Tax Arbitrage 10

Measuring the Volume of Arbitrage Bonds Under a Broader 

Definition of the Term 12

Estimated Volume of Arbitrage Bonds Under a Broader Definition of the Term 12

Estimated Amount of Arbitrage Debt 13

The Distribution of Arbitrage Debt 14

Comparison with Arbitrage Debt for Nonprofit Hospitals 15

Institutional Response to an Expanded Definition of Tax Arbitrage 16

Appendix: Alternative Calculations of Tax Arbitrage as Practiced by Colleges and 

Universities 17
VI TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES

CBO

Tables

1. Uses of Proceeds from TaxExempt Bonds Issued on Behalf of 

Colleges and Universities, 2003 5

2. Selected Assets and Liabilities Held by Colleges and Universities, 2003 9

3. TaxExempt Debt Classified as Earning Profits from Arbitrage in 2003

Under a Broader Definition of the Term 13

4. Colleges and Universities Conducting Tax Arbitrage in 2003 Under a 

Broader Definition of the Term 14

Figures

1. The Value of New Issues of TaxExempt Bonds, 1990 to 2007 4

2. The Distribution of Investment Assets and Outstanding TaxExempt Bonds 

Held by 251 Colleges and Universities in 2003 10

3. The Distribution of TaxExempt Debt Held by 251 Colleges and 

Universities in 2003 That Would Be Classified as Earning Profits from 

Arbitrage Under a Broader Definition of the Term 15

Box

1. Estimating the Extent of Indirect Arbitrage Practiced by Colleges and 

Universities 8
CBO

Tax Arbitrage by Colleges and Universities

Summary and Introduction

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 taxdeductible charitable contributions 

and allowed to use taxexempt debt to finance capital 

expenditures. 

This Congressional Budget Office (CBO) study focuses 

on one of those tax advantages, the ability of colleges 

and universities to borrow funds by issuing taxexempt 

debt. According to the staff of the Joint Committee on 

Taxation (JCT), 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 

lowercost taxexempt bonds to directly finance the 

purchase of higheryield securities—a practice known as 

tax arbitrage—is prohibited by law. Nevertheless, the 

law as currently implemented allows many colleges and 

universities to use taxexempt 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 taxexempt 

debt, they are benefiting from a form of “indirect” tax 

arbitrage.

Rules in the Internal Revenue Code (IRC) and regula

tions established by the Department of the Treasury limit 

tax arbitrage by restricting the yield on any investments 

held by the bond issuer that are deemed to be directly 

related to the taxexempt bond issue (for example, an 

asset pledged as collateral).1

 Other investment assets are 

not yieldrestricted even though they contribute indi

rectly to securing the bonds and are considered by rating 

agencies when rating the taxexempt debt. A broader 

definition of tax arbitrage would include most or all 

investment assets held by an institution borrowing with 

taxexempt debt.

Using data from information returns filed with the 

Internal Revenue Service (IRS) by institutions of higher 

learning and by issuers of taxexempt debt, CBO devel

oped measures of tax arbitrage as practiced by colleges 

and universities under a broader definition of the term 

that encompasses both direct and indirect tax arbitrage. 

Under one such definition, nearly all of the taxexempt 

bonds that 251 institutions issued in 2003 would be clas

sified as earning profits from tax arbitrage. If some invest

ment 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 earn

ing arbitrage profits under that expanded definition. By 

either measure, the amount of debt issued by colleges and 

universities that earns arbitrage profit would be consider

ably larger than that issued by nonprofit hospitals (which 

was the subject of a previous CBO study on broadening 

the definition of tax arbitrage).2

 Over time, if legislators 

were to expand the definition of tax arbitrage and thereby 

eliminate some of the benefits of taxexempt financing, 

1. Internal Revenue Code, 26 U.S.C. 148(b)(3)(A). The terms 

“debt” and “bond” are used interchangeably to refer to debt with 

maturities in excess of a year. The dollar figures for such debt cited 

in this analysis also include any leasing arrangements that are tax

exempt.

2. Congressional Budget Office, Nonprofit Hospitals and Tax 

Arbitrage, letter to the Honorable William M. Thomas 

(December 6, 2006).
2 TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES

CBO

nonprofit institutions would probably respond by reduc

ing the issuance of taxexempt debt. That response, in 

turn, would decrease the cost to the federal government 

of the tax preference.

Tax Preferences for Higher Education

Institutions of higher learning, both public and private, 

benefit from several types of preferential tax treatment. 

Like other nonprofit organizations defined in section 

501(c)(3) of the IRC, nonprofit private schools are 

exempt from the federal income tax, eligible to receive 

charitable contributions that donors may deduct from 

their taxable income, and allowed to use taxexempt debt 

to finance capital expenditures.3

 As state or local govern

ment entities, public colleges and universities receive 

broadly similar tax preferences: they are exempt from fed

eral income taxation, eligible for donations that are tax

deductible, and may have access to taxexempt debt. 

Although there are no estimates of the cost to the federal 

government of exempting contributions made specifically 

to colleges and universities, the deduction of charitable 

contributions to educational institutions at all levels is 

expected to cost about $6.6 billion in forgone tax reve

nues in 2010; charitable contributions to colleges and 

universities account for about 70 percent of all contribu

tions to educational institutions.4

 JCT estimates that 

allowing institutions of higher learning to borrow using 

taxexempt debt will cost the federal government—in the 

form of forgone tax revenues—about $5.5 billion in 

2010.5

As is the case with other nonprofit organizations, colleges 

and universities receive preferential tax treatment because 

they are viewed as serving a public purpose. Institutions 

of higher learning perform two activities that are typically 

considered to serve the needs of society: providing educa

tion and conducting research. Education is associated 

with a wide range of favorable outcomes. Investment in 

human capital through education confers considerable 

private benefits on an individual, in the form of higher 

income and better health.6

 Education probably also yields 

benefits for the community as a whole, including a more 

productive workforce, which leads to faster economic 

growth, as well as lower crime, a more informed elector

ate, and increased social mobility.7

 How much education 

an individual prefers to invest in depends solely on the 

private benefit he or she might expect from that invest

ment; in the absence of government intervention, that 

decision will yield fewer public benefits than is socially 

desirable.8

Some colleges and universities also perform research that 

may have large spillover effects that benefit the rest of the 

economy.9

 Although businesses make substantial invest

ments in research and development, private investors 

cannot retain all of the benefits from that spending 

because the knowledge produced by such research can be 

used by others. As is the case with individuals who must 

decide how much to invest in their own education, the 

private sector chooses the amount of research and devel

opment it is willing to fund on the basis of private, rather 

than social, benefit. 

3. Section 501(c)(3) of the Internal Revenue Code defines a quali

fied nonprofit as any entity “organized and operated exclusively 

for religious, charitable, scientific, testing for public safety, literary, 

or educational purposes, or to foster national or international 

amateur sports competition...or for the prevention of cruelty to 

children or animals.” A nonprofit may not engage in political 

activity, and none of its earnings may benefit any private share

holder or individual. 

4. Joint Committee on Taxation, Estimates of Federal Tax Expendi

tures for Fiscal Years 2008–2012, JCS208 (October 31, 2008), 

p. 53. 

5. Estimates of tax expenditures are not intended to capture all of the 

ways in which taxpayers might respond to a change in law. In par

ticular, the estimate discussed here assumes that if investors did 

not hold taxexempt bonds, they would hold taxable bonds 

instead. In one study, researchers examined some of the other ways 

in which investors might change their portfolios in response to 

limits on taxexempt bonds. That study found that because tax

able bonds are one of the most heavily taxed types of asset, inves

tors would probably seek alternatives that are less heavily taxed 

and, therefore, the revenue loss to the federal government would 

probably be smaller than the taxexpenditure cost discussed here. 

See James Poterba and Arturo Verdugo, Portfolio Substitution and 

the Revenue Cost of Exempting State and Local Government Interest 

Payments from Federal Income Tax, Working Paper No. 14439 

(Cambridge, Mass.: National Bureau of Economic Research, 

October 2008), available at www.nber.org/papers/w14439.

6. See David Card, “The Causal Effect of Education on Earnings,” 

in Orley Ashenfelter and David Card, eds., Handbook of Labor 

Economics, vol. 3 (Amsterdam: Elsevier Press, 1999), pp. 1801–

1863. Researchers in another study discuss the evidence for a pos

itive relationship between education and health outcomes, paying 

particular attention to the mechanisms through which education 

may lead to better health. See David M. Cutler and Adriana Lleras 

Muney, “Education and Health: Evaluating Theories and Evi

dence,” in Robert F. Schoeni and others, eds., Making Americans 

Healthier: Social and Economic Policy as Health Policy (New York: 

Russell Sage Foundation, January 2008).
TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES 3

CBO

Granting favorable tax treatment to postsecondary educa

tional institutions is just one way in which policymakers 

may be able to increase investment in human capital and 

research. Other ways that the federal government cur

rently subsidizes educational institutions include direct 

grants to states and localities for elementary and second

ary education, tax preferences for private institutions that 

provide elementary and secondary education, direct 

grants to schools for research, and subsidies and loan 

programs for individuals pursuing undergraduate and 

graduate degrees. 

Tax-Exempt Bonds and Tax Arbitrage

State and local governments use taxexempt bonds to 

finance their own capital projects and to provide the 

means for other entities, including nonprofit and state

supported colleges and universities, to use taxexempt 

debt. The tax code contains provisions that are designed 

to prevent that tax preference from becoming an unlim

ited subsidy for all types of spending and to restrict its use 

to financing capital investment in operating assets (such 

as the construction or renovation of buildings and the 

purchase or repair of equipment). Tax arbitrage—the use 

of proceeds from lowercost taxexempt bonds to finance 

the purchase of higheryield securities—is specifically 

prohibited both by the IRC and by Treasury regula

tions.10 However, in most situations, the law does not 

prevent taxexempt borrowers from engaging in what is 

essentially indirect tax arbitrage. 

Indirect tax arbitrage occurs when a borrower with tax

exempt status earns interest on investment assets not 

directly financed with bond proceeds that exceeds the 

interest cost incurred from contemporaneous taxexempt 

borrowing. A borrower could sell those assets to finance 

the capital expenditure instead of borrowing with tax

exempt debt. Holding those assets while borrowing on 

a taxexempt basis is, in effect, equivalent to using tax

exempt proceeds to invest in those higheryielding 

securities.

The Use of Tax-Exempt Bonds

About $290 billion in taxexempt bonds was issued in 

2007, the most recent year for which aggregate data 

are available—up from about $100 billion in 1990 

(see Figure 1). About 70 percent of those were govern

mental bonds, which are typically issued by state and 

local governments for public projects such as the con

struction of highways or public schools. The payment 

of interest on those obligations is generally funded 

through tax revenues.

The remaining taxexempt bonds were “qualified private

activity bonds”—taxexempt bonds issued by state and 

local governments on behalf of certain private entities or 

for designated activities.11 Eligible activities include 

financing student loans or mortgages for owneroccupied 

7. See Enrico Moretti, “Estimating the Social Return to Higher Edu

cation: Evidence from Longitudinal and Repeated CrossSectional 

Data,” Journal of Econometrics, vol. 121, no. 1–2 (July–August 

2004), pp. 175–212. In his analysis, Moretti found that college 

education creates positive spillovers in productivity and wages. See 

also Eric Hanushek and Ludger Woessmann, Do Better Schools 

Lead to More Growth? Cognitive Skills, Economic Outcomes, and 

Causation, Working Paper No. 14633 (Cambridge, Mass.: 

National Bureau of Economic Research, January 2009). In their 

analysis, the authors found empirical evidence of a causal relation

ship between educational attainment and growth rates across 

countries. Other research has found that educational attainment is 

associated with a decreased likelihood of incarceration or arrest. 

See Lance Lochner and Enrico Moretti, “The Effect of Education 

on Crime: Evidence from Prison Inmates, Arrests, and Self

Reports,” American Economic Review, vol. 94, no. 1 (March 2004), 

pp. 155–189. Still other research suggests a positive correlation 

between educational attainment and the likelihood of electoral 

participation. See Kevin Milligan, Enrico Moretti, and Philip 

Oreopoulos, “Does Education Improve Citizenship? Evidence 

from the United States and the United Kingdom,” Journal of Pub

lic Economics, vol. 88, no. 910 (August 2004), pp. 1667–1695. 

For a discussion of the relationship between postsecondary educa

tion and social mobility, see Robert Haveman and Timothy 

Smeeding, “The Role of Higher Education in Social Mobility,” 

Future of Children: Opportunity in America, vol. 16, no. 2 (Fall 

2006), pp. 125–150.

8. Individuals who face financial constraints may invest in less 

education than is either privately or socially desirable. Federal 

student loan programs are one way to reduce the impact of such 

constraints. See Congressional Budget Office, Costs and Policy 

Options for Federal Student Loan Programs (March 2010).

9. For a more detailed discussion of federal subsidies for research and 

development, see Congressional Budget Office, Federal Support for 

Research and Development (June 2007).

10. Internal Revenue Code, 26 U.S.C. 148; Treas. Reg., 26 C.F.R. 

1.1480.

11. Such bonds can be issued on behalf of a private entity if more 

than 10 percent of the proceeds is used for any private business 

purpose and if more than 10 percent of the payment of principal 

or interest is secured by an interest in property used for a private 

business purpose or is derived from payments for property used 

for a private business purpose. Privateactivity bonds are taxable 

unless they are issued for a qualified purpose or entity.
4 TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES

CBO

Figure 1.

The Value of New Issues of Tax-Exempt Bonds, 1990 to 2007

(Billions of dollars)

Source: Congressional Budget Office.

Notes: Private-activity bonds are issued on behalf of private entities by state and local governments. Unless they are issued for specific 

tax-exempt activities or entities, interest paid on such bonds is taxable. Activities that are eligible for tax-exempt status include the 

financing of student loans or mortgages for owner-occupied housing. Entities that qualify for tax-exempt status include nonprofit 

hospitals, schools, and other qualified 501(c)(3) organizations. Aside from nonprofit hospitals, the Internal Revenue Service does 

not separate out data on bond issues for any other type of 501(c)(3) organization.

The category “all other private-activity issues” consists primarily of bonds issued on behalf of hospitals, mortgage bonds, and

residential rental bonds.

Governmental bonds are typically issued by state and local governments for public projects such as the construction of schools or 

highways.

housing; eligible entities include nonprofit hospitals, 

nonprofit schools, and other qualified 501(c)(3) organi

zations. The interest on taxexempt privateactivity bonds 

is typically paid with revenue generated by the project 

that was financed with the bond proceeds rather than by 

state and local taxpayers. The volume of most eligible 

types of taxexempt privateactivity bonds that can be 

issued in a given year by a given state is limited by the 

Internal Revenue Code, as amended in 1986, but those 

caps do not apply to bonds issued on behalf of qualified 

501(c)(3) organizations. The only cap that applied to tax

exempt bonds issued on behalf of qualified 501(c)(3) 

organizations—previously $150 million for the benefit of 

any single organization—was lifted in 1997. 

New issues of taxexempt privateactivity bonds totaled 

$87 billion in 2007. Of that amount, about $27 billion 

was issued on behalf of qualified nonhospital 501(c)(3) 

organizations and $17 billion was issued on behalf of 

qualified 501(c)(3) hospitals. The IRS does not separate 

out data on bond issues for any other type of 501(c)(3) 

organization. Of the remaining taxexempt private

activity bonds, qualified mortgage bonds and qualified 

residential rental bonds were the largest categories by vol

ume; $14 billion of the former and $7 billion of the latter 

were issued that year. 

To estimate the amount of new bonds issued specifically 

for colleges and universities, CBO analyzed all informa

tion returns submitted to the IRS for bonds issued on 

behalf of 501(c)(3) organizations in 2003.12 That year, 

bonds issued on behalf of institutions of higher learning 

accounted for just under $6 billion of the $14 billion in 

new issues for nonhospital 501(c)(3) organizations. 

Including hospitals, total issues for all 501(c)(3) organiza

tions were about $24 billion that year, while all tax

exempt privateactivity issues totaled $46 billion. 

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

0

50

100

150

200

250

300

Governmental Issues

All Other Private-Activity Issues

Private-Activity Issues: Nonhospital 501(c)(3) Entities

12. Although data from more recent years are now available, the 

most current data available when CBO undertook this analysis 

were for 2003.
TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES 5

CBO

Table 1.

Uses of Proceeds from Tax-Exempt 

Bonds Issued on Behalf of 

Colleges and Universities, 2003

Source: Congressional Budget Office based on data provided by 

issuing authorities in nine states.

Notes: The number of issues in the various categories adds to more 

than 105 and the percentage of issues in each category adds 

to more than 100 percent because many projects span 

multiple categories.

n.a. = not applicable.

Since those data were collected, the market for tax

exempt bonds issued by institutions of higher learning 

and the value of the assets that those institutions hold 

have been greatly affected by the financial crisis that 

began in 2007. Interest rates for taxexempt debt rose 

sharply during that period, and issues by colleges and 

universities have probably declined since the crisis began. 

However, there are signs that the pressures created by the 

financial crisis are beginning to ease. In particular, the 

difference between interest rates on taxexempt debt and 

those on shortterm Treasury bonds—a standard measure 

of the risk premium that investors require in order to 

hold the bonds—has fallen. The liquidity problems that 

some borrowers face may decrease the use of certain types 

of shortterm debt, but that decrease seems unlikely to 

have a permanent effect on the availability of credit for 

longterm capital needs. Because of widespread declines 

in asset prices, educational endowments have fallen in 

value considerably from their peak, but they retain some 

of the benefit from previous years of growth. This analy

sis is intended to capture the effect of broadening the 

definition of tax arbitrage in the long term rather than 

the effects of the recent disruptions in financial markets. 

CBO also collected data on projects that were financed 

by taxexempt bonds issued on behalf of institutions of 

higher learning from issuing authorities in nine states in 

2003, covering $2.3 billion in issues (about 40 percent 

of all issues in that year). The most common use of 

proceeds from taxexempt bonds issued on behalf of col

leges and universities in 2003 was for maintenance proj

ects, such as improved heating and cooling systems, and 

safety enhancements, such as sprinkler systems. About 

43 percent of all bond issues involved such projects. (Pro

ceeds from a single issue may be used for projects in mul

tiple categories; see Table 1.) About the same number of 

bond issues (40 percent) involved the construction and/

or expansion of academic buildings; the next most com

mon use (nearly 30 percent) was for the construction 

and/or expansion of residence halls. The use of bond 

proceeds for athletic facilities, student centers, or the pur

chase of equipment was considerably less common.

Advantages and Disadvantages of Tax-Exempt Bonds

Compared with other ways the federal government could 

choose to subsidize colleges and universities, taxexempt 

bonds have both advantages and disadvantages. Because 

nonprofit institutions of higher learning are exempt from 

the income tax, any further subsidy through the tax code 

must be indirect, which leads to one disadvantage. The 

taxexemptbond subsidy is routed through investors, 

who are willing to accept a rate of return on a taxexempt 

bond that is lower than the return on a taxable bond by 

the amount they would have to pay in taxes on income 

from the taxable bond. As long as the supply of tax

exempt bonds exceeds the demand from taxpayers in the 

highest income tax bracket, the market interest rate on 

such bonds needs to fall below the rate on taxable bonds 

only by enough to induce taxpayers in a lower tax bracket 

to also hold the bonds; that rate is higher than what 

would be necessary to attract investors in the highest tax 

bracket. Therefore, investors in the highest bracket 

receive the interest taxfree at their higher marginal tax 

rate, retaining some of the value of the subsidy rather 

than passing it on to the issuer of the bonds. 

Another disadvantage is that, in contrast with federal 

spending programs, tax expenditures—including for

gone revenues on taxexempt bonds—are not explicitly 

42 40

Residence halls 34 32

Student centers 8 8

Athletic facilities 11 11

Equipment 10 10

Maintenance/Safety 45 43

Total 105 n.a.

Construction and/or

Expansion of Buildings

Academic buildings

Number of

Issues

Percentage of

Issues
6 TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES

CBO

identified in the budget.13 Also, unlike discretionary 

spending programs, they are not governed by the annual 

appropriation process. Thus, the federal government 

does directly control the issuance of taxexempt bonds, 

which is determined by state and local issuers in 

accordance with federal rules on the total volume and 

type of issue. Though state and local governments may be 

better equipped to identify beneficial capital investments 

by their local institutions, delegating decisionmaking 

power away from the federal government increases the 

probability that bond issues will be evaluated on the basis 

of their benefit to the locality, rather than to the federal 

taxpayers who finance the subsidy. 

One advantage to using taxexempt bonds as the means 

for offering a subsidy is that they provide a standard 

framework through which educational institutions can 

access capital markets. Access to the taxexemptbond 

market may increase the availability of bond financing for 

some educational institutions, although the schools most 

likely to be affected by the expanded definition of arbi

trage discussed in this study have investmentgrade credit 

ratings and therefore probably would be able to obtain 

funding in the taxablebond market. 

The use of taxexempt bonds also affects the allocation of 

resources. The lower cost of financing for projects funded 

by taxexempt bonds diverts resources toward those proj

ects and away from other activities. Whether that is an 

advantage or a disadvantage depends in part on whether 

the subsidized investment would have been undertaken 

even in the absence of the subsidy. On the one hand, if 

colleges and universities use taxexempt financing for 

projects that they would complete even without the sub

sidy, resources are just reallocated from taxpayers to the 

schools with no additional social benefit. On the other 

hand, if the subsidy finances capital projects that would 

not otherwise have been undertaken and that create a 

social benefit in addition to the benefit to the institution, 

it could improve the nation’s overall welfare. 

Direct and Indirect Tax Arbitrage

Because the purchasers of taxexempt bonds do not pay 

income tax on the interest those bonds earn, they are 

willing to accept a lower rate of interest than they would 

otherwise earn on taxable bonds of comparable risk and 

maturity. That yield differential presents an opportunity 

for some issuers of taxexempt debt to engage in tax 

arbitrage—borrowing with taxexempt debt and invest

ing the proceeds in higheryielding taxable assets. Those 

who meet the criteria for borrowing using taxexempt 

bonds—whether qualified 501(c)(3) organizations or 

state and local government entities—have an added 

incentive because they do not pay tax on their net 

income, regardless of whether it is from an operating 

surplus (the excess of revenue over cost) or from invest

ment income. The higher return on those taxable assets 

not only finances the lower interest cost of the taxexempt 

debt but also provides untaxed earnings to be used for 

other purposes.

To restrict such activity, the tax code specifies that 

“arbitrage bonds” are not taxexempt. Section 148 of 

the IRC defines an arbitrage bond as “any bond whose 

proceeds are reasonably expected to be used directly or 

indirectly to acquire higheryielding investment assets 

or to replace funds which were used directly or indirectly 

to acquire higheryielding securities.”14 The tax code has 

provisions that prevent the direct diversion of bond pro

ceeds away from investment in physical capital to the 

earning of investment income. In general, those provi

sions allow earnings from tax arbitrage only for tempo

rary periods before the proceeds are needed to fund the 

project for which they were designated or for specific 

types of investments such as reserve funds. (Such funds 

typically contain a portion of the proceeds from a bond 

issue that is set aside to pay debt service in case the 

expected sources of funds for that purpose are not avail

able). Outside of those limited exceptions, however, 

any earnings from tax arbitrage must be rebated to the 

Treasury. 

The Treasury regulates arbitrage using a “replacement 

proceeds rule” that requires the yield to be restricted 

on any investment assets or other amounts that have a 

connection (nexus) to a taxexemptbond issue that is 

sufficiently direct for one to conclude that, in the absence 

of proceeds from taxexempt borrowing, the assets or 

13. The Administration provides estimates of tax expenditures in the 

Analytical Perspectives volume of the budget. See Office of Man

agement and Budget, Analytical Perspectives, Budget of the U.S. 

Government, Fiscal Year 2011, Chapter 16. The Joint Committee 

on Taxation also reports annually on tax expenditures. See Joint 

Committee on Taxation, Estimates of Federal Tax Expenditures 

for Fiscal Years 2009–2013, JCS110 (January 11, 2010). 14. Internal Revenue Code, 26 U.S.C. 148(a). 
TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES 7

CBO

amounts would have been used to finance the project.15

For example, if a school uses securities as collateral for 

its debtservice obligation on a taxexempt bond, the 

securities are treated as replacement proceeds subject to 

yield restriction. The Treasury restricts the yield on 

investment assets in one of two ways. Under one method, 

the borrower may be required to return to the federal 

government any excess yields earned on an amount of 

assets that is equal to the value of the taxexempt bonds 

issued.16 (Excess yields are defined as earnings that exceed 

the interest paid on the bond.) Under a second method, 

the borrower may be required to sell an amount of assets 

that is equal in value to the bonds issued and to invest 

that money in a specially designed Treasury debt instru

ment that earns a discounted return to offset the federal 

government’s implicit contribution to the return on the 

taxexempt bonds.

Those provisions do not eliminate all opportunities for 

tax arbitrage, however. Because financial statements typi

cally do not report the use of particular assets as collateral, 

the replacement proceeds rule is difficult to enforce. In 

addition, if assets are not specifically pledged to pay the 

debt service on a taxexempt bond or if the assets have no 

other direct connection to the bonds, the arbitrage 

restrictions do not apply. However, it is widely recognized 

that assets and their earnings can be used to pay the inter

est on debt or to cover other expenses to free up funds for 

interest payments, regardless of whether they are directly 

pledged to do so.17 Such use of higheryielding assets to 

finance taxexempt debt constitutes indirect tax arbitrage.

The limited scope of the tax code’s restrictions on arbi

trage is not unique to colleges and universities. It applies 

equally to other nonprofit institutions, such as nonprofit 

hospitals, which have sizable financial assets. For all such 

institutions, the current tax arbitrage rules ensure that a 

bond issue is associated with the acquisition of new capi

tal, and they reduce its cost. Nonetheless, a change in the 

rules that broadened the definition of tax arbitrage would 

identify bonds earning arbitrage profits on the basis of 

the total assets that were implicitly available as collateral 

rather than requiring a direct relationship between pro

ceeds from taxexempt bonds and investment assets 

explicitly pledged as collateral. That expanded definition, 

which would encompass indirect tax arbitrage, would 

decrease the value of the federal subsidy that is currently 

available to institutions of higher learning through tax

exemptbond issues and reduce the net cost of the tax 

exemption to the federal government. 

Approaches to Measuring the Extent of 

Indirect Tax Arbitrage

Determining the degree to which colleges and universities 

benefit from the practice of indirect tax arbitrage requires 

data on the volume of new and outstanding issues of tax

exempt bonds and on the value of investment assets held 

by those institutions of higher learning. CBO collected 

data on assets and liabilities from IRS information 

returns (specifically, Forms 990 and 8038), adjusting the 

data to account both for the misreporting of taxexempt 

liabilities and for the presence of assets held by other 

organizations for the use of colleges and universities (see 

Box 1). To estimate the extent to which indirect tax arbi

trage occurs, CBO compared an institution’s outstanding 

bond issues (bonds that have not been completely retired) 

or new bond issues with the value of its existing invest

ment assets. If an institution held assets that were greater 

in value than its holdings of either outstanding or new 

bond issues, those bond issues were classified as earning 

returns from tax arbitrage. Presumably, the school chose 

to use taxexempt debt to finance capital projects rather 

than selling investment assets because it could earn a rate 

of return on those assets that was higher than the interest 

it was obligated to pay on the bonds. If the dollar value of 

investment assets was less than that of outstanding or new 

bond issues, only the portion of capital spending that 

could have been financed with the assets was considered 

to be earning arbitrage profit. CBO also calculated esti

mates of tax arbitrage allowing some investment assets to 

be set aside in a reserve that would be exempt from the 

broader definition of arbitrage. 

Investment Assets and Tax-Exempt Debt

Colleges and universities in aggregate hold investment 

assets that are significantly higher in value than the stock 

of outstanding taxexempt bonds, although the distribu

tion of both is highly skewed. That relationship holds 

both for amounts reported on IRS Form 990 returns and 

15. Treas. Reg., 26 C.F.R. 1.1481(c).

16. Such payments must be made every five years during the life 

of the issue, with the first payment made no later than five years 

after the issue date of a bond. If the computation in later years 

shows no arbitrage profit because the yield on restricted assets 

has declined, previous payments are refunded to the issuer.

17. It is also standard practice for rating agencies to base credit ratings 

for a particular debt issue on all available assets, not just on those 

directly pledged to that debt issue.
8 TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES

CBO

Box 1.

Estimating the Extent of Indirect Arbitrage Practiced by 

Colleges and Universities

As nonprofit entities, institutions of higher learning 

must file Form 990 information returns with the 

Internal Revenue Service (IRS) on an annual basis 

that provide data from their balance sheets on reve

nues, expenses, liabilities, and assets. The Congressio

nal Budget Office (CBO) used information from 

a sample of those returns, which are available from 

the IRS, to calculate the investment assets and out

standing stock of taxexempt debt—weighted to be 

representative of all schools that filed Form 990 

returns in 2003. CBO also used Form 990 returns 

from the IRS sample, supplemented by additional 

Form 990 returns from the National Center for 

Charitable Statistics (NCCS) at the Urban Institute, 

to calculate the investment assets and outstanding 

stock of taxexempt bonds for each institution that 

issued new taxexempt debt in 2003. To identify the 

latter group, CBO used information from Form 8038 

information returns, which all issuers of taxexempt 

debt are required to file annually. Those returns were 

then used to estimate the volume of taxexempt bor

rowing by institutions of higher learning in 2003. 

CBO found that Form 8038 returns were filed for 

324 bond issues made on behalf of colleges and uni

versities. Of those, 58 were classified as “refunding” 

bonds that refinanced debt already issued in previous 

years. Proceeds from the remaining 266 bond issues, 

which amounted to about $6 billion, were distrib

uted to 274 institutions (some bonds were issued 

on behalf of more than one organization). Of those 

274 institutions, CBO was able to identify and 

match 251 with information culled from Form 990 

returns (obtained either from the IRS sample or from 

the NCCS). Those 251 institutions received $5.7 bil

lion, or 94 percent, of all proceeds from taxexempt 

bonds issued on behalf of higher education in 2003.

One difficulty with measuring taxexempt debt is 

that, when filing Form 990 returns, institutions often 

misallocate balancesheet information on taxexempt 

liabilities. In an earlier study of taxexempt bonds 

issued on behalf of nonprofit hospitals, CBO found 

that the majority of taxexemptbond liabilities were 

misreported as “mortgages and other notes payable” 

on Form 990 returns.1

 Issuers of taxexempt bonds 

for educational institutions confirmed that such mis

reporting is present in returns for colleges and univer

sities as well. In many cases, schools consider the pro

ceeds of an issue as a loan from the issuing authority 

rather than as a taxexempt liability. CBO therefore 

adjusted the stock of taxexempt bonds reported on 

Form 990 returns to account for that misreporting 

using the factors estimated in CBO’s earlier study of 

hospitals.2

In some cases, the value of investment assets reported 

on Form 990 returns for institutions listed as the 

receiver of bond proceeds underestimated the true 

value of investment assets available to the institution. 

For public universities, particularly those with large 

endowments, the majority of investment assets are 

held not by the university, but by a foundation dedi

cated to the support of the institution and separately 

incorporated as a public charity. That separation 

allows statesupported institutions to exercise greater 

control over their endowment assets. Of the group 

of 251 borrowers, CBO was able to identify 27 insti

tutions that held assets in other 501(c)(3) organiza

tions. CBO adjusted their stock of investment assets 

and taxexempt liabilities to reflect the assets and 

liabilities of those related organizations.

1. See Congressional Budget Office, Nonprofit Hospitals and 

Tax Arbitrage, letter to the Honorable William M. Thomas 

(December 6, 2006). In its analysis, CBO found that for 

those institutions reporting no taxexempt liabilities, 

99.6 percent of their reported mortgage liabilities were tax

exempt liabilities. When an institution reported both tax

exempt liabilities and mortgages, on average, 84 percent of 

mortgage liability was actually taxexemptbond liability.

2. When an institution reported no taxexempt liabilities, CBO 

reclassified all mortgage liabilities as taxexempt liabilities. 

When an institution reported both taxexempt liabilities and 

mortgages, CBO reclassified 84 percent of mortgage liability 

as taxexemptbond liability. Such adjustment results are 

presented in the appendix.
TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES 9

CBO

Table 2.

Selected Assets and Liabilities Held by Colleges and Universities, 2003

(Millions of dollars)

Source: Congressional Budget Office based on data from information returns (Forms 8038 and 990) filed with the Internal Revenue Service.

Notes: Investment assets include publicly and privately held securities as well as land and buildings held for investment purposes, net of 

accumulated depreciation.

Tax-exempt debt is frequently misreported as “mortgages and other notes payable.” If no tax-exempt debt is reported, the adjusted 

stock of tax-exempt debt includes all mortgages reported by the institution. If both tax-exempt debt and mortgages are reported, 

the adjusted stock of tax-exempt debt includes 84 percent of mortgages reported.

The value of investment assets reported on a school’s Form 990 return does not include any assets in related organizations dedicated 

to the support of the institution and separately incorporated as a public charity. Of the group of 251 borrowers, CBO was able to 

identify 27 institutions that held assets in other 501(c)(3) organizations and adjusted their stock of investment assets and tax-exempt 

liabilities to reflect the assets and liabilities of those related organizations.

n.a. = not applicable.

a. CBO identified related organizations just for new borrowers in 2003.

for those amounts adjusted to correct for misreporting 

(see Box 1). Colleges and universities reported about 

$260 billion in total investment assets and about 

$45 billion in liabilities for taxexempt bonds in 2003 

(see Table 2). After adjusting for misreporting, CBO 

estimated that the outstanding stock of taxexempt debt 

was about $60 billion. The median amount of invest

ment assets reported on Form 990 returns for 2003 was 

about $4 million (that is, half of the institutions had 

more than $4 million in assets and half had less), and the 

median amount of taxexempt debt was zero. With 

adjustments for misreporting, the median stock of tax

exempt debt increased to about $2 million. 

The subset of schools that borrowed using taxexempt 

debt in 2003 also had total investment assets that far 

exceeded taxexempt liabilities. Those schools’ total 

investment assets, at about $150 billion, were nine times 

larger than the total reported stock of outstanding tax

exempt bonds and seven times larger than the total 

adjusted stock of outstanding taxexempt bonds. The 

median school that borrowed in 2003 had an estimated 

$39 million in investment assets. The median stock of 

taxexempt liabilities was about $22 million for schools 

that borrowed in 2003, about 40 percent less than the 

median amount of investment assets. 

Within the group of 2003 borrowers, the distributions of 

investment assets and taxexempt bonds were highly 

skewed (see Figure 2). The top 10 schools that borrowed 

in 2003, ranked by investment assets, made up about 

4 percent of the sample but held almost 75 percent of the 

total amount of investment assets held by the entire 

group. The top 50 schools that borrowed in 2003, ranked 

by investment assets, made up about 20 percent of the 

sample but held about 95 percent of total investment 

assets. The group of institutions with the largest share of 

investment assets had also issued a substantial share of the 

taxexempt bonds, but the distribution of the bond issu

ances was less skewed. The top 10 schools that borrowed

Net Investment Assets (Unadjusted) 262,151 4 151,053 37

Net Investment Assets (Adjusted) a a 152,324 39

Outstanding Tax-Exempt Debt (Reported) 44,326 0 16,901 10

Mortgage Debt (Reported) 17,524 1 5,935 3

Outstanding Tax-Exempt Debt (Adjusted) 60,442 2 22,199 22

New Bond Issues n.a. n.a. 5,703 10

Number of Institutions 913 n.a. 251 n.a.

Institutions that 

Memorandum:

Total Median Total Median

All Institutions Borrowed in 2003
10 TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES

CBO

Figure 2.

The Distribution of Investment Assets and Outstanding Tax-Exempt Bonds 

Held by 251 Colleges and Universities in 2003

(Percent)

Source: Congressional Budget Office.

Notes: In an earlier study of tax-exempt-bond issues made on behalf of nonprofit hospitals, CBO found that the majority of tax-exemptbond liabilities were misreported as “mortgages and other notes payable” on Form 990 returns (see Congressional Budget Office, 

Nonprofit Hospitals and Tax Arbitrage, letter to the Honorable William M. Thomas, December 6, 2006). Issuers of tax-exempt bonds 

for educational institutions confirmed that such misreporting is present in returns for colleges and universities as well. CBO therefore 

adjusted the stock of tax-exempt bonds reported on Form 990 returns to account for that misreporting using the factors estimated 

in the earlier study. 

Some public schools hold assets in separate 501(c)(3) foundations dedicated to the support of the institution. CBO adjusted the

amount of investment assets held by 27 institutions to reflect such assets held by foundations.

in 2003 accounted for about 40 percent of the out

standing value of such bonds, and the top 50 accounted 

for almost 75 percent of the outstanding value. 

The majority of outstanding taxexempt bonds were held 

by schools with substantial investment assets, which 

would probably allow them to borrow even if taxexempt 

borrowing was not an option. This suggests that, as cur

rently implemented, the subsidy is not used primarily to 

ease access to financial markets for schools that would 

otherwise have difficulty undertaking capital projects.

Possible Approaches to Expanding the Definition of 

Tax Arbitrage 

Any specification of the investment assets that would be 

covered under an expanded definition of tax arbitrage 

should account for the legitimate role that such assets 

play in the operation of colleges and universities. Those 

institutions accumulate investment assets for a variety of 

reasons: to earn income to fulfill the purposes that qualify 

them for taxexempt status; to protect against uncer

tainty; to obtain a stronger credit rating; to enhance their 

reputation; and to honor gift restrictions. Some of those 

reasons suggest that certain investment assets should not 

be counted when measuring earnings from tax arbitrage.

The need to maintain an operating reserve is one ratio

nale for allowing an institution to hold some investment 

assets while issuing taxexempt bonds. One possible rea

son for accumulating substantial operating reserves is to 

maintain spending levels as income from endowments 

and other sources of revenue fluctuate; but, in practice, 

most schools follow selfimposed spending rules that 

limit such “smoothing” and mandate spending reduc

tions when income falls. Another possible reason is that 

rating agencies offer higher credit ratings as the ratio of 

expendable financial resources (which include operating 

reserves) to yearly expenses increases, and those higher

1 to 10 11 to 50 51 to 100 101 to 150 151 to 200 201 to 251

0

10

20

30

40

50

60

70

80

Institutions Ranked According to Reported Investment Assets

Investment Assets (Adjusted)

Outstanding 

Stock of 

Tax-Exempt 

Bonds 

(Adjusted)
TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES 11

CBO

ratings lead to lower costs for borrowing.18 A comparison 

of investment assets and annual expenses shows that, by 

rating agencies’ standards, many schools that borrowed in 

2003 appear to have substantial operating reserves. For 

instance, the median ratio of investment assets to annual 

expenses was 1 for schools that borrowed in 2003; that is, 

investment assets were equal to about a year’s worth of 

expenses. (That ratio ranged from a high of 89.5 to zero.) 

Some investment assets held by colleges and universities 

are subject to restrictions by the donor. Because educa

tional institutions cannot use such assets for purposes 

other than those specified by the donor, it could be 

argued that those assets should not be included when 

measuring earnings from tax arbitrage. It might be possi

ble, however, to implement a broader measure of tax arbi

trage without forcing schools to violate most of those 

restrictions. For instance, if a donor restricted a gift to an 

academic institution’s endowment—that is, specified that 

the gift be used to generate future earnings rather than to 

help pay for current operating expenses—the require

ment, under a broader measure of arbitrage, that earnings 

on the gift be rebated if they exceeded the interest paid on 

a taxexempt bond would not necessarily violate the 

donor’s restriction. The gift itself would not be used to 

purchase the asset financed by the bonds; only the earn

ings on the gift would be affected.19 In cases where the 

donor directed that a gift (but not the earnings on that 

gift) be used for a specific purpose, similar reasoning 

would apply. Even in cases where the donor directed that 

both the gift and its earnings be used for a specific pur

pose, many restricted purposes—research, certain types of 

academic support, athletics—would be consistent with 

using earnings on that gift to finance the construction 

of academic and athletic buildings, laboratory facilities, 

and libraries.20

Another consideration is that exempting restricted gifts 

from an expanded definition of tax arbitrage would 

strengthen the incentive for schools to pursue restricted 

gifts. Colleges and universities frequently cite restrictions 

on gifts as one reason they require federal subsidies for 

other types of spending that are less preferred by donors 

or to justify their taxexempt endowments’ freedom from 

federally mandated spending requirements such as those 

that apply to charitable foundations. Currently, schools 

must weigh the support that additional restricted gifts 

lend to those arguments against the fact that unrestricted 

gifts allow the institution more flexibility in setting bud

getary priorities and eliminate the possibility of later dis

agreement between donor and institution regarding the 

use of a gift.21 Explicitly exempting restricted gifts from 

the calculation of tax arbitrage under an expanded defini

tion would increase the attractiveness of restrictions to 

schools, but encouraging such restrictions could reduce 

the social benefit of charitable giving—for instance, 

individual donors may impose restrictions on gifts that 

diminish the public benefits that a school provides.22

To reflect schools’ legitimate need for investment assets, 

CBO calculated measures of tax arbitrage that would 

allow some investment assets to be set aside in a reserve 

that, by definition, could not earn returns from tax arbi

trage. In calculating those measures, the value of invest

ment assets considered in the arbitrage calculation was 

reduced by an amount equaling one year’s operating 

expenses—the median amount of investment assets held 

by schools issuing debt in 2003. CBO did not separately 

adjust the arbitrage estimates for investment assets subject 

to restricted uses; reliable data on the type and strength of 

18. According to Moody’s Investors Service, the median ratio of 

unrestricted net resources to expenses was 0.9 in 2006. See Private 

College and University Medians 2007 (New York: Moody’s 

Investors Service, May 2007).

19. According to a survey conducted by the National Association of 

College and University Business Officers, about 60 percent of the 

assets in college and university endowments in 2003 were 

restricted to incomegenerating purposes.

20. Although no data exist that detail the exact purposes of accumu

lated restricted endowment assets, the Council on Aid to Educa

tion collects information on the restricted purposes of current gifts 

to school endowments. In 2008, the most common restriction for 

endowment gifts was for student financial aid, accounting for 

34 percent of restricted giving. Athletics and academic depart

ments each accounted for about 20 percent of restricted gifts to 

endowments.

21. Disagreements about such restrictions have increasingly resulted 

in costly legal battles between schools and donors. (See John 

Hechinger, “New Unrest on Campus as Donors Rebel,” Wall 

Street Journal, April 23, 2009). In the most prominent example of 

such a dispute, a donor’s heirs filed a lawsuit against Princeton 

University’s Woodrow Wilson School of Public and International 

Affairs, alleging that the school was not using a large donation 

dating to 1961 in accordance with the donor’s intent. Princeton 

paid a settlement of $100 million to end the ligation, which had 

stretched on for six years.

22. See Burton A. Weisbrod, Jeffrey P. Ballou, and Evelyn D. Asch, 

Mission and Money: Understanding the University (New York: 

Cambridge University Press, September 2008), p. 121.
12 TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES

CBO

restrictions that apply to existing endowments are not 

available.23

Measuring the Volume of Arbitrage Bonds Under a 

Broader Definition of the Term

CBO used two main measures to determine how much of 

the value of outstanding bonds issued by colleges and 

universities and their new taxexempt borrowing could be 

considered to earn returns from tax arbitrage under a 

broader definition of the term. Each approach compared 

an institution’s investment assets with a measure of its 

taxexemptbond liability. With the “historical” measure, 

CBO considered only the outstanding stock (in 2003) 

of previously issued bonds. According to that backward

looking measure, if the value of a college’s or university’s 

investment assets exceeded the value of the institution’s 

outstanding stock of taxexempt bonds, all the bonds 

were classified as earning returns from tax arbitrage. If the 

value of the stock of taxexempt bonds exceeded the value 

of the investment assets, the volume of bonds equal to the 

value of the investment assets was classified as earning 

arbitrage profit.

The second, more forwardlooking, measure of tax arbi

trage considered the position of colleges and universities 

in the years immediately following an expansion of the 

definition of arbitrage. That “firstyear” measure com

pared an institution’s new issues of taxexempt bonds in 

2003 with its stock of investment assets that year. Under 

the firstyear measure, if the value of investment assets 

exceeded the value of the new bond issues, all of the 

bonds were classified as earning arbitrage profit. If the 

value of the new issues of bonds exceeded the value of the 

institution’s investment assets, the amount of the new 

issues that was equal in value to the investment assets was 

considered to be earning profit from tax arbitrage. In the 

first few years after the implementation of such a policy, a 

relatively large share of new issues would probably be 

considered arbitrage bonds because the amount of invest

ment assets newly available for yield restriction would 

be large compared with new issues in any single year. 

Analogous to an estimate of tax expenditures, the first

year measure is not meant to capture all of the ways in 

which issuers might respond to a change in the definition 

of tax arbitrage. It does, however, capture the immediate 

effect of broadening that definition.24

Estimated Volume of Arbitrage Bonds 

Under a Broader Definition of the 

Term

A substantial portion of the taxexempt debt issued by 

colleges and universities is outstanding at the same time 

those institutions hold higheryielding investment assets. 

Such debt would earn profit from tax arbitrage under an 

expanded definition of the term that considered all 

investment assets, not just those directly related to the 

taxexempt debt. CBO’s analysis indicates the following:

B If no reserve was allowed, close to 100 percent of the 

outstanding taxexempt debt would be classified as 

earning full or partial returns from arbitrage under 

the broader definition. If schools were allowed to 

exempt investment assets equal to one year’s operating 

expenses as a reserve, 72 percent of the currently out

standing debt would be earning full or partial returns 

from arbitrage. 

B Considering only new issues, the share of debt with 

full or partial arbitrage profit would be about 99 per

cent if no assets were set aside in a reserve and about 

75 percent if a reserve equal to one year’s expenses was 

allowed. 

23. Of the 251 schools that borrowed in 2003, 238 provided informa

tion on temporary and permanent restrictions on their total net 

assets. About 55 percent of all net assets were under permanent 

restriction and 24 percent were under temporary restriction. No 

information is available on the nature of the restrictions. 

24. CBO also calculated a related measure of arbitrage bonds, not 

reported in the tables, based on both outstanding bonds and new 

issues. If schools continued to use taxexempt debt to finance cap

ital projects and accumulate investment assets as they have in the 

past, their new bond issues would tend to exhaust the assets sub

ject to yield restriction, lowering the share of new issues that 

would be earning arbitrage profits in later years.If that was the 

case, the current balance between the stock of investment assets 

and the outstanding stock of taxexempt bonds would remain the 

relationship between the two. Under that assumption, another 

way to estimate the amount of 2003 issues that would be consid

ered arbitrage bonds would be to measure the new bond issues 

against the investment assets that remained after the outstanding 

stock of previously issued bonds was applied to those assets. By 

that measure, if the value of a new bond issue was less than the 

difference between investment assets and the outstanding stock of 

taxexempt debt, the issue was classified as earning tax arbitrage. If 

a new issue was greater than the residual investment assets, the 

amount of the issue equal to residual investment assets was classi

fied as earning returns from arbitrage. By this definition, the pro

portion of debt that would be earning tax arbitrage was lower than 

that under the first year measure, by about 10 percentage points.
TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES 13

CBO

Table 3.

Tax-Exempt Debt Classified as Earning Profits from Arbitrage in 2003

Under a Broader Definition of the Term

(Percent)

Source: Congressional Budget Office based on information returns (Forms 8038 and 990) filed with the Internal Revenue Service by

institutions that borrowed in 2003.

Note: * = less than 0.1 percent.

a. The total volume of tax-exempt bonds issued as a percentage of net investment assets (adjusted for misreporting).

b. Estimated volume of tax-exempt bonds in the first year under a broader definition of tax arbitrage (approximated by the volume in 2003) 

as a percentage of net investment assets (adjusted for misreporting).

c. Issues held contemporaneously with investment assets lower in value than the total issue. 

Most of the debt that would be classified as earning 

returns from arbitrage is held by the schools that have the 

largest stocks of investment assets. Compared with 

CBO’s previous estimates of the volume of arbitrage 

bonds held by nonprofit hospitals, institutions of higher 

learning hold considerably more debt that would be 

classified as earning returns from arbitrage under a 

broader definition. 

Estimated Amount of Arbitrage Debt

The historical measure applies the broader definition 

of arbitrage to already outstanding taxexempt debt. 

Although the measure does not directly address the effect 

of a policy change—because such a change would affect 

only future issues—it provides a useful starting point 

for comparing the outstanding stock of taxexempt debt 

with investment assets. Using data corrected both for 

misclassified taxexempt debt and for underestimates 

of investment assets owned by institutions that hold 

assets in foundations, CBO found that in 2003 close to 

100 percent of the $22 billion in previously issued tax

exempt debt would be classified as earning returns from 

arbitrage under the broader definition (see Table 3).25 In 

other words, almost all of the outstanding debt was issued 

by schools that also held higheryielding investment 

assets. Furthermore, the majority of the debt that would 

be classified as arbitrage debt was fully arbitraged—that 

is, almost all of it was issued by schools that held invest

ment assets greater in value than their outstanding stock 

of bonds. In the first years after an expansion of the defi

nition of arbitrage, a high proportion of new issues would 

be subject to yield restriction because accumulated invest

ment assets are large relative to any single year’s issues. In 

2003, about 99 percent of new bond issues would have 

been considered to be earning profit from tax arbitrage 

under a broader definition.

100 99 72 75

Full Arbitrage 90 84 60 56

Partial Arbitragec 10 14 12 19

* 1 28 25

22,199 5,703 22,199 5,703

as a Reserve

Historical First-Year Historical First-Year

Memorandum:

Total Tax-Exempt Debt

(Millions of dollars)

Broader Definition

Broader Definition

Debt Not Classified as Earning

 

 No Assets Set Aside 

Measurea Measureb Measurea Measureb

Assets Set Aside 

as a Reserve

Debt Classified as Earning 

Arbitrage Profits Under a

Arbitrage Profits Under a

25. The appendix presents alternative calculations of bond holdings 

that would earn profits from tax arbitrage under a broader defini

tion using no adjustments for misreporting taxexemptbond 

liability or for assets held by supporting organizations.
14 TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES

CBO

Table 4.

Colleges and Universities Conducting Tax Arbitrage in 2003 Under a 

Broader Definition of the Term

(Percent)

Source: Congressional Budget Office based on information returns (Forms 8038 and 990) filed with the Internal Revenue Service by

institutions that borrowed in 2003.

a. Total volume of tax-exempt bonds issued as a percentage of net investment assets (adjusted for misreporting).

b. Estimated volume of tax-exempt bonds in the first year under a broader definition of tax arbitrage (approximated by the volume in 2003) 

as a percentage of net investment assets (adjusted for misreporting).

c. Issues held contemporaneously with investment assets lower in value than the total issue.

The amount of debt that earns returns from arbitrage falls 

when some assets are set aside as an exempt reserve. Using 

the historical measure (which compares the outstanding 

stock of taxexempt bonds to investment assets not set 

aside for a reserve), the amount of debt earning arbitrage 

profits in 2003 fell to about $16 billion, or about 

72 percent of the stock of outstanding taxexempt debt. 

For issues in 2003, about 75 percent of new taxexempt

bond issues would be classified as earning returns from 

tax arbitrage under a broader definition that allowed an 

exempt reserve equal to one year’s expenses.26

The Distribution of Arbitrage Debt

The percentage of institutions engaging in the practice 

of tax arbitrage is generally lower than the percentage of 

debt that generates arbitrage profits because the 50 

institutions with the most investment assets account for a 

large share of that debt. If the expanded definition of 

arbitrage was applied to the already outstanding stock of 

taxexempt debt, about 90 percent of institutions would 

be characterized as profiting from the practice of tax 

arbitrage (see Table 4). According to the firstyear mea

sure, nearly all of the institutions issuing new debt in 

2003 would be classified as earning arbitrage profits if a 

broader definition had been in effect that year.

Even if the broader definition of arbitrage allowed col

leges and universities to set aside substantial investment 

assets in a reserve, the majority of taxexempt debt held 

by those institutions would be classified as earning 

returns from tax arbitrage, regardless of the measure used. 

Because the distribution of arbitrage earnings is not uni

form, however, if a reserve was allowed, only about half of 

the taxexempt colleges and universities that borrowed in 

2003 would be viewed as conducting arbitrage at all, 

under either measure. Under the historical measure, the 

number of institutions conducting arbitrage would fall 

89 98 44 52

Full arbitrage 66 82 31 37

Partial arbitragec 23 16 14 15

Institutions Not Conducting Arbitrage

11 2 56 48

Memorandum:

Total Institutions 251 251 251 251

Under a Broader Definition

Measurea Measureb

Institutions Conducting Arbitrage

Under a Broader Definition

Measurea Measureb

Historical First-Year Historical First-Year

No Assets Set Aside as a Reserve Assets Set Aside as a Reserve 

26. By that measure, the total amount of debt that would be classified 

as earning returns from arbitrage under a broader definition is 

about the same if the exempt reserve is calculated as 70 percent of 

investment assets rather than as one year of operating expenses. 

However, the distribution of arbitrage debt among the schools 

would differ. Defining the exempt reserve on the basis of assets 

rather than expenses lowers the amount of arbitrage debt for 

schools with assets that are large in relation to expenses and 

increases it for schools with assets that are small in relation to 

expenses. In other words, defining an exempt reserve on the basis 

of assets favors schools that have better access to taxable 

borrowing. 
TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES 15

CBO

Figure 3.

The Distribution of Tax-Exempt Debt Held by 251 Colleges and Universities in 

2003 That Would Be Classified as Earning Profits from Arbitrage Under a 

Broader Definition of the Term

(Percent)

Source: Congressional Budget Office.

Notes: CBO used two main measures to determine how much of the outstanding stock of bonds held by colleges and universities and their 

new tax-exempt borrowing could be classified as earning profits from tax arbitrage under a broader definition of the term. With the 

“historical” measure, CBO considered only the historical (outstanding) stock of previously issued bonds. The second, more forwardlooking measure considered the position of colleges and universities in the years immediately following an expansion of the definition 

of arbitrage.

Allowing some assets to escape the broader definition of arbitrage lowers the share of debt considered to be earning arbitrage profits 

by schools with lower amounts of investment assets.

from 223 to 111, or to about 44 percent of all 2003 bor

rowers, if some assets were set aside in an exempt reserve. 

Using the firstyear measure, based on the volume of new 

issues, 52 percent of institutions would have been classi

fied as engaging in arbitrage with new issues in 2003 after 

accounting for an exempt reserve. 

Broadening the definition of tax arbitrage would affect 

institutions with large holdings of investment assets more 

than institutions with fewer holdings. The majority of 

bonds that would be classified as earning arbitrage profit 

using the firstyear measure were issued by the institu

tions with the largest investment assets. The 50 borrowers 

with the largest investment asset balances (which com

prised about 20 percent of all schools that issued new tax

exempt debt in 2003) accounted for just over 60 percent 

of the bonds earning tax arbitrage (see Figure 3). If assets 

equal in value to one year’s operating expenses were set 

aside, about 80 percent of the bonds earning returns from 

arbitrage would be on behalf of the 50 borrowers with the 

largest holdings of investment assets. 

Comparison with Arbitrage Debt for Nonprofit 

Hospitals

In a previous study, CBO used similar methods to esti

mate the percentage of nonprofit hospitals and their debt 

that would be classified as earning returns from tax arbi

trage under an expanded definition.27 By every measure, a 

much larger percentage of schools than nonprofit hospi

tals would be conducting arbitrage under an expanded 

definition, and a larger share of debt issued by colleges 

and universities than debt issued by nonprofit hospitals 

would be classified as earning arbitrage profits.

Using data adjusted for misreporting, CBO found that 

about 60 percent of the outstanding stock of taxexempt 

1 to 10 11 to 50 51 to 100 101 to 150 151 to 200 201 to 251

0

10

20

30

40

50

60

70

80

Institutions Ranked According to Reported Investment Assets

Bonds Earning Arbitrage Profits Using CBO's First-Year Measure (With No Assets in a Reserve)

Bonds Earning Arbitrage Profits Using CBO's First-Year Measure (With Assets in a Reserve)

27. Congressional Budget Office, Nonprofit Hospitals and Tax 

Arbitrage.
16 TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES

CBO

bonds issued by nonprofit hospitals in 2002 had been 

issued by hospitals that contemporaneously held higher

yielding investment assets. Using the firstyear measure, 

64 percent of bonds issued by nonprofit hospitals in that 

year would be classified as earning arbitrage profits under 

a broader definition. For colleges and universities, those 

figures were close to 100 percent.

Because different criteria are used to rate hospital bonds 

and those issued on behalf of colleges and universities, 

CBO used a different method in its previous study to cal

culate the amount of assets that might reasonably be set 

aside as a reserve.28 According to those estimates, if an 

exempt reserve had been allowed under an expanded def

inition of tax arbitrage in 2002, about 33 percent of the 

outstanding stock of bonds issued by nonprofit hospitals 

would be earning arbitrage profits in that year. Under the 

firstyear measure, and assuming that an exempt reserve 

for hospitals would be allowed, CBO determined that 

32 percent of new issues of taxexempt bonds would be 

classified as earning arbitrage profits under a broader def

inition. The corresponding figures for colleges and uni

versities were over 70 percent.

Institutional Response to an Expanded Definition of 

Tax Arbitrage

Schools could adjust to a broadened definition of arbi

trage in several different ways. They could issue fewer 

bonds and reduce their capital spending. They could sell 

or reduce their stock of investment assets in order to 

finance capital spending, rather than issuing taxexempt 

debt and rebating the yield on investment assets to the 

federal government. They could also replace borrowing 

that would result in yield restriction with taxable debt. In 

all cases, the net cost of the tax preference to the federal 

government would be reduced. 

Another possibility is that decreasing the attractiveness of 

taxexempt privateactivity bonds might encourage insti

tutions of higher learning to pursue taxexempt financing 

through other channels. For example, when the Tax 

Reform Act of 1986 limited the use of privateactivity 

bonds for the financing of sports stadiums, agreements 

between local governments and sports teams led to the 

issuance of bonds specifically designed for stadium 

financing but legally considered general revenue bonds 

because they were backed by revenue from general 

sources. In those cases, the requirement that debt service 

be paid from revenues not generated by the stadium 

essentially ensured that local governments would offer 

teams very favorable lease terms and that the tax burden 

of such facilities would be shared by all local taxpayers 

rather than the users of the facility, who most benefited 

from it.29

Local governments could allow both public and private 

universities to circumvent expanded tax arbitrage rules 

for privateactivity bonds in a similar fashion. Although 

colleges and universities do not enjoy the monopoly 

power of major sports teams, many institutions of higher 

learning are large landowners and employers at the local 

level, giving them substantial negotiating power with 

local governments. Local governments could also desig

nate public schools as separate units of government for 

the purpose of issuing bonds, allowing those schools to 

issue general revenue bonds on their own. Although care

ful regulation could in theory circumvent that problem, it 

is likely that at least some issuance of taxexempt private

activity bonds would simply shift to the issuance of tax

exempt revenue bonds, limiting the revenue gain to the 

federal government.

Broadening the rule would reduce the tax preference for 

schools with large asset portfolios to a greater degree than 

it would for schools with fewer resources. Because the 

new rule would be more likely to apply to the few schools 

with very large portfolios, those schools would effectively 

face an increase in interest costs relative to schools with 

smaller portfolios. However, those schools with signifi

cant investment assets already tend to have investment

grade credit ratings, suggesting that limiting their ability 

to issue taxexempt debt would probably not prevent 

them from accessing financial markets. Whether divert

ing the taxexemptbond subsidy away from schools with 

larger endowments would be a more efficient use of 

scarce resources would depend on the marginal social 

benefit of subsidies to such schools. If the marginal social 

benefit of the subsidy decreased as endowments rose, a 

reduction in the subsidy to schools with large endow

ments could improve the allocation of the nation’s 

resources. If the marginal social benefit of the subsidy 

increased as endowments rose, a reduction in the subsidy 

to schools with large endowments would worsen resource 

allocation.

28. The reserve was set equal to 100 days of operating expenses; the 

median hospital in the sample had 117 days of cash on hand.

29. Dennis Zimmerman, “Subsidizing Stadiums: Who Benefits, Who 

Pays,” in Roger G. Noll and Andrew S. Zimbalist, eds., Sports, 

Jobs, and Taxes: the Economic Impact of Sports Teams and Stadiums, 

(Washington, DC: Brookings Institution Press, 1997), 

pp. 119–145.
CBO

Appendix: 

Alternative Calculations of Tax Arbitrage as 

Practiced by Colleges and Universities 

In the main text of this report, the Congressional 

Budget Office (CBO) calculated the extent of tax arbi

trage that colleges and universities would be practicing 

under an expanded definition of the term. To do so, 

CBO adjusted the outstanding stock of taxexempt bonds 

held by those institutions to reflect the fact that they 

often misreported such debt as mortgages and expanded 

their measured investment assets to include assets held by 

related organizations. In this appendix, CBO presents 

estimates based on the same data—taken directly from 

information returns (specifically, Form 990 returns) filed 

with the Internal Revenue Service (IRS)—but without 

making such adjustments. 

According to unadjusted data from Form 990 returns, 

which nonprofit entities are required to submit to the 

IRS on an annual basis, the percentage of previously 

issued outstanding debt that would be classified as earn

ing returns from arbitrage under a broader definition 

would be similar to the percentage produced using 

adjusted data. (In determining those percentages, CBO 

used the historical stock of previously issued bonds, 

which it terms the “historical” measure). However, 

148 institutions—slightly less than 60 percent of the 

251 schools that borrowed in 2003—had investment 

assets with a value that exceeded the reported stock of 

taxexempt liabilities, a considerably smaller percentage 

than was the case when adjusted data were used. Most of 

the additional stock of debt added by the adjustment was 

for institutions that reported no taxexempt debt at all on 

Form 990 returns; but the additional stock of bonds 

attributable to the adjustment would be small relative to 

the total stock of bonds. 

Estimates that were produced using what CBO terms the 

“firstyear” measure—which considers the position of 

colleges and universities in the years immediately 

following an expansion of the definition of arbitrage—do 

not include information on the outstanding stock of 

taxexempt bonds, so they are affected only by the adjust

ment to investment assets. Using that measure and 

unadjusted data, CBO determined that the share of debt 

earning returns from arbitrage would be slightly lower, by 

about 1 percentage point, than when adjusted data were 

used. Using that measure and unadjusted data, the num

ber of institutions conducting arbitrage would be slightly 

lower as well, by about 2 percentage points. Again, both 

the adjusted and unadjusted data show that a majority of 

the new issues of taxexempt bonds for institutions of 

higher learning would be classified as earning arbitrage 

profits after an expansion of the definition of tax 

arbitrage.