PRESEN

TO IN

HOUSE C

JOIN

NT LAW A

NFRASTR

Scheduled f

B

COMMITTE

on Oct

Prepar

NT COMMI

Octo

JC

AND ISSU

RUCTURE

for a Public H

Before the 

EE ON WAY

tober 29, 20

red by the St

of the 

ITTEE ON T

ober 24, 2008

CX-83-08 

UES RELA

E FINANC

Hearing 

YS AND ME

08 

taff 

TAXATION

8

ATED 

CE 

EANS 

N
i 

CONTENTS 

Page

INTRODUCTION AND SUMMARY ........................................................................................... 1

I. TAX-EXEMPT BONDS .................................................................................................... 3

A. Overview ...................................................................................................................... 3

B. Tax-Exempt Governmental Bonds ............................................................................... 4

C. Qualified Private Activity Bonds ................................................................................. 6

D. Rules Applicable to All Tax-Exempt Bonds .............................................................. 15

II. TAX-CREDIT BONDS .................................................................................................... 18

III. BENEFITS AND COSTS OF TAX-EXEMPT BOND AND TAX-CREDIT BOND 

FINANCING..................................................................................................................... 23

A. Tax-Exempt Bonds ..................................................................................................... 23

B. Tax-Credit Bonds ....................................................................................................... 32
1 

INTRODUCTION AND SUMMARY 

The Committee on Ways and Means has scheduled a public hearing on October 29, 2008 

on economic recovery, job creation and investment in America. Among the issues the 

Committee will consider is the ability of State and local governments to finance infrastructure 

needs. This document1

 provides a description of present law relating to tax-exempt bonds issued 

by State and local governments and a description of present law relating to tax-credit bonds, both 

of which operate to deliver a Federal subsidy to eligible borrowers, albeit by different 

mechanisms and with different degrees of efficiency. The document also provides background 

data and an economic discussion of tax-exempt bonds and tax-credit bonds. 

Tax-exempt bonds 

Interest paid on bonds issued by State and local governments generally is excluded from 

gross income for Federal income tax purposes. Because the income is excludible, investors 

generally are willing to accept a lower rate of interest on tax-exempt bonds than they might 

otherwise accept on a taxable investment. This, in turn, lowers the borrowing cost for the 

beneficiaries of such financing. 

Bonds issued by State and local governments may be classified as either governmental 

bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are 

primarily used to finance governmental functions or which are repaid with governmental funds. 

Private activity bonds are bonds in which the State or local government serves as a conduit 

providing financing to nongovernmental persons (e.g., private businesses or individuals). The 

exclusion from income for State and local bonds does not apply to private activity bonds unless 

the bonds are issued for certain permitted purposes (“qualified private activity bonds”) and other 

Code requirements are met. 

Like other activities carried out and paid for by State and local governments, the 

construction, renovation, and operation of governmental transportation infrastructure projects 

such as public highways or governmental mass commuting systems (e.g., rail and bus) are 

eligible for financing with the proceeds of governmental bonds. In addition, certain privately 

owned and/or operated infrastructure projects may be financed with qualified private activity 

bonds. 

Tax-credit bonds

Tax-credit bonds are not interest-bearing obligations. Rather, the taxpayer holding a taxcredit bond on a credit allowance date is entitled to a tax credit in lieu of an interest payment. In 

the Code, there are currently tax-credit bonds for qualified zone academies (“QZABs”), taxcredit bonds for capital expenditures relating to certain renewable energy facilities (clean 

 1

 This document may be cited as follows: Joint Committee on Taxation, Present Law and Issues 

Related to Infrastructure Finance (JCX-83-08), October 24, 2008. This document can also be found on 

our website at www.jct.gov. 
2 

renewable energy bonds “CREBs” and “New CREBs”), Gulf tax-credit bonds, Midwest taxcredit bonds, qualified energy conservation bonds, and qualified forestry conservation bonds. 

Economic discussion of tax-exempt bonds and tax-credit bonds

Tax-exempt financing provides an implicit Federal subsidy to the borrower (i.e., either 

the qualified governmental unit or the conduit borrower) but, in practice, some of the subsidy 

also redounds to the bond investor (the lender). Because interest income on the bonds is 

excluded from gross income, the bond investor is willing to accept a lower interest rate on the 

bonds than he might otherwise accept on an identical taxable investment. Thus, the borrower 

receives an implicit Federal subsidy equal to the difference between the tax-exempt interest rate 

paid and the taxable rate that otherwise would be paid. In this way, the income exclusion lowers 

the cost of capital for the State and local governments (or private parties in the case of private 

activity bonds). The bond investor also receives a Federal subsidy from tax-exempt financing 

equal to the difference between the tax-exempt interest rate and the after-tax yield on a taxable 

investment. The bond investor’s willingness to purchase tax-exempt bonds also depends on the 

bond investor’s marginal tax rate. The fact that some bond investors receive a tax benefit greater 

than the reduction in interest cost achieved by the borrower is a source of economic inefficiency 

in tax-exempt bonds. 

Under present law, the subsidy provided by tax-credit bonds is deeper than the subsidy 

for tax-exempt bonds. This is because (if the bonds are not issued at discount) the issuer of taxcredit bonds pays no interest, only principal. The “interest” is paid by the Federal Government 

in the form of tax credits. The credit is includible in gross income of the bond investor as if it 

were an interest payment on the bond, and can be claimed against regular income tax liability 

and alternative minimum tax liability. With a tax-credit bond, the bond investor’s tax saving is 

independent of his or her marginal tax rate. As a consequence, with a tax-credit bond, the loss in 

Federal receipts from the tax credit equals the reduction in the tax-credit bond issuer’s interest 

cost. 

 For most present-law categories of tax-credit bonds, the credit rate on the bonds is 

determined by the Secretary of the Treasury and is an estimate of the rate that permits issuance 

of such bonds without discount and interest cost to the qualified issuer. That is, the tax credit 

generally is chosen to approximate an interest rate subsidy of 100 percent. In the case of new 

CREBs and qualified energy conservation bonds the tax credit rate is chosen to equal 70 percent 

of the credit rate that would be provided to the other present-law tax credit bonds. 
3 

I. TAX-EXEMPT BONDS 

A. Overview 

Interest paid on bonds issued by State and local governments generally is excluded from 

gross income for Federal income tax purposes.2

 Because the income is excludible, investors 

generally are willing to accept a lower rate of interest on tax-exempt bonds than they might 

otherwise accept on a taxable investment. This, in turn, lowers the borrowing cost for the 

beneficiaries of such financing. 

Bonds issued by State and local governments may be classified as either governmental 

bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are 

primarily used to finance governmental functions or which are repaid with governmental funds. 

Private activity bonds are bonds in which the State or local government serves as a conduit 

providing financing to nongovernmental persons (e.g., private businesses or individuals). The 

exclusion from income for State and local bonds does not apply to private activity bonds, unless 

the bonds are issued for certain permitted purposes (“qualified private activity bonds”) and other 

Code requirements are met. 

Like other activities carried out and paid for by State and local governments, the 

construction, renovation, and operation of governmental transportation infrastructure projects 

such as public highways or governmental mass commuting systems (e.g., rail and bus) are 

eligible for financing with the proceeds of governmental bonds. In addition, certain privately 

owned and/or operated infrastructure projects may be financed with qualified private activity 

bonds. 

 2

 In order to be tax-exempt, such bonds must also satisfy any applicable State and local laws 

(e.g., because some States prohibit the issuance of public debt with the full faith and credit of the issuer 

for private purposes many private activity bonds are not general obligations of the issuer but revenue 

bonds). 
4 

B. Tax-Exempt Governmental Bonds and Private Activity Bonds 

In general 

Present law does not limit the types of facilities that can be financed with governmental 

bonds. Thus, State and local governments can issue tax-exempt, governmental bonds to finance 

a broad range of transportation infrastructure projects, including highways, railways, airports, 

etc. However, while the types of projects eligible for governmental bond financing are not 

circumscribed, present law imposes restrictions on the parties that may benefit from such 

financing. For example, present law limits the amount of governmental bond proceeds that can 

be used by nongovernmental persons. Use of bond proceeds by nongovernmental persons in 

excess of amounts permitted by present law may result in such bonds being treated as taxable 

private activity bonds, rather than tax-exempt governmental bonds. The Code3

 does not 

expressly define a “governmental bond.” Instead it defines a private activity bond as any bond 

that satisfies (1) the private business use test and the private security or payment test (“the 

private business test”); or (2) “the private loan financing test.”4

 Generally, private activity bonds 

are taxable unless issued as qualified private activity bonds. 

Generally, governmental bonds are not subject to restrictions that apply to bonds used to 

finance private activities. For example, governmental bonds are not subject to issuance cost, 

maturity, and annual volume limitations that generally apply to qualified private activity bonds. 

Private business test

Under the private business test, a bond is a private activity bond if it is part of an issue in 

which: 

1. More than 10 percent of the proceeds of the issue (including use of the bond-financed 

property) are to be used in the trade or business of any person other than a 

governmental unit (“private business use”); and 

2. More than 10 percent of the payment of principal or interest on the issue is, directly or 

indirectly, secured by (a) property used or to be used for a private business use or (b) 

to be derived from payments in respect of property, or borrowed money, used or to be 

used for a private business use (“private payment test”).5

 3

 Unless otherwise stated, all section references are to the Internal Revenue Code of 1986, as 

amended (the “Code”) and all regulation references are to the Treasury Regulations promulgated 

thereunder. 

4

 Sec. 141. 

5

 The 10 percent private business test is reduced to five percent in the case of private business 

uses (and payments with respect to such uses) that are unrelated to any governmental use being financed 

by the issue. 
5 

A bond is not a private activity bond unless both parts of the private business test (i.e., the 

private business use test and the private payment test) are met. Thus, a facility that is 100 

percent privately used does not cause the bonds financing such facility to be private activity 

bonds if the bonds are not secured by or paid with private payments. For example, land 

improvements that benefit a privately-owned factory may be financed with governmental bonds 

if the debt service on such bonds is not paid by the factory owner or other private parties. 

A contract between a private management or other service company and a governmental 

unit to operate bond-financed governmental facilities may result in private business use 

depending on the terms of the contract.6

 In general, a management contract gives rise to private 

business use if the compensation under the contract is based on net profits. For example, a 

management contract with respect to a commuter rail facility that compensates the management 

company based on the profits of such facility would result in private use. Contracts for service 

incidental to the facility’s primary functions, such as janitorial, office equipment repair and 

similar services, are not considered management contracts. 

For purposes of the private payment test, both direct and indirect payments made by any 

private person treated as using the financed property are taken into account. Payments by a 

person for the use of proceeds generally do not include payments for ordinary and necessary 

expenses (within the meaning of section 162) attributable to the operation and maintenance of 

financed property.7

Private loan financing test

A bond issue satisfies the private loan financing test if proceeds exceeding the lesser of 

$5 million or five percent of such proceeds are used directly or indirectly to finance loans to one 

or more nongovernmental persons. Private loans include both business and other (e.g., personal) 

uses and payments by private persons; however, in the case of business uses and payments, all 

private loans also constitute private business uses and payments subject to the private business 

test. 

 

 6

 Treas. Reg. sec. 1.141-3(b)(4). 

7

 Treas. Reg. sec. 1.141-4(c)(3). 
6 

C. Qualified Private Activity Bonds 

In general

Qualified private activity bonds are tax-exempt bonds issued to provide financing for 

specified privately used facilities. The definition of a qualified private activity bond includes an 

exempt facility bond, or qualified mortgage, veterans’ mortgage, small issue, redevelopment, 

501(c)(3), or student loan bond.8

Exempt facility bonds for infrastructure

To qualify as an exempt facility bond, 95 percent of the net proceeds must be used to 

finance an eligible facility.9

 Business facilities eligible for this financing include transportation 

(airports, ports, local mass commuting, high-speed intercity rail facilities, and qualified highway 

or surface freight transfer facilities) and privately owned and/or operated public works facilities. 

Airports

Exempt facility bonds may be issued to finance airports. Exempt facility bonds for 

airports are not subject to the State volume cap. However, all tax-exempt-bond-financed airport 

property must be governmentally owned. Property eligible for this financing includes land, 

terminals, runways, public parking facilities, and related equipment. Airplanes are not eligible 

for tax-exempt financing. Additionally, certain real property facilities (and related equipment) 

are excluded from this financing. 

Port facilities

Exempt-facility bonds may be issued to finance port (“dock and wharf”) facilities and 

related storage and training facilities. Facilities that are specifically ineligible for financing with 

airport bonds may not be financed with port bonds. Further, ships and other vessels are not 

eligible for private activity tax-exempt bond financing. All property financed with these bonds 

must be governmentally owned. Exempt facility bonds issued for ports are not subject to the 

State volume cap described below. 

Mass commuting facilities

Exempt facility bond financing for mass commuting facilities is subject to similar 

restrictions as those which apply to such bonds for airports and ports. All property financed with 

these bonds must be governmentally owned. Further, “rolling stock” (e.g., buses and rail cars) 

are not eligible for financing with exempt facility bonds. 

 8

 Sec. 141(e). 

9

 Sec. 142(a). 
7 

High-speed intercity rail facilities

The definition of an exempt facility bond includes bonds issued to finance high-speed 

intercity rail facilities.10 A facility qualifies as a high-speed intercity rail facility if it is a facility 

(other than rolling stock) for fixed guideway rail transportation of passengers and their baggage 

between metropolitan statistical areas.11 The facilities must use vehicles that are reasonably 

expected to operate at speeds in excess of 150 miles per hour between scheduled stops, and the 

facilities must be made available to members of the general public as passengers. 

Unlike other bond-financed transportation facilities, high-speed intercity rail facilities 

may be privately owned. However, if the bonds are to be issued for a nongovernmental owner of 

the facility, such owner must irrevocably elect not to claim depreciation or credits with respect to 

the property financed by the net proceeds of the issue.12

The Code imposes a special redemption requirement for these types of bonds. Any 

proceeds not used within three years of the date of issuance of the bonds must be used within the 

following six months to redeem such bonds.13

Seventy-five percent of the principal amount of the bonds issued for high-speed rail 

facilities is exempt from the volume limit.14 If all the property to be financed by the net proceeds 

of the issue is to be owned by a governmental unit, then such bonds are completely exempt from 

the volume limit. 

Qualified highway or surface freight transfer facility bonds

Present law authorizes the issuance pf tax-exempt private activity bonds to finance 

qualified highway or surface freight transfer facilities. A qualified highway facility or surface 

freight transfer facility is any surface transportation or international bridge or tunnel project (for 

which an international entity authorized under Federal or State law is responsible) which 

receives Federal assistance under title 23 of the United States Code or any facility for the transfer 

of freight from truck to rail or rail to truck which receives Federal assistance under title 23 or 

title 49 of the United States Code. 

Qualified highway or surface freight transfer facility bonds are not subject to the State 

volume limitations. Rather, the Secretary of Transportation is authorized to allocate a total of 

 10 Sec. 142(a)(11) and sec. 142(i). 

11 A metropolitan statistical area for this purpose is defined by reference to section 143(k)(2)(B). 

Under that provision, the term metropolitan statistical area includes the area defined as such by the 

Secretary of Commerce. 

12 Sec. 142(i)(2). 

13 Sec. 142(i)(3). 

14 Sec. 146(g)(4). 
8 

$15 billion of issuance authority to qualified highway or surface freight transfer facilities in such 

manner as the Secretary determines appropriate.15

Similar to the requirement for high-speed intercity rail facilities, the Code imposes a 

special redemption requirement for qualified highway or surface freight transfer facility bonds. 

Under present law, the proceeds of qualified highway or surface freight transfer facility bonds 

must be spent on qualified projects within five years from the date of issuance of such bonds. 

Proceeds that remain unspent after five years must be used to redeem outstanding bonds. 

Sewage facilities 

The Code permits the issuance of exempt facility bonds for sewage facilities. This 

includes property used for certain levels of treatment of wastewater and property used for 

collection, storage, use, processing, or final disposal of wastewater, sewage, septage. 

Water facilities

The Code permits the issuance of exempt facility bonds for water facilities. This 

provision covers facilities furnishing water that is made available to the general public, including 

electric utility, industrial, agricultural, or other commercial users. Such facilities must be 

operated by a governmental unit or the rates for sale of water must be approved by a 

governmental unit. 

Facilities for the local furnishing of electric energy or gas

The Code permits the issuance of exempt facility bonds for facilities for the local 

furnishing of electric energy or gas. This generally includes a facility furnishing electric energy 

 15 As of July 14, 2008, the Department of Transportation had made the following allocations of 

the $15 billion in qualified highway or surface freight transfer facility bond authority: 

Project Allocation 

(millions of dollars) 

Port of Miami Tunnel, Consortium Miami Access Tunnel 980.0 

Missouri DOT Safe and Sound Bridge Improvement Project 700.0 

Knik Arm Crossing, Alaska 600.0 

Virginia I-495 Capital Beltway HOT Lanes 589.0 

Texas Department of Transportation Interstate Highway 635 

(LBJ Freeway) 288.0 

Pennsylvania Turnpike Capital Improvements 2,000.0 

Ambassador Bridge Gateway Project - Phase I (Detroit, Michigan 

-Windsor, Ontario, Canada 212.6 

 Total approved allocations as of 7/14/08 5,369.6 

Source: Federal Highway Administration 
9 

or gas serving an area not to exceed two contiguous counties or a city and one contiguous 

county. 

Local district heating or cooling facilities

The Code permits the issuance of exempt facility bonds for local district heating and 

cooling facilities. Such a facility provides hot water, chilled water, or steam to two or more users 

for residential, commercial, or industrial heating or cooling, or process steam. 

Hazardous Waste Disposal Facilities

Facilities for the incineration or permanent entombment of hazardous waste are permitted 

to be financed by exempt facility bonds if certain requirements are met. 

Other qualified private activity bonds

Other exempt facility bonds

In addition to exempt facility bonds for transportation and privately owned and/or 

operated public works facilities discussed above, tax-exempt exempt facility bonds may be used 

for privately-owned and/or operated residential rental housing, qualified public educational 

facilities, and qualified green building and sustainable design projects. Environmental 

enhancements of hydro-electric generating facilities also may qualify for exempt facility bonds. 

Qualified mortgage bonds

Owner-occupied housing may be financed with qualified mortgage bonds. Qualified 

mortgage bonds are bonds issued to make mortgage loans to qualified mortgagors for the 

purchase, improvement, or rehabilitation of owner-occupied residences. The Code imposes 

several limitations on qualified mortgage bonds, including income limitations for homebuyers 

and purchase price limitations for the home financed with bond proceeds. In addition to these 

limitations, qualified mortgage bonds generally cannot be used to finance a mortgage for a 

homebuyer who had an ownership interest in a principal residence in the three years preceding 

the execution of the mortgage (the “first-time homebuyer” requirement). Special income and 

purchase price limitations and first-time homebuyer waivers apply to targeted area residences 

and in certain disaster areas. Also, the Code provides an exception from the first-time 

homebuyer requirement for certain veterans provided that the veteran has not previously received 

financing under any State’s qualified mortgage bond program. 

Qualified mortgage bonds also may be used to finance qualified home-improvement 

loans. Qualified home-improvement loans are defined as loans to finance alterations, repairs, 

and improvements on an existing residence, but only if such alterations, repairs, and 

improvements substantially protect or improve the basic livability or energy efficiency of the 

property. Generally, qualified home-improvement loans may not exceed $15,000, however 

special rules apply for certain disaster areas, including increasing the loan maximum. 
10 

Qualified veterans’ mortgage bonds

Qualified veterans’ mortgage bonds are bonds the proceeds of which are used to finance 

the purchase, or qualifying rehabilitation or improvement, of single-family, owner-occupied 

residences of qualified veterans located within the jurisdiction of the issuer of the bonds. A 

qualified veterans’ mortgage bond may be issued only by those States that issued such bonds 

before June 22, 1984. These States are Alaska, California, Oregon, Texas, and Wisconsin. 

Annual issuance of qualified veterans’ mortgage bonds is subject to a separate State limit, but not 

to the unified State volume cap applicable to most other private activity bonds. 

Persons receiving qualified veterans’ mortgage bond loans must be veterans who served 

on active duty, and who applied for the financing before the date 25 years after the last date on 

which the borrower left active service. There are no restrictions on purchase price or borrower 

income, and no first-time homebuyer requirement for qualified veterans’ mortgage bond loans. 

Student loan bonds

Qualified student loan bonds are bonds issued to finance eligible student loans. Interest 

on qualified student loan bonds is tax-exempt. Eligible student loans include Federally 

guaranteed loans under the Higher Education Act of 1965 and other loans financed as part of a 

program of general application approved by the State.16

Small issue bonds

Qualified small issue bonds are tax-exempt bonds issued by State and local governments 

to finance private business manufacturing facilities (including certain directly related and 

ancillary facilities) or the acquisition of land and equipment by certain farmers. In both 

instances, these bonds are subject to limits on the amount of financing that may be provided, 

both for a single borrowing and in the aggregate. 

Redevelopment bonds

Qualified redevelopment bonds are bonds issued as part of an issue 95-percent or more of 

the net proceeds of which is to be used for one or more redevelopment purposes in a designated 

“blighted area.” A blighted area is an area designated as such by the local governing body of 

such area based on the substantial presence of factors such as excessive vacant, abandoned or 

vacant buildings, substandard structures, vacancies, and delinquencies in payment of real 

property taxes. 

Qualified 501(c)(3) bonds 

State and local governments may issue tax-exempt bonds to finance the activities of 

charitable organizations described in section 501(c)(3) (“qualified 501(c)(3) bonds”). The 

beneficiaries of this type of financing frequently are private, nonprofit hospitals and private, 

 16 Sec. 144(b)(1). 
11 

nonprofit colleges and universities. Both capital expenditures and limited working capital 

expenditures of charitable organizations described in section 501(c)(3) of the Code may be 

financed with qualified 501(c)(3) bonds. 

Qualified 501(c)(3) bonds are not subject to the State volume cap. 

New York Liberty Zone Bonds

Present law permits an aggregate of $8 billion in exempt facility bonds for the purpose of 

financing the construction and rehabilitation of nonresidential real property and residential rental 

real property in a designated “Liberty Zone” of New York City (“Liberty Zone Bonds”). Liberty 

Zone Bonds must be issued before January 1, 2010, and are not subject to the State volume cap. 

Gulf Opportunity Zone Bonds

Present law permits the issuance of qualified private activity bonds to finance the 

construction and rehabilitation of residential and nonresidential property located in the Gulf 

Opportunity Zone (“Gulf Opportunity Zone Bonds”).17 Gulf Opportunity Zone Bonds must be 

issued before January 1, 2011. 

Midwestern disaster area bonds

Present law provides tax-exempt bond financing like Gulf Opportunity Zone Bonds with 

certain modifications to the Midwestern disaster area.18 Specifically, it allows the issuance of 

qualified private activity bonds (“qualified Midwestern disaster area bonds”) to finance the 

construction and rehabilitation of certain residential and nonresidential property located in the 

Midwestern disaster area. Qualified Midwestern disaster area bonds must be issued before 

January 1, 2013. Other tax-exempt bond rules that apply to Gulf Opportunity Zone Bonds 

generally apply to qualified Midwestern disaster area bonds. 

 17 The “Gulf Opportunity Zone” is defined as that portion of the Hurricane Katrina Disaster Area 

determined by the President to warrant individual or individual and public assistance from the Federal 

Government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act by reason of 

Hurricane Katrina. 

18 The “Midwestern disaster area” is defined as an area with respect to which a major disaster 

was declared by the President on or after May 20, 2008, and before August 1, 2008, under section 401 of 

the Robert T. Stafford Disaster Relief and Emergency Assistance Act (“Stafford Act”) by reason of severe 

storms, tornados, or flooding occurring in any of the States of Arkansas, Illinois, Indiana, Iowa, Kansas, 

Michigan, Minnesota, Missouri, Nebraska, and Wisconsin, and determined by the President to warrant 

individual or individual and public assistance from the Federal government under such Act with respect to 

damages attributable to such severe storms, tornados, or flooding. For certain provisions, areas eligible 

for only public assistance are included in the definition of Midwestern disaster area. 
12 

Hurricane Ike disaster area bonds

Present law provides tax-exempt bond financing like Gulf Opportunity Zone Bonds with 

certain modifications to Louisiana, and Texas, (or any political subdivisions thereof). 

Specifically, it allows the issuance of qualified private activity bonds (“Hurricane Ike disaster 

area bonds”) to finance the construction and rehabilitation of certain residential and 

nonresidential property located in the Hurricane Ike disaster area.19 Hurricane Ike disaster area 

bonds must be issued before January 1, 2013. Other tax-exempt bond rules that apply to Gulf 

Opportunity Zone Bonds generally apply to Hurricane Ike disaster bonds. 

Tax-exempt enterprise zone facility bonds

Enterprise zone facility bonds are issued to finance “enterprise zone facilities” located in 

“enterprise communities” or “empowerment zones” if the principal users of such facilities are 

“qualified enterprise zone businesses.” Ninety-five percent or more of the net proceeds of the 

bonds must be used to provide an enterprise zone facility. An enterprise zone facility is defined 

as any qualified zone property the principal user of which is an “enterprise zone business,” and 

any land that is functionally related and subordinate to such property.20 Enterprise zone 

businesses are defined as certain partnerships or corporations conducting a qualified business in, 

and employing residents of, an empowerment zone.21

 

 19 The “Hurricane Ike disaster area” is defined as an area in the State of Texas or Louisiana with 

respect to which a major disaster has been declared by the President on September 13, 2008, under 

section 401 of the Stafford Act by reason of Hurricane Ike, and determined by the President to warrant 

individual or individual and public assistance from the Federal government under such Act with respect to 

damages attributable to Hurricane Ike. 

20 Sec. 1394(b). 

21 Sec. 1397C. 
13 

Additional qualified private activity bonds requirements

Volume cap

Unlike governmental bonds, the aggregate volume of most qualified private activity 

bonds is restricted by the annual volume cap imposed on issuers within each State.22 As 

discussed above, the volume cap rules reflect Congress’ intent to control the total volume of taxexempt bonds issued for private activities. For calendar year 2008, the State volume cap, which 

is indexed for inflation, equals $85 per resident of the State, or $262.09 million, if greater. 

Exceptions from the volume cap are provided for bonds for certain governmentally 

owned facilities (e.g., airports, ports, high-speed intercity rail, and solid waste disposal) and 

bonds issued to finance the activities of certain charitable organizations. In addition, bonds 

which are subject to separate local, State, or national volume limits are not subject to the unified 

volume cap (e.g., public/private educational facility bonds, enterprise zone facility bonds, 

qualified green building bonds, and qualified highway or surface freight transfer facility bonds). 

If an issuer’s volume cap for a calendar year exceeds the aggregate amount of tax-exempt 

private activity bonds issued during the year, the authority may elect to treat all (or any portion) 

of the excess as a carryforward for one or more specified “carryforward purposes.” The issuing 

authority is required to identify the purpose for which the carryforward is elected and specify the 

portion of the carryforward which is to be used for that purpose. The Code defines 

“carryforward purpose” to mean one of four purposes: issuing exempt facility bonds; issuing 

qualified mortgage bonds or mortgage credit certificates; issuing qualified student loan bonds; 

and issuing qualified redevelopment bonds.23 Carryforwards of unused volume cap are valid for 

three years. 

Maturity limitations

Most qualified private activity bonds are subject to a term to maturity rule which limits 

the period of time such bonds may remain outstanding. Generally, this rule provides that the 

average maturity of a qualified private activity bond cannot exceed 120 percent of the economic 

life of the property being financed.24 The term to maturity rule does not apply to qualified 

mortgage or student loan bonds.25

 22 Sec. 146. 

23 Sec. 146(f)(5). 

24 Sec. 147(b). 

25 Sec. 147(h). 
14 

Issuance costs

Generally, the amount of costs of issuance (e.g., bond counsel and underwriter fees) that 

may be paid from qualified private activity bond proceeds is limited to two percent. In addition, 

amounts paid for costs of issuance are not treated as spent for the exempt purpose of the 

borrowing (i.e., are not “good costs”). 

Public approval

To be a qualified private activity bond, a bond must satisfy a public approval requirement 

including providing reasonable public notice for a hearing. Regardless of State and local law, 

reasonable public notice must include notice “published in one or more newspapers of general 

circulation available to residents of that locality or if announced by radio or television broadcast 

to those residents.”26

Prohibited facilities

Qualified private activity bonds generally are subject to restrictions on the use of 

proceeds for the acquisition of land and existing property, use of proceeds to finance certain 

specified facilities (e.g., airplanes, skyboxes, other luxury boxes, health club facilities, gambling 

facilities, and liquor stores), and use of proceeds to pay costs of issuance. Small-issue and 

redevelopment bonds also are subject to additional restrictions on the use of proceeds for certain 

facilities (e.g., golf courses and massage parlors). 

 

 26 Treas. Reg. sec. 5f.103-2(g)(3). 
15 

D. Rules Applicable to All Tax-Exempt Bonds 

Arbitrage restrictions 

To prevent the issuance of Federally subsidized tax-exempt bonds that do not directly 

support governmental projects or specified activities, the tax exemption for State and local bonds 

does not apply to any arbitrage bond.27 An arbitrage bond is defined as any bond that is part of 

an issue if any proceeds of the issue are reasonably expected to be used (or intentionally are 

used) to acquire higher yielding investments or to replace funds that are used to acquire higher 

yielding investments.28 In general, arbitrage profits may be earned only during specified periods 

(e.g., defined “temporary periods”) before funds are needed for the purpose of the borrowing or 

on specified types of investments (e.g., “reasonably required reserve or replacement funds”). 

Subject to limited exceptions, investment profits that are earned during these periods or on such 

investments must be rebated to the Federal government (“arbitrage rebate”). 

Advance refundings

A refunding bond is defined as any bond used to pay principal, interest, or redemption 

price on a prior bond issue (the refunded bond). The Code contains different rules for “current” 

as opposed to advance refunding bonds. A current refunding occurs when the refunded bond is 

redeemed within 90 days of issuance of the refunding bonds. Conversely, a bond is classified as 

an advance refunding if it is issued more than 90 days before the redemption of the refunded 

bond (thus, two or more issues of tax-exempt bonds are outstanding simultaneously).29 An 

advance refunding often takes place when interest rates fall and the issuer, in an effort to save 

money, seeks to redeem an existing issue with new funds borrowed at a lower rate. If the 

existing issue has “call protection,” that is, provisions of the bonds that prohibit redemption by 

the issuer for a period of years in order to protect the holders, the issuer cannot immediately 

redeem the existing bond issue with the proceeds of the advance refunding bond issue. For that 

reason, proceeds of advance refunding bonds are generally invested in an escrow account and 

held until a future date when the refunded bond may be redeemed. 

Although there is no statutory limitation on the number of times that tax-exempt bonds 

may be currently refunded, the Code limits advance refundings. Generally, governmental bonds 

 27 Secs. 103(a) and (b)(2). 

28 For example, a tax-exempt issuer might be able to borrow money at six percent and invest the 

funds in taxable securities that yield eight percent. The tax exempt issuer would earn a profit of two 

percent. This two-percent profit is, in effect, a subsidy from the Federal government to the tax-exempt 

issuer. The arbitrage restrictions are necessary to control this subsidy. 

29 Sec. 149(d)(5). 
16 

and qualified 501(c)(3) bonds may be advance refunded one time.30 Private activity bonds, other 

than qualified 501(c)(3) bonds, may not be advance refunded at all.31 

Federal guarantees

Generally, interest on State and local bonds that are Federally guaranteed does not qualify 

for tax exemption. A bond is Federally guaranteed if: (1) the payment of principal or interest 

with respect to such bond is guaranteed (in whole or in part) by the United States (or any agency 

or instrumentality thereof); (2) such bond is issued as part of an issue and five percent of more of 

the proceeds of such issue is to be (a) used in making loans the payment of principal or interest 

with respect to which is guaranteed (in whole or in part) by the United States (or any agency or 

instrumentality thereof), or (b) invested directly or indirectly in federally insured deposits or 

accounts; or (3) the payment of principal or interest on such bond is otherwise indirectly 

guaranteed (in whole or in part) by the United States (or any agency or instrumentality thereof). 

The Federal guarantee restriction was enacted in 1984 with certain exceptions for certain 

guarantee programs in existence at that time.32 In response to current market instability, the 

Department of the Treasury is making available certain funds from its Exchange Stabilization 

Fund on a temporary basis to certain money market funds to enable the funds to maintain stable 

$1.00 per share net asset values. Notice 2008-81 provides that the program will not result in any 

violations of the restrictions against Federal guarantees of tax-exempt bonds with respect to the 

tax-exempt bond assets of tax-exempt money market funds, as defined by the notice. 

Information returns

An issuer of bonds must file with the IRS certain information in order for the interest on 

such bond to be tax-exempt.33 Generally, this information return is required to be filed no later 

 30 Sec. 149(d)(3). Bonds issued before 1986 and pursuant to certain transition rules contained in 

the Tax Reform Act of 1986 may be advance refunded more than one time in certain cases. 

31 Sec. 149(d)(2). Special rules apply for certain advance refundings in the New York Liberty 

Zone and the Gulf Opportunity Zone. 

32 The exceptions include guarantees by: the Federal Housing Administration, the Department of 

Veterans’ Affairs, the Federal National Mortgage Association, the Federal Home Loan Mortgage 

Association, the Government National Mortgage Association; the Student Loan Marketing Association; 

and the Bonneville Power Authority pursuant to the Northwest Power Act (16 U.S.C. sec. 839d). The 

exception also includes guarantees for certain housing programs. These are: (a) private activity bonds for 

a qualified residential rental project or a housing program obligation under section 11(b) of the United 

States Housing Act of 1937; (b) a qualified mortgage bond; or (c) a qualified veterans’ mortgage bond. In 

addition, if certain requirements are met, the Federal guarantee prohibition does not apply to any 

guarantee by a Federal home loan bank made in connection with the original issuance of a bond during 

the period July 30, 2008 through December 31, 2010. 

33 Sec. 149(e). 
17 

the 15th day of the second month after the close of the calendar quarter in which the bonds were 

issued. 
18 

II. TAX-CREDIT BONDS 

In general

Tax-credit bonds are not interest-bearing obligations. Rather, the taxpayer holding a taxcredit bond on a credit allowance date is entitled to a tax credit. In the Code, there are currently 

tax-credit bonds for qualified zone academies (“QZABs”), tax-credit bonds for capital 

expenditures relating to certain renewable energy facilities (clean renewable energy bonds, 

“CREBs” and “New CREBs”), Gulf Tax-credit Bonds, Midwest Tax-credit Bonds, qualified 

energy conservation bonds, and qualified forestry conservation bonds. 

Types of tax-credit bonds

Qualified Zone Academy Bonds

QZABs are defined as any bond issued by a State or local government, provided that (1) 

at least 95 percent of the proceeds are used for the purpose of renovating, providing equipment 

to, developing course materials for use at, or training teachers and other school personnel in a 

“qualified zone academy,” and (2) private entities have promised to contribute to the qualified 

zone academy certain equipment, technical assistance or training, employee services, or other 

property or services with a value equal to at least 10 percent of the bond proceeds. 

A school is a “qualified zone academy” if (1) the school is a public school that provides 

education and training below the college level, (2) the school operates a special academic 

program in cooperation with businesses to enhance the academic curriculum and increase 

graduation and employment rates, and (3) either (a) the school is located in an empowerment 

zone or enterprise community designated under the Code, or (b) it is reasonably expected that at 

least 35 percent of the students at the school will be eligible for free or reduced-cost lunches 

under the school lunch program established under the National School Lunch Act. 

A total of $400 million of QZABs has been authorized to be issued annually in calendar 

years 1998 through 2009. The $400 million aggregate bond cap is allocated to the States 

according to their respective populations of individuals below the poverty line. Each State, in 

turn, allocates the credit authority to qualified zone academies within such State. 

Gulf Tax-Credit Bonds and Midwest Tax-Credit Bonds

Gulf tax-credit bonds may be issued by the States of Louisiana, Mississippi, and 

Alabama. To qualify as Gulf tax-credit bonds, 95 percent or more of the proceeds of such bonds 

must be used to (i) pay principal, interest, or premium on a bond (other than a private activity 

bond) that was outstanding on August 28, 2005, and was issued by the State issuing the Gulf taxcredit bonds, or any political subdivision thereof, or (ii) make a loan to any political subdivision 

of such State to pay principal, interest, or premium on a bond issued by such political 

subdivision. In addition, the issuer of Gulf tax-credit bonds must provide additional funds to pay 

principal, interest, or premium on outstanding bonds equal to the amount of Gulf tax-credit 

bonds issued to repay such outstanding bonds. Gulf tax-credit bonds must be a general 

obligation of the issuing State and must be designated by the Governor of such State. The 
19 

maximum maturity on Gulf tax-credit bonds is two years. The arbitrage rules restricting the 

ability of State and local governments to invest bond proceeds apply to Gulf tax-credit bonds. 

Gulf tax-credit bonds must be issued in calendar year 2006. The maximum amount of 

Gulf tax-credit bonds that may be issued is $200 million in the case of Louisiana, $100 million in 

the case of Mississippi, and $50 million in the case of Alabama. Gulf tax-credit bonds may not 

be used to pay principal, interest, or premium on any bond with respect to which there is any 

outstanding refunded or refunding bond. Gulf tax-credit bonds may not be used to pay principal, 

interest, or premium on any prior bond if the proceeds of such prior bond were used to provide 

any of the following types of property: a private or commercial golf course, country club, 

massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or 

any store the principal purpose of which is the sale of alcoholic beverages for consumption off 

premises. 

Also, present law allows Midwestern tax-credit bonds to be issued in 2009 by any State 

in which a Midwestern disaster area is located (or any instrumentality of the State). The 

operation and effect of these Midwestern tax-credit bonds are otherwise identical to Gulf taxcredit bonds except for different volume caps. Under the provision, the maximum amount of 

Midwestern tax-credit bonds that may be issued is: (1) $100 million for any State with an 

aggregate population located in all Midwestern disaster areas within the State of at least 

2,000,000; (2) (1) $50 million for any State with an aggregate population located in all 

Midwestern disaster areas within the State of at least 1,000,000 but less than 2,000,000; and (3) 

$0 for any other State. This provision is effective for bonds issued after December 31, 2008. 

Qualified Energy Conservation Bonds

The Energy Improvement and Extension Act of 2008 created a new category of tax-credit 

bonds, qualified energy conservation bonds. Qualified energy conservation bonds may be used 

to finance qualified conservation purposes. 

The term “qualified conservation purpose” means: 

1. Capital expenditures incurred for purposes of reducing energy consumption in 

publicly owned buildings by at least 20 percent; implementing green community 

programs; rural development involving the production of electricity from renewable 

energy resources; or any facility eligible for the production tax credit under section 45 

(other than Indian coal and refined coal production facilities); 

2. Expenditures with respect to facilities or grants that support research in: (A) 

development of cellulosic ethanol or other nonfossil fuels; (B) technologies for the 

capture and sequestration of carbon dioxide produced through the use of fossil fuels; 

(C) increasing the efficiency of existing technologies for producing nonfossil fuels; 

(D) automobile battery technologies and other technologies to reduce fossil fuel 

consumption in transportation; and (E) technologies to reduce energy use in buildings; 

3. Mass commuting facilities and related facilities that reduce the consumption of 

energy, including expenditures to reduce pollution from vehicles used for mass 

commuting; 
20 

4. Demonstration projects designed to promote the commercialization of: (A) green 

building technology; (B) conversion of agricultural waste for use in the production of 

fuel or otherwise; (C) advanced battery manufacturing technologies; (D) technologies 

to reduce peak-use of electricity; and (D) technologies for the capture and 

sequestration of carbon dioxide emitted from combusting fossil fuels in order to 

produce electricity; and 

5. Public education campaigns to promote energy efficiency (other than movies, 

concerts, and other events held primarily for entertainment purposes). 

There is a national limitation on qualified energy conservation bonds of $800 million. 

The credit rate for qualified energy conservation bonds is set by the Secretary at a rate that is 70 

percent (rather than 100 percent) of the rate that would permit issuance of such bonds without 

discount and interest cost to the issuer. Allocations of qualified energy conservation bonds are 

made to the States with sub-allocations to large local governments. 

Clean Renewable Energy Bonds and New Clean Renewable Energy Bonds

CREBs and New CREBs are used to finance capital expenditures incurred by qualified 

borrowers for facilities that qualify for the tax credit under section 45 (other than Indian coal 

production facilities and, in the case of New CREBs, refined coal facilities), without regard to 

the placed-in-service date requirements of that section. There is a national CREB limitation of 

$1.2 million. Of that amount, no more than $750 million may be allocated to governmental 

bodies. CREBs must be issued before December 31, 2009. 

For New CREBs, there is a national limitation of $800 million. Unlike CREBs, however, 

the credit rate on New CREBs is set by the Secretary at a rate that is 70 percent (rather than 100 

percent) of the rate that would permit issuance of such bonds without discount and interest cost 

to the issuer. No more than one-third of the national limit may be allocated to projects of public 

power providers, governmental bodies, or cooperative electric companies. Allocations to 

governmental bodies and cooperative electric companies may be made in the manner the 

Secretary determines appropriate. Allocations to projects of public power providers are to be 

made, to the extent practicable, in such manner that the amount allocated to each such project 

bears the same ratio to the cost of such project as the maximum allocation limitation to projects 

of public power providers bears to the cost of all such projects. 

Qualified Forestry Conservation Bonds

Qualified forestry conservation bonds are bonds issued by qualified issuers to finance 

qualified forestry conservation projects. The term “qualified issuer” means a State or a section 

501(c)(3) organization. The term “qualified forestry conservation project” means the acquisition 

by a State or section 501(c)(3) organization from an unrelated person of forest and forest land 

that meets the following qualifications: (1) some portion of the land acquired must be adjacent to 

United States Forest Service Land; (2) at least half of the land acquired must be transferred to the 

United States Forest Service at no net cost and not more than half of the land acquired may either 

remain with or be donated to a State; (3) all of the land must be subject to a habitat conservation 
21 

plan for native fish approved by the United States Fish and Wildlife Service; and (4) the amount 

of acreage acquired must be at least 40,000 acres. 

A qualified issuer receiving an allocation to issue qualified forestry conservation bonds 

may, in lieu of issuing bonds, elect to treat such allocation as a deemed payment of tax 

(regardless of whether the issuer is subject to tax under chapter 1 of the Code) that is equal to 50 

percent of the amount of such allocation. An election to treat an allocation of qualified forestry 

conservation bonds as a deemed payment is not valid unless the qualified issuer certifies to the 

Secretary that any payment of tax refunded to the issuer will be used exclusively for one or more 

qualified forestry conservation purposes. The deemed tax payment may not be used as an offset 

or credit against any other tax and shall not accrue interest. In addition, if the qualified issuer 

fails to use any portion of the overpayment for qualified forestry conservation purposes, the 

issuer shall be liable to the United States in an amount equal to such portion, plus interest, for the 

period from the date such portion was refunded to the date such amount is paid. 

General rules applicable to qualified tax-credit bonds34

The following bonds are classified as “qualified tax-credit bonds”: qualified forestry 

conservation bonds, New CREBs, qualified energy conservation bonds and QZABs issued after 

the date of enactment of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008. 

Unlike tax-exempt bonds, qualified tax-credit bonds generally are not interest-bearing 

obligations. Rather, the taxpayer holding a qualified tax-credit bond on a credit allowance date 

is entitled to a tax credit. The amount of the credit is determined by multiplying the bond’s 

credit rate by the face amount on the holder’s bond. The credit rate for an issue of qualified tax 

credit bonds is determined by the Secretary and is estimated to be a rate that permits issuance of 

the qualified tax-credit bonds without discount and interest cost to the qualified issuer.35 The 

credit accrues quarterly and is includible in gross income (as if it were an interest payment on the 

bond), and can be claimed against regular income tax liability and alternative minimum tax 

liability. Unused credits may be carried forward to succeeding taxable years. In addition, credits 

may be separated from the ownership of the underlying bond similar to how interest coupons can 

be stripped for interest-bearing bonds. 

Qualified tax-credit bonds are subject to a maximum maturity limitation. The maximum 

maturity is the term which the Secretary estimates will result in the present value of the 

obligation to repay the principal on a qualified tax-credit bond being equal to 50 percent of the 

face amount of such bond. The discount rate used to determine the present value amount is the 

average annual interest rate of tax-exempt obligations having a term of 10 years or more which 

are issued during the month the qualified tax-credit bonds are issued. 

 34 Separate rules apply in the case of tax-credit bonds which are not qualified tax-credit bonds 

(e.g., “old QZABs,” “Gulf tax-credit bonds,” “Midwestern tax-credit bonds,” and “old CREBs”). 

35 However, for New CREBs and qualified energy conservation bonds, the applicable credit rate 

is 70 percent of the otherwise applicable rate. 
22 

For qualified tax-credit bonds, 100 percent of the available project proceeds must be used 

within the three-year period that begins on the date of issuance. Available project proceeds are 

proceeds from the sale of the bond issue less issuance costs (not to exceed two percent) and any 

investment earnings on such sale proceeds. To the extent less than 100 percent of the available 

project proceeds are used to finance qualified projects during the three-year spending period, 

bonds will continue to qualify as qualified tax-credit bonds if unspent proceeds are used within 

90 days from the end of such three-year period to redeem bonds. The three-year spending period 

may be extended by the Secretary upon the qualified issuer’s request demonstrating that the 

failure to satisfy the three-year requirement is due to reasonable cause and the projects will 

continue to proceed with due diligence. 

Qualified tax-credit bonds also are subject to the arbitrage requirements of section 148 

that apply to traditional tax-exempt bonds. Principles under section 148 and the regulations 

thereunder apply for purposes of determining the yield restriction and arbitrage rebate 

requirements applicable to qualified tax-credit bonds. However, available project proceeds 

invested during the three-year spending period are not subject to the arbitrage restrictions (i.e., 

yield restriction and rebate requirements). In addition, amounts invested in a reserve fund are 

not subject to the arbitrage restrictions to the extent: (1) such fund is funded at a rate not more 

rapid than equal annual installments; (2) such fund is funded in a manner reasonably expected to 

result in an amount not greater than an amount necessary to repay the issue; and (3) the yield on 

such fund is not greater than the average annual interest rate of tax-exempt obligations having a 

term of 10 years or more that are issued during the month the qualified tax-credit bonds are 

issued. 

Issuers of qualified tax-credit bonds are required to report issuance to the IRS in a 

manner similar to the information returns required for tax-exempt bonds. In addition, issuers of 

qualified tax-credit bonds are required to certify that applicable State and local law requirements 

governing conflicts of interest are satisfied with respect to such issue, and if the Secretary 

prescribes additional conflicts of interest rules governing the appropriate Members of Congress, 

Federal, State, and local officials, and their spouses, such additional rules are satisfied with 

respect to such issue. 

 
23 

III. BENEFITS AND COSTS OF TAX-EXEMPT BOND 

AND TAX-CREDIT BOND FINANCING 

A. Tax-Exempt Bonds 

Benefits and costs of the subsidy

Issuer benefit

Tax-exempt financing provides an implicit Federal subsidy to the borrower (i.e., either 

the qualified governmental unit or the conduit borrower) but, in practice some of the subsidy 

redounds to the bond investor (the lender). Because interest income on the bonds is excluded 

from gross income, the bond investor is willing to accept a lower interest rate on the bonds than 

he might otherwise accept on an identical taxable investment. Thus, the borrower receives an 

implicit Federal subsidy equal to the difference between the tax-exempt interest rate paid and the 

taxable rate that otherwise would be paid. In this way, the income exclusion lowers the cost of 

capital for the State and local governments (or private parties in the case of private activity 

bonds). 

The following example illustrates the Federal subsidy measured as a percentage of the 

otherwise applicable taxable rate. Assume a school district may borrow either at a taxable rate of 

6.25 percent or a tax-exempt rate of 4.5 percent. The yield spread in this example is 1.75 

percentage points and the ratio of tax-exempt to taxable rates is 0.72, or 72 percent, and the 

subsidy is equal to 28 percent of the otherwise applicable taxable rate.36 To illustrate the benefit 

of the subsidy in dollar terms, if the school district borrows $1 million at the taxable rate of 6.25 

percent and $1 million at the tax-exempt rate of 4.5 percent, the school district’s annual interest 

payments would be $62,500 on the taxable debt, but $45,000 on the tax-exempt debt, a $17,500 

savings. In practice, however, this calculation overstates the borrower’s interest savings because 

of certain inefficiencies associated with the issuance of tax-exempt bonds (explained below). 

Finally, as the ratio of tax-exempt rates to taxable rates moves closer to one (i.e., the 

spread between tax-exempt and taxable interest rates narrows), the value of the subsidy to the 

borrower also diminishes. Among other reasons, this may occur as the volume of tax-exempt 

bond issuances increases and tax-exempt borrowers respond by offering higher interest rates to 

attract bond investors. (See Figure 1.a., below, comparing the average tax-exempt interest rate 

on high-grade municipal bonds and the average taxable interest rate on corporate bonds for the 

period 1986-2007. Figure 1.b., below separately reports the yield spread between the interest 

rates on tax-exempt and taxable bonds). 

 36 Column 5 of Table 1, on page 28, may be used to illustrate the measure of the subsidy 

measured as a percentage of the otherwise applicable taxable rate for the period 1986-2007. 
24 

 

0

2

4

6

8

10

12

1986 1989 1992 1995 1998 2001 2004 2007

Interest Rate

Year

Figure 1.a.−Comparison of Long‐Term Municipal Bond Interest Rates

and Corporate Bond Interest Rates,

1986‐2007

Municipal

Bond

Corporate

Bond
25 

Bond investor benefit

The bond investor also receives a Federal subsidy from tax-exempt financing equal to the 

difference between the tax-exempt interest rate and the after-tax yield on a taxable investment. 

The bond investor’s willingness to purchase tax-exempt bonds also depends on the bond 

investor’s marginal tax rate. Generally, all other things being equal (such as credit worthiness), a 

bond investor is indifferent between a tax-exempt bond and a taxable bond with an equivalent 

after-tax yield.37 To illustrate using the example from above, if a bond investor with a 28-

percent marginal tax rate purchased a $1 million taxable bond at a 6.25-percent rate, as an 

alternative to the tax-exempt bond, the investor would receive $62,500 in interest income and 

pay $17,500 in income tax for a net return of $45,000 and an after-tax yield of 4.5 percent. This 

is the same net return the bond investor receives if he were to purchase the $1 million tax-exempt 

 37 This may be represented as re= (1-t)r, where re is the tax-exempt yield, t is the investor’s 

marginal tax rate, and r is the taxable bond yield. 

0

0.5

1

1.5

2

2.5

1986 1989 1992 1995 1998 2001 2004 2007

Interest Rate

Year

Figure 1.b.−Yield Spread Between Long‐Term

Municipal Bonds and Corporate Bonds,

1986‐2007
26 

bond. Thus, this bond investor generally would be indifferent to a taxable investment with a 

6.25-percent rate and a tax-exempt investment with a 4.5-percent rate. 

With many bond investors in different tax brackets, bond investors in higher marginal 

tax-brackets receive a larger tax benefit than those in lower brackets. For example, if a bond 

investor with a 33-percent marginal tax rate purchased the alternative $1 million taxable bond at 

a 6.25-percent rate, the investor would receive $62,500 in interest income and pay $20,625 in 

income tax for a net return of $41,875 and an after-tax yield of 4.19 percent. However, this bond 

investor would receive a 4.5 percent net return on the school district’s tax-exempt bond. Thus, 

unlike the bond investor in the 28-percent marginal tax rate who is indifferent to investment in 

taxable or tax-exempt bonds, the bond investor in the 33-percent marginal tax rate receives a 

greater benefit by purchasing the tax-exempt bond. In contrast, a bond investor with a 15-

percent marginal tax rate receives no benefit from purchasing the tax-exempt bond. 

Revenue loss associated with tax-exempt bonds

The direct cost to the Federal government of the interest exclusion for State and local 

bonds is the income tax revenue forgone. Under our example, if the bond investor with a 28-

percent marginal tax rate purchases the school district’s $1 million tax-exempt bond with a 4.5-

percent interest rate, the bond investor receives $45,000 of tax-exempt interest income for each 

year the bond is outstanding. However, assuming the bond investor’s preferred alternative 

investment is a taxable bond, the actual revenue loss to the Federal government is based upon the 

taxable yield the bond investor forgoes. For example, if the bond investor purchased the taxable 

bond at a 6.25-percent rate, rather than the tax-exempt bond, the bond investor would have 

received $62,500 in interest income and paid $17,500 in income tax. In this case, the revenue 

forgone to the Federal Government equals the interest savings of the school district. 

However, using the second part of the example from above, if the bond investor in the 

33-percent bracket purchases the school district’s tax-exempt bond, it costs the Federal 

Government $20,625 ($62,500 of interest income taxed at a 33-percent rate). Due to the 

existence of multiple tax brackets, the loss of Federal receipts is greater than the reduction in the 

tax-exempt issuer’s interest cost. In this case, the $17,500 interest subsidy realized by the school 

district costs the Federal Government $20,625. The difference accrues to bond investors in tax 

brackets higher than those that would be implied by the yield spread between taxable and taxexempt bonds. Thus, if a bond investor in the 28-percent bracket finds it profitable to hold a taxexempt security, a bond investor in the 33-percent bracket will find it even more profitable. This 

implies that the Federal Government will lose more in revenue than the tax-exempt issuer gains 

in reduced interest payments.38 This is one source of inefficiency to the subsidy provided by the 

tax exemption. 

 

 38 To the extent that bond investors in lower tax brackets purchase tax-exempt bonds for nontax 

reasons, such as to help support the local schools, the revenue forgone would be less than the issuer’s 

interest savings. 
27 

Table 1, below, reports the data used for Figures 1.a. and 1.b. It also calculates the 

implied marginal tax rate at which the bond investor would be indifferent between holding the 

average corporate bond and the average municipal bond.39 The table shows that generally over 

the past two decades any holdings of tax-exempt bonds by bond investors in a 25-percent 

marginal tax bracket and above would have led to the inefficiency described above.40 

 

 39 Some analysts suggest that consideration of other financial assets beyond a comparison of 

taxable and tax-exempt bonds determine the yield spread between taxable and tax-exempt interest rates. 

In particular, these analysts suggest that the yield spread increases (decreases) as the dividend yield on 

corporate stocks increases (decreases). (N. Gregory Mankiw and James M. Poterba, “Stock Market 

Yields and the Pricing of Municipal Bonds,” National Bureau of Economic Research Working Paper 

#5607, June 1996.) However, such an augmented analysis of the yield spread does not alter the 

conclusion that the Federal Government loses more in revenue from State and local issuance of taxexempt bonds, than the borrower gains in reduced interest costs. 

40 Individual taxpayers are asked to self-report tax-exempt interest income earned during the 

taxable year, although there is no penalty for a failure to report (e.g., line 8a of Form 1040). The staff of 

the Joint Committee on Taxation projects that for 2009 approximately 4.9 million individual taxpayers 

will report approximately $71 billion of tax-exempt interest. Of those totals, the staff of the Joint 

Committee on Taxation projects that 3.2 million taxpayers will be in marginal tax brackets of 25 percent 

or higher in 2009 and they will report in excess of $56 billion in tax-exempt interest. 
28 

Table 1.−Comparison of Taxable Interest Rates and Tax-Exempt Interest Rates, 

1986-2007 

Year 

Corporate 

Bonds [1] 

[Percent] 

High-Grade 

Municipal 

Bonds [2] 

[Percent] 

Yield 

Spread 

[Percent] 

Implied Tax 

Rate of 

Marginal 

Investor 

[Percent] 

1986 9.02 7.33 1.69 18.7 

1987 9.38 7.66 1.72 18.3 

1988 9.71 7.68 2.03 20.9 

1989 9.26 7.23 2.03 21.9 

1990 9.32 7.27 2.05 22.0 

1991 8.77 6.92 1.85 21.1 

1992 8.14 6.44 1.70 20.9 

1993 7.22 5.59 1.63 22.6 

1994 7.96 6.19 1.77 22.2 

1995 7.59 5.95 1.64 21.6 

1996 7.37 5.76 1.61 21.8 

1997 7.26 5.52 1.74 24.0 

1998 6.53 5.09 1.44 22.1 

1999 7.04 5.44 1.60 22.7 

2000 7.62 5.71 1.91 25.1 

2001 7.08 5.15 1.93 27.3 

2002 6.49 5.04 1.45 22.3 

2003 5.67 4.74 0.93 16.4 

2004 5.63 4.68 0.95 16.9 

2005 5.24 4.40 0.84 16.0 

2006 5.59 4.40 1.19 21.3 

2007 5.56 4.40 1.16 20.9 

1

 Annual average bond yield for Moody’s Long Term Aaa Corporate Bond Index. Source: Economic Report 

of the President, 2008. 

2

 Bond Buyer 20-year Municipal Bond Index, an index consisting of 20 general obligation bonds that mature in 20 

years. The average rating of the bonds is roughly equivalent to Moody’s Aa1 rating. Source: 2008 Thompson 

Financial Bond Buyer Year Book. 
29 

Issuance costs

Borrowers always incur transactions costs in attaining loanable funds. Generally, issuing 

tax-exempt bonds to finance capital costs is a complex and expensive process. In addition to the 

borrower and bond investor, there are a number of parties employed to facilitate a bond issuance 

(e.g., service providers such as investment bankers and attorneys). The requirements for tax 

exemption may result in higher incremental costs of issuance for tax-exempt bonds than those 

associated with issuing taxable bonds. Because a portion of the benefits of tax exemption flows 

to these service providers in the way of fees, such fees are a second potential source of 

inefficiency resulting from tax-exempt financing. 

Arbitrage potential

As described in Part II.D, above, present law generally restricts the ability of qualified 

governmental units and other parties to earn and retain arbitrage profits. Without these rules, the 

reduced cost of funds obtained through tax-exempt bonds provides issuers the opportunity to 

earn arbitrage profits by investing tax-exempt bond proceeds in higher yielding investments. For 

example, the average yield spread between taxable and tax-exempt debt for the period 1986-

2007, as reported in Table 1, above, was approximately 1.6 percent. Consider a simple arbitrage 

transaction of the type available to borrowers using tax-exempt debt prior to restrictions adopted 

by the Congress in 1969. Assume a local government planned to construct a $10 million 

building. Further assume the local government issued $10 million in tax-exempt bonds with the 

knowledge that the construction schedule was such that the local government could invest a fiveyear average of $5 million of the $10 million in bond proceeds in taxable securities yielding 

interest at 1.00 percent greater than the interest the issuer would owe on its tax-exempt bonds. 

This investment would generate $50,000 in profit to the local governmental issuer annually net 

of interest payments to the owners of the local government’s bonds.41 Over the five-year period, 

the quarter of million dollar profit equals 2.5 percent of principal value of the bond issue. The 

ability to earn arbitrage profits means that project costs are lowered beyond the benefit reflected 

in a comparison of taxable and tax-exempt interest rates. One could say that, if the yield spread 

reflects the implicit Federal subsidy to a State or local issuer’s borrowing costs, potential 

arbitrage profits reflect an implicit Federal subsidy to the payment of the principal amount of the 

State or local issuer’s borrowing. 

Arbitrage transactions have no economic substance, as the issuance of one financial 

instrument (the tax-exempt bond) is offset by the purchase of another financial instrument 

(typically another debt instrument). The transaction is made profitable solely through the ability 

to borrow at tax-exempt rates in reliance on a Federal subsidy of borrowing costs. If permitted to 

earn and retain arbitrage profits, borrowers would have a substantial incentive to issue more 

bonds, to issue them earlier, and to leave them outstanding longer than necessary. From the 

Federal Government’s standpoint, allowing arbitrage profits to be earned from the issuance of 

tax-exempt bonds is an inefficient alternative to additional borrowing, because it is more costly 

 41 For simple examples and explanations of arbitrage transactions, see, Dennis Zimmerman, The 

Private Use of Tax-Exempt Bonds, (Washington, D.C.: The Urban Institute Press), 1991, pp. 158-162. 
30 

to the Federal Government in terms of forgone tax revenue than the additional borrowing that 

would be necessary to produce the same amount of proceeds. 

More recent market conditions for tax-exempt debt

With recent financial market turmoil the value of Federal tax exemption has declined. 

Figure 2, below, makes the same comparison as does Figure 1, comparing the average yield on 

20-year general obligation tax-exempt bonds to roughly comparable 20-year taxable bonds. 

Figure 2 reports bond yields monthly on the middle Thursday of each month. In both September 

and October of 2008, the market has priced the implicit subsidy from tax-exempt borrowing at 

less than 11 percent. 

Figures 1 and 2 have reported bond yields on long-term bonds. State and local issuers 

also issue short-term debt, such as exempt commercial paper. Like taxable enterprises, State and 

local governments use short-term borrowing to finance payroll and other current budget needs 

that are not perfectly matched to timing of their tax revenues. Figure 3, below, compares yields 

for 30-day tax-exempt commercial paper to yields on 30-day Aa rated nonfinancial commercial 

0

1

2

3

4

5

6

7

January

February

March

April

May

June

July

August

September

October

November

December

January

February

March

April

May

June

July

August

September

October

2007 2008

Interest Rate

Figure 2.−Comparison of Long‐Term Municipal Bond Investment

Rates and Corporate Bond Internet Rates,

Monthly 2007 and 2008

Municipal

Bond

Corporate

Bond
31 

paper.

42 Figure 3 documents that the yield spread between taxable and tax-exempt commercial 

paper has narrowed significantly over the past 12 months. In October 2008, tax-exempt 

commercial paper traded at a yield in excess of that of taxable commercial paper, 

notwithstanding the tax exemption available. 

 42 The source for yields on tax-exempt commercial paper in Figure 3 is Municipal Market Data. 

The source for yields on nonfinancial commercial paper is the Federal Reserve. The data in Figure 3 

represent the quoted yields reported on the middle Friday of each month. 

0

1

2

3

4

5

6

January

February

March

April

May

June

July

August

September

October

November

December

January

February

March

April

May

June

July

August

September

October

2007 2008

Interest Rate

Figure 3.−Comparison of Yields on Tax-Exempt

and Taxable Commercial Paper,

Monthly 2007 and 2008

Municipal Market

30‐Day

Commercial Paper

30‐Day

Nonfinancial

Commercial Paper
32 

B. Tax-Credit Bonds 

Benefits and costs of the subsidy43

One hundred percent interest credit

As described above, tax-credit bonds that have been issued to date are not interestbearing obligations. Rather, the taxpayer holding a tax-credit bond on a credit allowance date is 

entitled to a tax credit. The amount of the credit is determined by multiplying the bond’s credit 

rate by the face amount44 on the holder’s bond. For the present law categories of tax-credit 

bonds, the credit rate on the bonds is determined by the Secretary of the Treasury and is an 

estimate of the rate that permits issuance of such bonds without discount and interest cost to the 

qualified issuer. That is, the tax credit is chosen to approximate an interest rate subsidy of 100 

percent. The credit is includible in gross income (as if it were an interest payment on the bond), 

and can be claimed against regular income tax liability and alternative minimum tax liability. 

Under present law, the Federal subsidy provided to issuers by tax-credit bonds is deeper 

than the subsidy for tax-exempt bonds. This is because the issuer of tax-credit bonds pays no 

interest, only principal.45 The “interest” is paid by the Federal Government in the form of tax 

credits. Thus, the issuer theoretically has an interest-free loan. In comparison, issuers of taxexempt bonds pay interest on such obligations, albeit at a lower interest rate than if the debt were 

taxable. As noted above, the Federal subsidy provided to borrowers using tax-exempt bonds is 

limited to the difference between the tax-exempt interest rate paid and the taxable bond rate that 

otherwise would be paid.46

The Federal subsidy for tax-credit bonds is economically equivalent to the Federal 

government directly paying the interest on a taxable bond issue on behalf of the State or local 

 43 Congressional Budget Office, Tax-Credit Bonds and the Federal Cost of Financing Public 

Expenditures, July 2004, offers an analysis of the economics of tax-credit bonds and alternatives. 

44 The “face amount” (or par value) represents the value of a bond at maturity as stated on the 

bond certificate. 

45 This conclusion assumes the bonds are not issued at discount. If tax-credit bonds are issued at 

discount, i.e., less than par value, the issuer incurs interest cost to the extent its debt service payments will 

exceed the amount of proceeds received from the sale of the bonds. This may occur because the rate on a 

prospective issue of tax-credit bonds is set lower than what investors are willing to accept to purchase the 

bonds at par value. To illustrate, assume the credit rate on tax-credit bonds with a face amount of $100 is 

set at five percent. If investors do not view the five percent credit rate as an acceptable return given the 

riskiness of the investment, they will purchase the bonds for something less than $100, e.g., $90. Because 

the credit is determined by reference to the face amount of bonds ($100), the investor purchasing taxcredit bonds at a discount ($90) receives a higher yield than the stated credit rate. However, the issuer 

must repay the full face value of the bonds, $100 in this example, even though it received less than $100 

in proceeds. 

46 This discussion ignores any potential for permitted arbitrage earnings. 
33 

government benefiting from the bond proceeds.47 To see this, consider any taxable bond that 

bears an interest rate of 10 percent. A thousand dollar bond would thus produce an interest 

payment of $100 annually. The owner of the bond that receives this payment would receive a 

net payment of $100 less the taxes owed on that interest. If the taxpayer were in the 28-percent 

Federal tax bracket, such taxpayer would receive $72 after Federal taxes. Regardless of whether 

the State government or the Federal government pays the interest, the taxpayer receives the same 

net-of-tax return of $72. In the case of tax-credit bonds, no cash interest is paid by the Federal 

government. Rather, a tax credit of $100 is allowed to be taken by the holder of the bond. In 

general, a $100 tax credit would be worth $100 to a taxpayer, provided that the taxpayer had at 

least $100 in tax liability. However, for tax-credit bonds, the $100 credit also has to be claimed 

as income. Claiming an additional $100 in income costs a taxpayer in the 28-percent tax bracket 

an additional $28 in income taxes, payable to the Federal government. With the $100 tax credit 

that is ultimately claimed, the taxpayer nets $72 of interest income by holding the bond. The 

Federal government loses $100 on the credit, but recoups $28 of that by the requirement that it 

be included in income, for a net cost of $72, which is exactly the net return to the taxpayer. If 

the Federal government had simply agreed to pay the interest on behalf of the State or local 

government, both the Federal government and the bondholder/taxpayer would be in the same 

situation. The Federal government would make outlays of $100 in interest payments, but would 

recoup $28 of that in tax receipts, for a net budgetary cost of $72, as before. Similarly, the 

bondholder/taxpayer would receive a taxable $100 in interest, and would owe $28 in taxes, for a 

net gain of $72, as before. The State or local government also would be in the same situation in 

both cases. 

In addition to the deeper subsidy provided by 100-percent tax credit bonds, tax-credit 

bonds do not generate the same revenue loss inefficiency as do tax-exempt bonds. As explained 

in Part III.A., above, in the case of a tax-exempt bond, the loss of Federal receipts is greater than 

the reduction in the tax-exempt issuer’s interest cost. This is due to the existence of multiple tax 

brackets and the bond investor’s tax saving is dependent upon the bond investor’s marginal tax 

rate. With a tax-credit bond, the bond investor’s tax saving is independent of the bond investor’s 

marginal tax rate. As a consequence, with a tax-credit bond, the loss in Federal receipts from the 

tax credit equals the reduction in the tax-credit bond issuer’s interest cost. 

Partial tax-credit bonds

As explained above, present-law tax-credit bonds attempt to offer a 100-percent interest 

rate subsidy. A tax-credit bond need not be structured as solely an instrument that offers a 100-

percent interest subsidy. The Energy Improvement and Extension Act of 2008 authorizes the 

Treasury to allocate $800 million in new CREBs and $800 million in qualified energy 

conservation bonds that will carry a tax-credit equal to 70 percent of a 100-percent tax-credit 

bond. As such bonds have not yet been issued, it is unclear if issuers will choose to supplement 

 47 This is true provided that the taxpayer faces tax liability of at least the amount of the credit. 

Without sufficient tax liability, the proposed tax-credit arrangement would not be as advantageous. 

Presumably, only taxpayers who anticipate having sufficient tax liability to be offset by the proposed 

credit would hold these bonds. 
34 

the bond with a cash coupon such that the bond will initially sell at par or merely rely on the 

proceeds of a bond that likely would sell at a discount to par. Other analysts have suggested a 

different structure in which issuers would issue tax-credit bonds that have a cash interest 

component, the interest income of which would be taxable, and that a tax credit also may be 

claimed for receipt of such cash interest payments.48 

As reported in Table 1, above, tax-exempt debt generally has offered borrowers an 

interest rate subsidy of 25 percent or less for the past two decades. Because the additional 

revenue cost to the Federal government that arises as a result of the current income tax 

structure’s increasing marginal tax rates does not arise when individuals or institutions hold taxcredit bonds rather than tax-exempt bonds (a credit generally has the same value regardless of a 

taxpayer’s marginal tax rate), it may be possible to choose a credit rate that provides an interest 

rate subsidy of greater than 25 percent (but substantially less than 100 percent) and cost the 

Federal government less in forgone revenue than would the issuance of a traditional tax-exempt 

bond for the same State or local purpose. 

Issuance costs and arbitrage potential

Issuance costs

At present, issuance costs for tax-credit bonds likely exceed those of tax-exempt bonds. 

Because tax-credit bonds are relatively new financial instruments, fewer potential borrowers are 

familiar with the applicable rules. Also, present law limits the total dollar value of issuance of 

these instruments. This, too, would likely discourage participation by some service providers 

(i.e., investment bankers, financial advisors, and bond counsel). These factors generally would 

result in fewer service providers competing for the business of helping borrowers issue tax-credit 

debt, with the result being higher prices for such services. Because a portion of the benefit of the 

tax credit flows to these service providers in the way of fees, such fees are a second potential 

source of inefficiency resulting from tax-exempt financing. Through time more service 

providers would be expected to become familiar with these financial instruments reducing 

current disparities in the issuance costs of tax-exempt and tax-credit bonds. If the Congress were 

to continue to permit the issuance of tax-credit bonds, their increased share in the financial 

market also would be expected to reduce current disparities in the issuance costs of tax-exempt 

and tax-credit bonds. Nevertheless, as is the case with tax-exempt bonds, the additional 

requirements for tax-credit bonds may result in higher incremental costs of issuance for taxcredit bonds than those associated with issuing taxable bonds. 

Arbitrage potential

In general tax-credit bonds are subject to the same arbitrage and rebate requirements, as 

detailed in section 148 of the Code, applicable to tax-exempt State and local bonds. However, 

issuers of QZABs, new CREBs, qualified energy conservation bonds, and forestry conservation 

bonds are allowed to take advantage of special arbitrage rules that provide a limited ability for 

 48 One such vision of a partial tax-credit bond is described in CBO, Tax-Credit Bonds and the 

Federal Cost of Financing Public Expenditures. 
35 

borrowers to invest bond proceeds and use the earnings from such investments to make 

additional qualified expenditures. This ability to invest bond proceeds and retain the earnings 

increases the magnitude of the tax expenditure available for qualified expenditure purposes 

beyond the interest cost saving achieved through having the borrower’s interest costs paid in full, 

or in part, by the Federal tax credit. If as a general matter issuers of tax-credit bonds had the 

ability to earn and retain arbitrage profits, issuers would have an incentive to issue more taxcredit bonds and to issue the bonds earlier than necessary to fund a qualified project. As a result, 

there may be increased delays in the expenditure of bond proceeds for approved purposes to earn 

greater arbitrage profits.