III ****************************** 

Tax Exempt Financing 
III-A 

STATE ~NO LOCAL TAXABLE BOND OPTION 

Present Law 

Since the adoption of the Federal income tax in 1913r 

interest on State and local government obligations generally 

has been exempt from Federal income tax. This exemption 

represents a recognition of the independent sovereignty of 

States and their instrumentalities under our federal system 

as well as the desire to enhance the strength of State and 

local governments, as entities closest to the people, in 

solving local problems. 

The exemption applies to all State and local government 

obligations, except for most industrial development bonds and 

arbitrage bonds. Industrial development bonds are 

obligations issued nominally by a State or local government 

to raise funds for private development. (See discussion in 

TAX TREATMENT OF INDUSTRIAL DEVELOPMENT BONDS.) 

Arbitrage bonds are obligations issued to provide funds 

for financial investment, generally in taxable Federal 

securities. Since Federal credit underlies the arbitrage 

bonds, the issuer of such bonds is guaranteed a market and a 

profit at no risk to itself. Therefore, since 1969 the Code 

has provided that arbitrage bonds do not qualify for the 

exemption. 

Reasons for Change 

The tax exemption of interest on State and local bonds 

should not be interferred with in any way. Any recommendation for change in current financing mechanisms is intended 

only to complement rather than to replace tax exemption as a 

means of aiding State and local governments and to reduce the 

inequities and inefficiencies that arise when tax exemption 

provides the sole form of State and local financing. 

The tax-exempt market for financing capital outlays of 

State and local governments is characteri~ed by three 

interrelated problems. First, from the viewpoint of 

structural tax policy, tax exemption is an inequitable way of 

providing a subsidy to the State and local sector. Secondly, 

the subsidy provide d by tax exemption is an inefficient one 

in that only a portion of the revenue loss to the Federal 

treasury results in benefits to State and local governments. Thirdly, the municipal bond market, while performing 

reasonably well over the long term, has, as a result of its 

tax-exempt character, exhibited periods of considerable 

instability which have been disruptive of the financial 

- 215 -
planning of States and localities. Related to this last 

consideration, is the longer term concern that the sources of 

funds for State and local borrowing may not expand 

sufficientl·y to accommodate the capital financing 

requirements of the sector. Each of these problems of the 

municipal market will be considered in some detail. Each can 

be mitigated by the taxable bond option which will provide 

State and local governments with access to the market for 

taxable bonds in addition to the market for conventional 

tax-exempt securities. 

Tax exemption and tax equity. A tax-exempt source of 

income, such as the interest on State and local bonds, 

violates the principles of both horizontal and vertical 

equity: that is, tax-exempt income reduces the progressivity 

of the tax structure and fails to tax all income alike. 

Vertical equity is violated since taxpayers in different 

income classes and, therefore, in different marginal tax 

brackets receive varying benefits from tax exemption. Thus, 

$100 of tax-exempt income is equivalent to $333 in before-tax 

income to an investor in the 70 percent marginal tax bracket 

but to only $143 to an investor in the 30 percent marginal 

tax bracket. Also, for reasons explained below, tax-exempt bonds are generally not economic investments for those in tax 

brackets below 30 percent. As a significant source of 

tax-exempt income, interest on municipal bonds, therefore, 

tends to undermine the progressivity of the tax structure. 

Tax-exempt income also is a violation of horizontal 

equity since all sources of income are not taxed equally. 

Two taxpayers may have the ~xact same before-tax income -- in 

one case derived from wages and salaries and in the other 

from tax-exempt interest -- but will pay quite different 

amounts of tax. It has been claimed that holders of 

tax-exempt bonds do, in fact, pay a tax on their inter~st 

income since they receive a lower before tax yield than muy 

be earned on comparable taxable debt. While this is true, 

this implicit tex on municipal bond interest generally 

amounts to only 30 percent, fer less than the tax high-income 

investors would pay on fully taxable income. 

Tax Exemption as an Inefficient Subsidy. Tax exemption 

provides a subsidy to State and local governments by enabling 

them to issue bonds at interest rctes below those prevailing 

on comparable taxable securities. However, as a device to 

reduce State and local borrowing costs, tax exemption is an 

inefficient use of Federal funds because the loss in revenue 

to the Treasury is greater than the reduction in interest 

costs to the borrower. The difference accrues in the form of 

windfall gains to high-income purchasers of tax-exempt bonds. 

To demonstrate the inefficiency of tax exemption as a 

subsidy, it is first necessary to dete rmine the actual 

subsicy which tex exP.mption provide s to Sta te and local 

- 216 -
governments. As Table IIIA-1 indicates, tax-exempt borrowers 

over the years have benefited from interest rates on average 

equal to about 70 percent of taxable rates. Thus, the 

implicit subsidy of tax exemption is equivalent to a 30 

percent interest rate reduction. The 30 percent implicit subsidy to tax-exempt securities is an average across the 

matu rity spectrum of State end local bonds as well as over 

time. The current operation of the municipal bond market 

provides a larger subsidy for securities with maturities of 

five years or less--on the order of 40 percent below taxable 

rates--and a smaller subsidy on 20 to 30 year securities--on 

the order of 25 percent. Thus, as maturities l engthen, 

interest rates for State and local bonds rise more steeply 

than those for comparable taxable debt. The reason for this 

is the domination of the shorter term municipal market by 

commercial banks. However, to simplify the analysis, the 

discussion which follows generally considers the market as a 

whole with an average implicit subsidy of 30 perc ent. 

Although the average subsidy ~rovided by tax exemption 

is 30 percent, a reason a ble estimate of the average marginal 

tax rate of all purchasers of t a x-exempt bonds -- households 

or individual investors, commercial banks, and other 

financial institutions -- is about 42 percent . In other 

words, if municipal bond interest income were subject to tax, 

issuers of this debt would lose a subsidy of 30 p0rcent of 

the taxable rate and the Treasury would gain revenues equal 

to about 42 percent of the t a xable r a te. This means that 

less than 75 percent of the Trea sury revenue loss flows to 

State and local governments. 

There is no inconsistency in the fact that tax-exempt interest rates average about 70 percent of taxable rates at 

the same time that the average investor is in the 42 percent 

marginal tax bracket. Clearly , not all holders of tax-exempt 

debt are in the 42 percent tax bracket . Some, such as banks 

and high-income individuals are in higher tax bracke ts and 

others with smaller amounts of taxable income are in lower 

tax brackets. High-income taxpayers generally have a strong 

incentive to invest heavily in tax-exempt debt, since their 

after-tax returns from such investments tend to greatly exceed their after-tax returns on comparable taxable 

securities. Indeed, high tax bracket individuals and 

institutions comprise the bulk of the purchasers of 

tax-exempt bonds. 

If issuers of bonds, however, wish to borrow more funds 

than are generally supplied from high-tax bracket individuals 

and institutions, tax-exempt debt has to be made attractive 

to potential lenders with more moderate incomes. The only 

way this can occur is by inc r easing the tax-exempt interest 

rate relative to the taxable rate so that tax-ex empt bonds 

yield a higher after-tax return even to those in less than 

the highest tax brackets. To be sure, the very rich may a lso 

- 217 -
be induced to increose their lending a t more favorable 

tax-exempt rates, but tax-e xempt rates will continue to rise 

until lenders across all t ax br acke ts are su~plying the e xact 

amount of fun ds that State and local governments wish to 

borrow. 

Year 

1960 

1961 

1962 

1963 

1964 

1965 

1966 

1967 

1968 

1969 

1970 

1971 

1972 

1973 

1974 

1975 

1976 

1977 

Table III A-1 

Tax-Exempt and Taxable Interest Rates 

Tax-Exempt 

Interest Rate 

(Bond Buyer 20) 

3.54 

3.45 

3.17 

3.16 

3.22 

3.25 

3.81 

3.92 

4.42 

5.66 

6.36 

5.52 

5.25 

5.22 

6.09 

7.06 

6.70 

5.68 

Taxable Interest Rate 

(Moody's Newly 

(Ibsued Industrials) 

4.67 

4.70 

4.53 

4.42 

4.51 

4.80 

5.52 

5.79 

6.64 

7.84 

8.86 

7.80 

7.51 

7.86 

8.87 

9.12 

8. 61 

8.15 

Ratio 

75.8 

73.4 

70.0 

71.5 

71.4 

67.7 

69.0 

67.7 

66.6 

72.2 

71.8 

70.8 

69.9 

66.4 

68.7 

77.4 

77.8 

69.7 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

January 18, 1978 

- 218 -
This analysis indicates why tax- exempt bonds, on the 

average , trade at interest rates equal to 70 perc~nt of thos~ 

on taxable securities. For current levels of borrowing , it 

is necessary for tax-exempt rates to rise to the point where 

the investor in the 30 percent marginal te.x bracket can 

benefit fr om buying t ax- exempt bonds. T~us , while it was 

earlier stated that the average lenders of funds a r e in the 

42 pe rcent tax bracket , the last, or the marginal , l enders of 

funds are in about the 30 percent tax br~cket. The margin31 

tax rate of the marginal lender dete rmi nes the interest r2te 

advantage to the issuing governments, but the marginal tax 

rate of all borrowers together determines the losses to the -

Treasury. The r eason why tax exemption as a subsidy is 

inefficient is tha t the marginal tax rate of the last lender 

is below the marginal tax rate of all lenders t a ken tog~th . 

Individual investors, of course , are not the only source 

of funds for State and local governments. ~s considered 

be l ow, commercial banks play a ma jor role in the municipa l 

bond market as well. Nonetheless, to the extent that State 

and local governments wish to borrow more than commercial 

banks are willing t o l end, individual investors have to be 

drawn into the market. To attract individuaJs in low~r tax 

brackets to tax-exempt bonds, t a x-e xempt r ates must increase 

relative to taxable rates . 

Thus, tax exemption as ? source of tax inequity a nd as 

an inefficient subsidy a r e two r efl ections of the same image . ~ higher tax-exempt rate r elative to the taxable rat~ means 

both a l owe r subsidy to State and local qove rnments and 

greater windf a ll gains to high bracket individuals. ~n 

investor in the 50 percent tax bracket, for e xample , would be 

willing to buy tax-e xempt bonds as long as the return was 

JUSt about one-halt ot that on te.xable instrum:nts. As 

municipal r ates rise to 60 pe rcent , 65 percent and 70 percent 

of the taxable rate , this investor finds that the after-ta x 

r eturn becomes increasingly above that required tc induce him 

to invest. This e xtr a return is purely a windfall gcin for 

him . Thus, t he higher the ta x-exempt rate r elative to the 

taxable rate, the smaller the ad vantage of tax-exempt 

financing to the borrowe r and the greater the windfall gains 

to the lenders. 

The Cyclical Vol a tility of the Tax-Exempt Market. The 

tax-exempt bond ma rket, large ly as a cons eque nce of the tax 

exemption itself, e xhibits a high degree of volntility over 

the business cycle . While the long-t erm tr end of issues of 

State and local governmen t securities has been upward as 

shown in Table IIIA-2, ther e av ~ ~een periods of tight 

money, such as the ye a rs 1966 and 1969, whe n the volume of 

new issues has either been stagnant or has declined . 

Moreover, as indicated by the ratio of tax-exempt to taxable 

interest r a tes in Table IIIA-1, there is a strong tendency for t ax- e xempt rates to incr ease r elative to t axabl e rates in 

- 219 -
Table Ill A-2 

Volume of Gross New Issues of Long-Term Municipal Bonds by Year 

Year Gross Issues 

1960 7,229 

1961 8,359 

1962 8,558 

1963 10,107 

1964 10,544 

1965 11,084 

1966 11,089 

1967 14,288 

1968 16,374 

1969 11,460 

1970 17,762 

1971 24,370 

1972 22,941 

1973 22,953 

1974 22,824 

1975 29,326 

1976 33,845 

1977 44,915 

Office of the Secretary of the Treasury January 18, 1978 

Office of Tax Analysis 

Source: Bond Buyer. 
such periods. These phenomena mean that when credit 

conditions tighten State and local governments experience relatively higher borrowing costs and are among the first 

borrowers to be crowded out of c a pital markets. 

To understand why the tax-exempt market exhibits this 

volatility, it is necessary to e xamine the behavior of the 

major participants in the municipal bond market. The 

traditional sources of lending to State and local governments 

consist of individua ls and institutions in sufficiently high 

marginal tax brackets to find tax-exempt securities 

attractive. Three groups comprise the major sources of 

demand for State and local bonds: commercial banks, casualty 

insurcnce companies, and household investors. Table IIIA-3 

shows the ownership of outstanding municipal securities by 

these three investor groups and all others tcken together by 

five year intervals from 1960 through 1975. Table IIIA-4 

indicates the annual net purchases of State and local bonds 

by these same investors over the period 1960 to 1976. 

- 221 -
Table III A-3 

Ownership of Municipal Securities 

Year-End Outstandings, Selected Years 

(millions of dollars) 

Households CoDIDerciar B8tiK!iis : Nonlife Insurance : All Other 

Millions Millions : : Millions : :Millions: 

Year Total of : Percent of : Percent : of : Percent : of : Percent 

Dollars Dollars : ~ Dollars : :Dollars 

1960 $ 70.8 $ 30.8 43.51. $ 17.7 25.01. $ 8.1 11.41. $ 14.2 20.1% 

1965 100.3 36.4 36.3 38.8 38.7 11.3 11.3 13.8 13.8 

1970 144.4 46.0 31.9 70.2 48.6 17.0 11.8 11.2 7.8 

1975 221.9 67.5 30.4 102.8 46.3 33.3 15.0 18.3 8.3 

1977 1/ 259.1 79.7 30.8 114.2 44.1 42.8 16.5 22.4 8.7 

Office of the Secretary of the Treasury ,January 18, 1978 

Office of Tax Analysis 

Source: Federal Reserve Board, flow of funds data. 

!I Estimated for end of third quarter. 
Table III A-4 

Net Change in Ownership of Municipal Securities 

Seasonally Adjusted Annual Rates 

Total : Individuals : Commercial Banks : Fire & Casualty : All Other 

:Billions : : Billions : : Billions : : Insurance Com2anies :Billions: 

of : : of : : of : : Billions : : of 

Year :Dollars : Percent : Dollars : Percent : Dollars : Percent : of Dollars : Percent:Dollars :Percent 

1960 5.3 100.0 3.6 67.9 .6 11.3 .8 15.1 .3 5.7 

1961 5.1 100.0 1.2 23.5 2.8 54.9 1.0 19.6 .1 2.0 

1962 5.4 100 . 0 -1.0 -18.5 5.7 105.6 .8 14. 8 -.1 -1.9 

1963 5.7 100.0 1.0 17.6 3.9 68.4 .7 12.3 .1 1.8 

1964 6.0 100.0 2.6 43.3 3.6 60.0 .4 6.7 -.6 -10.0 

1965 7.3 100.0 1.8 24.7 5.1 69.9 .4 5.5 .o 

1966 5.6 100.0 4.0 71.4 2.4 42.9 0.7 12.5 -1.5 -26.8 

.1967 7.8 100.0 -2.3 -29.5 9. 1 116.7 1.5 19.2 -.5 -6.4 

1968 9.5 100.0 -.5 -5.3 8.6 90.5 0.9 9.5 0.5 5.3 

1969 9.9 100.0 9.3 93.9 .6 6.1 1.1 11.1 - 1.1 -11.1 

1970 11.2 100.0 -.9 -8.0 10.7 95.,5 1.5 13.4 -.1 -0.9 

1971 17.4 100.0 0.1 0.6 12.6 72.4 3.5 20.1 1.2 6.9 

1972 14.7 100.0 2.3 15.7 7.2 49.0 4.3 29.3 .9 6.1 

1973 14.7 100.0 5.3 36.1 5.7 38.8 3.6 24.5 .1 0.7 

1974 17.1 100.0 8.9 52.1 .5.5 32.2 2.2 12.9 .5 2.9 

1975 13.6 100.0 5.0 36.8 1.7 12.5 2.6 19.1 4.3 31.6 

1976 15.1 100.0 4.2 27.8 3.0 19.9 4.2 27.8 3.7 24.5 

1977 1/ 29.0 100.0 9.3 32.1 11.9 41.0 7.2 24.8 0.6 2.1 

Office of the Secretary of the Treasury January 18, 1978 

Office of Tax Analysis 

!/ FiTst three quarters of year expresse at annual rates. 

Source: Federal Reserve Board, flow of funds data. 
These tubles illustrate tno important impact of 

commercial bank behavior on the municipal bond market. When 

money is tight, commercial banks first look to meet the 

demand for loans by their custo~ary business cli~nts, and 

only as their resources permit do they purchase municipal bonds. Thus, the most difficult periods of financing for 

States and localities arc generally when commercial banks are 

able to absorb only a small portion of the net issues of 

municipal debt , such as occured in the ye~rs 1966 and 1969 

and more recently in 1975 and 1976. During these periods, 

increased purchases of municipal debt by households only 

partially offset the decline in commercial bank 

participation. Borrowing costs to ~tate and local 

governments rise, and the do llar volume of new issues falls. 

The reason tax- exempt rates must rise when banks leave the 

market is to provide a sufficient incentive for households to 

absorb a larger share of municipal debt. In periods of 

credit stringency, then, the loss of bank demand for 

municipal bonds is only partially compensated by increased 

household purchases. At the same time, the rise in the 

tax-exempt rate relative to the taxable rate reduces the 

v~lue of the subsidy provided by tax exemption . 

Tables IIIA-3 and IIIA-4 also indicate that the overall 

participation of commercial banks in the municipal bond 

market has declined in recent years. Throughout the 1960's, 

commercial banks absorbed 63 percent of the total supply of 

State and local debt. In the 1970's commercial banks have 

absorbed only 40 percent. Table III~-5 presents even more 

sharply the declining role of commercial banks in the 

municipal bond market. This table shows net changes in 

holdings of credit market instruments other than o.s. 

securities by commercial banks since 1965. Through 1971, 

municipal bonds generally amounted to 50 percent of 

commercial bank acquisitions of credit market securities. 

Since 1972, however, partly as a result of the availability 

of other sources of tax-favored income, the share of such 

security purchases accounted for by State and local bonds has 

declined to the range of 20 to 30 percent. Thus, in addition 

to the cyclical volatility of the market, there is some 

concern that traditional purchasers of tax-exempt debt will 

fail to provide funds for State and local capital financing 

over the longer term. In 1975 and 1976, other investors took 

up the slack of a reduced volume of purchases by commercial 

banks. In part these other investors were State and local 

pension funds whose purchases reflect the unusual 

circumstances in New York City and State. Since pension 

funds derive no advantage from tax exemption , they cannot be 

expected to continue as a permanent source of State and local 

financing. 

- 224 -
Table III A-5 

Net Changes in Holdings of Credit Market 

Instruments Other Than u.s. Securities by C011111ercia1 Banks 

State & State & Local Bonds 

Local Corporate Ccn.ercial Other as Percentage 

Year Bonds Bonds Mortsases Mortsases Total of Total 

( ..••.••..•••••••••• b"illions of dollars •••••••••••••.•• ) ( •••••••••• % ••••••••• ) 

1965 5.1 -.1 2.0 3.7 10.7 47.7 

1966 2.4 • 2.0 2.7 7.1 33.8 

1967 9.1 0.8 1.6 3.0 14.4 63.2 

1968 8.6 0.3 2.6 4.0 15.4 55.8 

1969 0.6 -.1 1.8 3.7 6.0 10.0 

1970 10.7 0.8 1.2 1.0 13.6 78.7 

1971 12.6 1.2 3.0 6.7 23.6 53.4 

1972 7.2 1.7 5.4 11.4 25.6 28.1 

1973 5.7 0.4 6.9 12.8 25.9 22.0 

1974 5.5 1.1 5.0 7.9 19.4 28.4 

1975 1.7 1.8 3.2 1.1 7.8 21.8 

1976 2.9 -0.6 2.6 11.0 15.9 18.2 

1977 !/ 11.9 -0.4 8.0 18.1 37.6 31.7 

Office of the Secretary of the Treasury January 18, 1978 

Office of Tax Analysis 

!/ First three quarters expressed at annual rates. 

* Less than $0.05 billion. 
General Explanation 

The Administration proposal will establish an election 

in the Internal Revenue Code for State and local governments 

to issue taxable bonds and other debt obligations with the 

Federal Government paying a fixed portion of the actual 

dollar amount of the issuer's inter est cost. For obligations 

issued during 1979 and 1980, the Federal Government will pay 35 percent of the interest cost. For obligations issued 

thereafter, the Federal Government pay 40 percent. All 

tax-exempt State and local obligations will be eligible for 

this taxable bond alternative. These include general 

obligation and revenue bonds issued by a State and local 

9overnment as well as industrial development bonds, the 

Interest on which is tax exempt. There would be no Federal 

control over the purposes for which the taxable obligations 

could be issued. However, obligations held by related 

entities (such as related pension funds) would be eligible 

for the election only if the obligations were issued through 

a competitive public offering. The Federal interest subsidy would be paid to the issuer (or its paying agent) which would 

act as paying agent for the Federal Government. The Federal 

Government would not be liable for its portion of the 

interest until the issuer pays the remaining interest. The 

proposal would establish an entitlement for State and local 

governments to assure that funds necessary to pay the Federal 

Government's portion of the interest would be appropriated 

annually. 

Analysis of Impact 

The taxable bond option, under which State and local 

governments will have the choice of issuing either 

conventional tax-exempt bonds or subsidized taxable bonds, 

will deal s imultaneously with all of the major problems in 

the tax exempt bond market. To determine the extent to which 

the taxable bond option will contribute to tax equity, the 

efficiency of the subsidy now provided to State and local 

governments, and the stability of the municipal bond market, 

it is first necessary to analyze how the option will operate. 

Under the taxable bond option, State and local 

governments which choose to issue taxable bond in place of 

tax-exempt bonds will receive a Federal subsidy equal to a 

fixed percentage of the interest costs on the taxable 

securities. It is important to emphasize the voluntary 

nature of this plan. State and local governments on their 

own volition will decide whether they wish to issue 

subsidized taxable or conventional tax-exempt debt. Since 

this decision ~ill presumably be made on the basis of which 

type of security affords the lower net interest cost, State 

ana local qovern~ents can only benefit from the plan. If the 

subsid ized taxable bond fails to yi e ld lowe r net interest 

costs, States and loca l ities simply wi ll not avail t hems e lve s 

- 226 -
of it. Furthermore, the higher the subsidy the greater the 

benefits to the issuing governments. 

Nonetheless, some representatives of State and local 

governments have expressed a concern that the subsidy rate 

could be too high. The basis of this concern i s that if 

taxable bonds were made too attractive, the tax-exempt market 

would virtually disappear and issuers would no longer have 

available a tax-exempt market i n the event that the subsidy 

to taxable bonds were discontinued. On these grounds, the 

subsidy should never be so high as to completely eliminate 

the tax-exempt market. 

On the other hand, too low a rate of subsidy would 

clearly undermine the objectives of the plan. ~ low subsidy 

would in the first instance accomplish little in solving the 

basic problems of the tax-exempt market. In addition , the 

subsidy must be large enough to elicit a sufficiently large 

volume of issues of the new taxable security to generate 

market acceptance. If only a slight volume of tax~ble 

municipal debt were issued, such debt could very well be 

regarded as a mere market curiosity wit~ little secondary 

trading, poor liquidity characteristics, and an attendant 

loss of interest on the part of potential lenders. Thus, the 

subsidy under the taxable bond option must be provided at a 

level which will maintain both the taxable and the tax-exempt alternatives for State and local financing. It must neither 

be so high as to eliminate the tax-exempt market nor so low 

as to preclude the development of a taxable municipal market. 

A permanent subsidy of 40 percent (after a two year 

transitional subsidy of 35 percent) would meintain markets 

for both taxable and t ax-exempt municipal debt. 

The permanent 40 percent subsidy on taxable bonds will 

operate as follows. For each of their bond issues, State and 

local governments presumably will accept bids on both a 

tax-exempt and a taxable basis. Then, after accounting for 

the Federal subsidy on taxable bonds, they will decide which 

form of security will yield the lower interest costs. 

Initially, with market yields unchanged, it may be expected 

that subsidized taxable bonds would provide the low~r 

interest costs. In fact, to forestall too large an initial 

shift of financing out ot the tax-exempt market which could 

have e disruptive impact on that market, the subsidy for the 

first two years of operation of the plan is set at 35 percent 

rather than 40 percent. ~s the volume of tax-exempt debt 

declines in response to the taxable subsidy, interest rates 

qn tax-exempt debt also will decline, since the reduced 

volume will no longer require higher interest rates to 

attract marginal lenders. 

This decline in t?x-exempt r ates will itself k~eo 

tax-exempt financing attractive, and the flexibility of 

financial markets will soon effect an equivalence of interest 

- 227 -
costs between subsidized taxable and tax-exempt debt. The 

issuing governments themselves, along with the underwriters 

of their debt, will be instrumental in bringing this 

equivalence about since States and localities will tend to 

issue debt in that sector of the market providing the most 

advantageous financing terms. Thus, State and local 

governments will generally face a situation where the 

interest costs of taxable borrowing (net of the Federal 

subsidy) will equal the costs of tax-exempt borrowing. At 

this point, the issuing governments will be indifferent to 

the particular type of debt they issue, and the form of debt 

will merely reflect the market preferences of lenders for 

tax-exempt as opposed to taxable securities. 

The voluntary nature of the plan assures that States and 

localities will gain significant benefits in terms of reduced 

borrowing costs. They will only choose the taxable option if 

it offers cost advantages. As long as taxable bonds are 

issued, however, tax-exempt interest costs will also decline. 

Thus, a saving in interest costs will occur on the total 

volume of debt issued and will be independent of the form in 

which it is issued. The equilibrium outcome, then, will be 

that under the 40 percent subsidy, tax-exempt interest rates 

will be 40 percent below taxable rates and States and 

localities will be indifferent between issuing subsidized 

taxable or tax-ex'empt debt. 

The benefits of the taxable bond option will accrue to 

all issuers of tax-exempt debt regardless of their relative 

credit standings. The Federal Government's agreement to pay 

a portion of the interest cost on taxable bonds will not in 

any way constitute a guarantee of the issuer's obligation to 

pay principal or its portion of the interest cost. 

Consequently, the taxable bond option will not enable issuers 

with a poor credit standing to gain any greater access to 

financial markets than that available to more creditworthy 

issuers. The taxable bond option will establish a tax-exempt 

rate for all grades of issuers at approximately 60 percent of 

the taxable rate for comparable credits. All issuers, 

therefore--both those with good and poor credit 

standings--will benefit from a reduction in their borrowing 

costs. 

The new volume of issues of taxable and tax-exempt debt 

under a 40 percent subsidy is not easy to estimate. It 

depends not only on what lenders will wish to hold in their 

portfolios at the new structure of interest rates but also on 

how quickly they will be able to adjust their portfolios from 

their current pattern of holdings. A reasonable calculation, 

based on informed market opinion as well as on estimates 

derived from econometric models, is that after an adjustment 

period of possibly five years, about 25 percent of State and 

local bond issues will be in taxable form and 75 percent in 

tax-exempt form. This is the likely response to tax-exempt 

- 228 -
rates 4U pe rcent be low t a xa ble r c tes rathGr than 30 pe rcent 

z s un de r current l aw. I n the s hort run, howe ve r, in orde r to 

bring about this large a portfolio shift in Jong-run as se t 

holdin3s, perh aps 50 percent of the m? rk c t will be t a xabl e 

until fin a l equilibrium is a chieved. The r e ve nue e stima t e s 

provided be low r e fl e ct t he s e assumptions. 

Eff e cts on Equity. On equity grounds, a 40 pe r cent 

subsidy will mean a higher implicit tax r a t e on t hose hold ing 

municipal bonds -- 40 pe rc ent rather tha n the curr en t 

implicit tax r a t e of about 30 percent. Ve ry high-br acke t 

taxpayers will continue to find t a x-e xempt bonds to be an 

advantageous investment since even the increa sed implicit tax 

of 40 percent will rema in be low the explicit t a xe s the y wil l 

pay on taxable debt. Nonetheless, the a fter-tax income 

distribution in gen e ral will exhibit gr ea t e r equity as a 

result of the r educed opportunity for tax avoidance by those 

in high-income tax brackets. 

The improvement in tax equity will be brought about in 

two ways. First, there will be a smaller volume of taxexempt debt available 3S some State and local gov rnm nts 

choose to issue subsidized taxable rather then tax-exPmpt 

debt. Secondly, the tax-exempt debt which continues to be 

issued will command lower interest rates on the ma rket. For 

both of these reasons, the dollar volume of interest income 

avoiding tax would be reduced by about 35 percent unde r the 

taxable bond option. ~t current levels, this will amount to 

a reduction of tax-exempt interest income of about $4.0 

billion. 

Effects on Tax Exemption as a Subsidy. The taxable bond 

option also will increase the e££ic1ency of the current 

subsidy which tax exemption provides to State and local 

governments. Onder current law, these governments receive 

less than 75 cents in reduced interest costs for each dollar 

of tax revenue foregone by the Federal Tr easury. The 

incremental bene fit to cost ratio under the t a xable bond 

option is much more favor a ble. In the first five years of 

the plan, each doll a r of Fede ral subsidy net of r e venue gain 

will provide between $2 and $2.50 of inte r e st savings. In 

the long run, this number will rise to over $4 per dollar of 

net Federal cost. 

The high leverage of the taxable bond option e s me asured 

by State and local interest saving per doll a r of net Federal 

cost results from two source s. The first, as already noted, 

is that the subsidy is only paid on issues of taxa ble bonds, 

whereas States and localities also benefit from the lowe r 

interest rates which will prevail on tax-exempt bonds. The 

second source of the high leverage of this plan is the f a ct 

that a portion of the cost of subsidizing taxable municipal 

bonds will be recouped as increased tax revenues on t he new 

taxable securities. The result is that the net cost of the 

- 229 -
taxable bond option is considerably lower than the gross 

outlays for the subsidy. Under the assumption that the 

option is made available on January 1, 1979, the saving in 

interest costs for States and localities beyond that 

currently provided by tax exemption is as follows: 

1979 1980 

0.1 0.3 

Calendar Year 

($ billions) 

1981 

0.5 

1982 1983 

0.9 1.3 

Effects on Cyclical Volatility. The taxable bond option will 

also help to solve the problem of the cyclical volatility of 

the municipal market. The main source of this short-run 

volatility, as well as a possible troublesome deve lopment in 

tne long run, is the tendency of commerci al banks to abandon 

the tax-exempt market causing tax-exempt interest rates to 

rise. Under the taxable bond option, the tax-exempt r ate 

will be linked necessarily to the tax bl e r ate by the subsidy 

percentage. With a 40 percent su~sidy, borrowers trying to 

minimize interest costs will maintain the t a x-exempt rate at 

60 percent of the taxable rate. If the tax-exempt r a te were 

to temporarily rise to more than 60 percent of the taxable 

rat~, State and local governments would switch their new 

issues from the tax-exempt to the subsidized taxable market 

until the tax-exempt rate aga in declin ed to 60 percent of t he 

taxable rate. Since the taxable bond option will ~ss ur e that 

the tax-exempt rate is effectively tied to 60 pe rcent of the 

taxable rate, the withdrawal of commerci l banks from the 

tax-exempt market will not cause a rise in St a te end local 

borrowing costs. Instead, a decline in commercicl bank 

participation will be reflected in an increased volume of 

t~xable issues as State and loca l governments co~o sa te for 

the lost bank demand by turning to othe r sources of lending such as tax-exempt institutions, life insurance companies and 

individual investors who are not inter ested in tax e xemption . The taxable bond option will a llow these governments to 

retain the benefit of a constant borrowing cost differential 

below taxable rates because they will be able to tap new 

sources of funds and new investors beyond those who now 

derive adv3ntages from tax-exempt interest income. 

Effective Date 

The taxable bond option will apply to obligations issuen 

after December 31, 1978. 

- 230 -
Revenue Estimate 

1978 1979 

156 

Outlay Estimate 

1978 1979 

199 

Change In Tax Liability 

($ millions) 

Calendar Years 

1980 1981 

465 863 

Change in Outlays ($ millions) 

Calendar Years 

1980 1981 

592 1115 

Technical Explanation 

1982 1983 

1355 1808 

1982 1983 

1770 2374 

The Internal Revenue Code will provide an election for 

State and local governments, possessions or territories of 

the United States and the District of Columbia, to issue 

taxable obligations. The Federal Government will provide an 

interest subsidy of 35 percent of the interest cost on 

taxable obligations issued during 1979 and 1980, and 40 

percent for obligations issued thereafter. 

Form of Election. The election will be made in the form 

of a notice to the Secretary of the Treasury (or another 

official designated by the Secretary). 

A separate election will be made by the issuer for each 

taxable issue. It is intended that the election be made at 

any time before the obligations are, in fact, issued (i.e., 

before there is a physical delivery of the evidences of - indebtedness in exchange for the issue price). Thus, the 

issuer will be able to request dual bids (separate bids for 

tax-exempt bonds and for taxable bonds) and make the election 

based upon the bids received for both types of bonds.l/ 

An election with respect to any issue will be 

irrevocable once the obliga tions are issued. Thus, any notificetion to the Federal Government relating to en 

- 231 -
election could be withdrawn at any time before obligations 

ace issued. No zdvance ruling or any other form of advance 

approval by the Secretary or any other Federal official will 

be required before the election can be made . 2/ 

Eligibility. In general , all obligations the intPrest 

on which is exempt from tax under the Internal Revenue Code 

will be eligible for the taxable bond election. This 

includes general obligation bonds, revenue bonds, and 

short-term obligations such as tax anticipation notes. Also, 

industrial development bonds, the interest on which is exempt from tax under the Internal Revenue Code, and obligations the 

interest on which is presently tax-exempt under the Housing 

Act of 1937 will be eligible for the election. The election 

will not apply to arbitrage bonds, which are denied tax 

exemption under the Code, non-exempt industrial development 

bonds and obligations whose exemption derives from provisions other than the Internal Revenue Code or the Housing ~ct of 

1937. 

Obligations on which the United States guarantees all or 

part of the principal or interest or is liable to pay any 

part of the principal or interest will not be eligible for 

the subsidy. Further, obligations which the United States is 

committed to purchase as a means of providing financial 

assistance will not be eligible for the subsidy. For 

example, the United States may purchase or promise to 

purchase obligations at a price higher than the market price 

as a means of guaranteeing the bonds or subsidizing their 

interest payments. 

Obligations will be eligible for this subsidy, however, 

even though the United States indirectly provides funds 

for the payment of part of the principal or interest. For 

example, obligations issued under Section 8 of the Housing 

Act of 1937 will be eligible for the subsidy. 

Related Entities. The election to issue taxable bonds 

will not apply to any obligation which is held by an entity 

related to the issuer if the obligation is not issued 

pursuant to a public underwriting. This requirement is inten~ed to prevent issuance of taxable bonds at an inflated 

rate to take advantage of the Federal subsidy. Since a State 

or local government may be making payments to related 

entities in any event, its share of an inflated interest rate 

may not be ~ real cost. Where these obligations are 

distributed through a public underwriting, the Federnl 

Government can be assured th?t the interest rate on any 

obligation held by related entities is not overstated. In 

limited circumstances where a State or local government needs 

immediate funding and ther e is no public market for the 

obligations, the Secretary may waive the requirern nt of a 

oublic underwriting if he is s a tisfied that the inte rest rate 

ls not artificially infla t e d . 

- 232 -
An issue of obligations will be considered to hove been 

issued pursuant to a public underwriting if the obligations 

are purchased by independent underwriters for resale to the 

general public. An issue will not be considered to have 

been purchased for resale to the general public unless at 

least 40 percent of the face amount of the issue is acquired 

for investment by persons which are not related entities. 

Further, in any case in which an issue is composed of 

obligations bearing different rates of interest, at least 40 

percent of the face amount of the obligations issued at each 

separate interest rate must be acquired for investment 

purposes by persons who are not related entities. 

Related entities include, in the case of a State, any 

political subdivision of the State, and, in the case of a 

political subdivision of a State, the State itself and any other political subdivision of the same State. Thus, unless 

issued in a public underwriting, bonds of one municipality 

purchased by another municipality within the same State will 

not be eligible for the taxable bond election. Furthermore, 

the State cannot, except through a public underwriting, buy 

eligible obligations of any of its municipalities nor can 

municipalities buy eligible obligations of their State. Any 

agency or instrumentality of a State or political subdivision 

(including any trust or plan for the benefit of the employees of a State or political subdivision) will be treated as part 

of the State or political subdivision. Thus, a 

municipality's pension fund is a related entity of the 

municipality, of all other municipalities of the State, and 

of the State. However, a municipal bond bank, whose function 

is to assist the marketing of obligations of small 

governmental issuers, will not be treated as a related party. 

Finally, in the case of obligations issued by an 

instrumentality of two or more St~tes, all of the States 

involved and political subdivisions within those States will 

be considered related entities to the instrumentality. 

Arbitrage. The arbitrage bond provisions of the Code 

currently applicable to tax-exempt bonds will be applicable 

to taxable bonds issued under the election. Thus, bonds 

denied the tax exemption under the arbitrage rules of the 

Code will not be eligible for the subsidy. In determining 

whether or not an obligation is an crbitrage bond (i.e., whether its proceeds are reasonably expected to be used to 

acquire securities which will produce a yield materially 

higher th~n the yield on the obligations issued), the yield 

on the issue will be determined with reference only to that 

portion of the yield which is to be paid by the . issuing State 

or local government. In this way municipalities will have no 

incentive to issue taxable oblig3tions in order to reinvest 

the proceeds in other taxable securities. 

- 233 -
Payment of Subsidy. The Federel Government will make a 

payment of 35 or 40 percent (depending on the date on which 

the obligation was issued) of the inte rest liability of the 

issuer on each obligation to which a taxable bond election 

applies. The Treasury Dep~rtment will pay its portion of the 

interest to the issuer (or to a paying agent appointed by the 

issuer). However, the Feder a l Government will not be liable 

for its oayment on the obligation until the issuer has paid its portlon of the interest on the obligation. Thu~, if e 

State or local government defaults on its interest ~ayment, 

the Federal Government will not be requir ed to pay its 

portion of the interest on the obligation. Of course , the 

Federal Government will pay its portion at any time that the 

issuer cures its default by making its peyment to the holders 

of the obligation. 

The interest subsidy payment will be mad~ without any condition or requirement by the Secretary of the Treasury. 

Thus, unless the bond or other obligation is determin ed to be 

ineligible for the election under the Code, the payment will 

be made automatically. In addition, the purposes for which 

the obligation is issued will not be revi ewed by the 

Secretary as long as the obligation qualifies for the 

election under the Code. 

The availability of funds necessary to financ e the 

Federal interest subsidy will be assured by establishing an 

entitlement for State and local governments to the amount of 

appropriations necessary to ~ay the full accrued cost of the 

interest subsidy . Annual appropriations of the ne cessary 

funds will be automatic since, if no funds are appropriated, 

State and local government issuers will be able to sue the 

United States in the Court of Claims for payment of the 

funds. Such legal action will not be necessary since the Con~ress has not once failed to appropriate funds und t 

ent1tlement programs. 

- 234 -
Footnotes 

1/ It is anticipated that bids Qn issues of serial bonds 

(i.e., where the bonds in the issue have varying maturities) 

will often innicate that a State or local government should 

split its issue, with the longer term bonds being taxable and 

the shorter term bonds tax-exempt. Nothing in this ~roposal 

will prevent a State or local government from splitt1ng such 

an issue. For purposes of these provisions, however, the 

taxable bonds and the tax-exempt bonds will be considered to 

be separate issues. 

2/ Of course, if a tax ruling is requested by the issuer 

prior to making the election, the Treasury Department will 

require that appropriate documents, as is the case today for 

tax-exempt bond rulings, be submitted or be made available to 

show that the obligations included in the issue qualify for 

the election under the Internal Revenue Code. 

- 235 -
IIIB 

TAX TREATMENT OF INDUSTRIAL DEVELOPMENT BONDS 

Present Law 

Industrial development bonds (IDBs) are obligations 

which raise capital for private business enterprise but are 

nominally issued by State or local governments. Most 

fr equently, the proceeds of an issue of lOBs are used to 

acquire or to construct a facility: the facility is then 

"leased" to a private user for a r ental exactly sufficient to 

pay debt service on the bonds. The lease generally provides 

that the private user may purchase the facility for a nominal 

amount at the end of the lease term. Payment of debt service 

on the bonds is secured by the rental payments and the 

facility itself. Generally the nominal issuer is not liable 

for payment of debt service on the bonds and the holders must 

look solely to the credit of the private user. 

In issuing lOBs a State or local government essentially 

lends its tax exemption to a private business to enable it to 

finance facilities at the lowe r interest rates prevailing in 

the tax exempt market. In addition, the "lease" agreement 

between the issuer and the private user is generally treated 

as a conditional sale contract for Federal income tax 

purposes: the user is, therefore, able to obtain the tax 

benefits associated with ownership of the property, including 

investment tax credits and accelerated depreciation or 

amortization. State and local governments use IDB financing 

to ~ssist local industri a l de velopment. Since these 

governments incur no liability on the bonds, which are 

universally recognized as a debt of the private user, the 

issuance of IDBs has nd direct consequence to the nominal 

issuer. 

Inte r e st on State and local government obligations is 

gener ally exempt from tax under the Internal Revenue Code. 

However, the Revenue and Expenditure Control Act of 1968 

denied tax exemption to IDBs, with certain exce ptions. In 

general, a bond is an IDB under the Code if (1) the proceeds 

of the issue are to be used in any tr ade or business not 

carried on by a government or tax-exempt organization and if 

(2) repayment of principal or interest is secured by an 

interest in, or derived from payments with respect to, 

property used in a tr a de or business. Obligations issued by 

a State or local govP.rnment to raise funds for use by a 

non-profit, charitable organization in its trade or business 

arc not gen e r?.lly tre ated as ID9s r. nd are thus tax exempt . 

- 236 -

I 
The exceptions to the ge neral ru le allow t~x exemption 

for IDBs issued to finance certain enumerated facilities and 

for certain "small issues". The enumereted facilities for 

which tax-exempt IDBs ma y be issued without any dollar amount 

limitation, include: 

(1) Residential r0al property for family units, 

(2) Sports facilities, 

(3) Convention or trade show facilities, 

(4) Airports, docks, wharves, mass commuting 

facilitie s, parking facilities, or storage or 

training facilities directly related to th~se 

faciliti es , 

(5) Public utility facilities used to provide sewage 

treatment or solid waste disposal and facilities 

designed for the local furnishing of electric 

energy or gas, 

(6) Air or water pollution control facilities, 

(7) Facilities for the furnishing of water, if 

available on reasonable demand to members of the 

general public , and 

(0) Industrial parks. 

There is also an exemption for "small issues" of ID9s in 

amounts of $1 million or less if the proceeds are used for 

the acquisition or construction of land or depreciable ~roperty. The $1 million limitation applies to all bonds 

issued to provide facilities in one municipality or county 

for the same person or group of related persons. At the 

election of the issuer, the $1 million limitation may be 

increased to $5 million; if elected , however, the hiqher $5 

million limitation is restricted to projects where the total 

ccpital expenditures over a 6-yea r period will not ~xceed $5 

million. 

Reasons for Change 

Prior to 1968, interest on ind ustrial development bonds 

(IDBs) issued by State and local governments had been exempt 

from Federul income taxation. The use of such ID~s had been 

growing in importance as a ec h~nism by which State and local 

governments sought to attract plants to their communities. Through the use of lOBs , these gove rnments had bePn a ble to 

extend the t2x exemption afforded to interest on th~ir 

securitie s issued for public investment to interest on bonds 

issued for essenticlly private purposes. Of course , ?s m?ny 

- 237 -
States and localities came to utilize this method, the 

competitive advantage was lost and the increased volume of 

tax-exempt financing affected the interest cost of public 

issues. These factors, ~nd f e ar of increasing revenue losses 

to Treasury as use of this method of financing long-term private debt expanded, led to the limits on tax-exempt IDBs 

included in the Revenue and Expenditure Control Act of 1968. 

In this Act, Congress did not remove the exemption for 

all industrial development bonds. In terms of the dollar 

volume of obligations, the most important of the exceptions that remain is for financing pollution control expenditures. 

As Table IIIB-1 shows, pollution control lOBs for the years 

1973 - 1977 accounted for over 80 percent of private 

tax-exempt borrowing, and for 6 to 7 percent of all 

tax-exempt borrowing. 

Table IIIB-1 

Tax-Exempt Borrowing: 1971-1917 

rosa 

Long-Tera Private lOBs 1/ Pollution Control 

Tax-Exempt Pollution as Percent of: 

Borrowing Control Others Ail· Tax- Private 

Year ($millions) ($millions) ($millions) Exempt lOB's 

1971 24,370 77 220 0.9 25.9 

1972 22,941 563 471 2.5 54.5 

1973 22,953 1771 270 7.7 86.8 

1974 22,824 1673 340 7.3 83.1 

1975 29,326 2134 518 7.3 80.5 1976 33,845 20.64 357 6.1 85.3 

1977 44,915 2982 476 6.6 86.2 

Source: Weekly Bond auyer 

!I Includes pollution control, sm.-.11 issues and industrial park lOBs .• 

Does not include lOBs of a quasi-governmental character, such 

as airports, docks, wharves, and residential real property for 

family un 1 ts. 

As recently as 1971, in contrast, tax-exempt financing of 

pollution control facilities accounted for less than one 

percent of all tax-exempt borrowing. In fact, the annual 

volume of tax-exempt pollution control financing today is 

more than double the total annual volume of all industrial 

development bond financing in 1967 ($1.4 billion) which had 

motivated legislation to limit the use of tax-exempt 

lOBs. !/ 

- 238 -
Table IIIB-2 shows how dramatically t ax- e xempt borrowing 

has increased as a source of funds for pollution control 

expenditures. Using estima tes on a ir and water pollution 

control expenditures supplied by McGraw-Hill, the table shows 

that t a x-exempt borrowing fincnced only 2.4 percent of 

pollution control expenditures in 1971. In contrest, 

tax-exempt borrowing has accounted for between one-fourth and 

one-third of all pollution control expenditures for the years 

1973 through 1976. 

Year 

1971 

1972 

1973 

1974 

1975 

1976 

Source: 

Industrial 

Pollution 

Control 

9orrowing 

($millions) 

17 

563 

1771 

1673 

2134 

2064 

Table IIIB-2 

Import~nce of Tax-Exempt Borrowing for 

Pollution Control Expenditures 

"ir and Water 

Pollution Control 

Expenditures 

BEA 

( $mi 11 ions) 

n.a. 

3913 

4938 

5219 

6152 

6336 

McGraw-Hill 

($mill ions) 

3245 

4501 

5687 

6922 

6702 

7713 

\ of Pollution Control 

Expenditures Financed by 

Tax-Exempt Borrowing 

BEA MeG r aw-R ill 

n.a. 2.4 

14.4 12.5 

35.9 31.1 

32.1 24.2 

34.7 31.8 

32.6 26.8 

Weekly Bond Buyer, various issues, o.s. Department 

of Commerce, Bureau of Economic Analysis (BEA) 

Survey of Current Business, July issues, McGraw 

Hill, Pollution Control Expenditures: 'nnual 

Surveys 

In permitting the pollution control exception in 1968, 

Congress could not have contemplated this large a volume of 

tax-exempt financing. It was argued at that time that 

private investments for pollution control could justify some 

type of Federal subsidy since these investmPnts produced 

239 -
benefits to the public in terms of environmental improvement 

for which ~irms might not be compensated in 9rivate markets. 

Moreover, 1t was argued that the low level of spending on 

such investments assured that the revenue loss from exempting 

the interest on IDBs used to finance them would be small. 

Furthermore, whatever their merit in the past, the 

reasons for allowing tax free interest on IDBs for pollution control no longer apply. In recent years, many pollution 

control investments have been effectively mandated by the 

requirements of Federal law and by EP~ regulations that firms 

meet specified emissions standards.2/ Because these 

regulations compel firms to undertake the desired 

investments, tax exemption no longer functions cs an 

effective incentive. 

Moreover, continuing to allow tax-fre~ IDBs to finance 

pollution control facilities has three undesirable effects: 

1) It lessens tax equity by increa sing the amount of 

interest income which is tax-exempt. 

2) It creates economic in e fficiencies by encouraging 

the wrong types of investments in pollution 

control equipm~nt and by subsidizing some 

industries relative to others. 

3) It raises the cost to State and local governments 

of borrowing in the tax-exempt market for public 

sector investments. 

Thus, as discussed in detail below, the e limin a tion of 

tax-exempt financing for pollution control equipment would 

promote tax equity and economic e ffici ency end would lowe r 

the cost of borrowing to State and local governments. 

The two other types of tax-exempt TDBs that relate to 

borrowing for essentially priva te purposes a r e small issue ID~s and lOBs for incustrial parks. Repecling the tax-exempt 

tr ea tment of these bonds would also improve t a x equity, 

increase economic efficiency, and r educe borrowing costs to 

State and local gove rnments. However, an exception should be 

made for small issue IDBs in some economically distressed 

areas to promote economic deve lopment where it is most 

needed. 

Finally, it is desirable to limit the use of t ax-exempt 

bonds in financing hospital construction. Limits on such 

financing are complementary to other propos a ls included in 

the Administration's Hospital Cost Containment Act designed 

to prevent excess expansion of hospit al facilities. 

- 240 -
Gen e ral Expl anation 

The Administration proposal will rev ise the tax law 

relating to IDBs in three respects. First, it will repeal 

the tax exemption for roes issued to finance pollution 

control facilities and industrial parks. These facilities 

will be placed on the same footing a s other purely private 

facilities. The proposa l will thus restrict access to the 

tax-exempt market to bonds issued to finance activities and 

facilities which are generally governmental in nature, 

thereby improving the access of those bonds to the market. 

Second, the Administration proposal will revise the 

small issue exemption by doubling the $5 million small issue 

limitrtion to $10 million. The proposal will also limit this 

exemption to IDBs issued to finance the acquisition or 

construction of land or depreciable property in economically distressed areas. The utility of the small issue exemption 

will thus be enhanced, while at the same time the subsidy 

afforded by t ax exemption will be targeted towards those 

areas in which it is most needed. 

Third, as part of the ~dministration's Hospital Cost 

Containment program, the proposal will revise the definition 

of industrial development bonds to deny tax exemption to 

obli9ations issued to finance certain hospitals for which a 

c e rt1fication of need has not been issued. Under present 

law, obligations issued by a State or local government to 

r aise funds for use by a non-profit, charitable organization 

in its trade or business are not generally treated as lOBs 

and are thus tax-exempt. Under the Administration proposal, 

the de finition of a t a xable IDB will be expanded to include 

obligations issued to fin ance hospital facilities that are 

oper a ted by such organ iza tions, unless a need for the 

facilities has been established under the relevant provisions of the Public Health Services ~ct or the Social Security Act. 

If a need for the facility has been established, interest on 

the bond will r emain t a x-exempt. 

Any industrial dev e lopment bonds which can be issued on 

a tax-exempt basis may, a t the e lection of the issuer, 

qualify for th~ Federa l interest subsidy provided for State 

and local government issues under the ~dministration's 

taxeble bond option proposal. (See T~XA~LE BOND OPTION.) 

Analysis of Impact 

Pollution Control Bonds 

It is undesirable to continue financing of pollution 

control investment with tax-exempt bonds beca use they 

dec r ease tax equity , reduce economic efficiency , and i ncrease 

State and local bo r rowing costs. 

- 241 -
Tax Equity. The existence of an 09portunity to earn tax 

free income from e.ny type of investment reduces the effe ctive 

progressivity of the tax system by enabling high-income 

individuals to earn greater after-tax returns on c apital than 

they otherwise would obta in. This windfall to high bracket 

lenders occurs because individuals in high tax bracke ts have 

more to gain from owning a tax free asset than individuals in 

low tax brackets. As the relative volume of tax-exempt 

borrowing increases, the interest r a tes on such bonds as 

compared to the rate on t a xable bonds must rise to make them 

attractive to investors in lowe r tax brackets. As a result, 

the interest rate d i fferential, in equilibrium, between 

tax-free and taxable bonds will be determined by the relative 

supplies of the two types of securities and by the statutory 

schedule of marginal tax rates. In the equilibrium thus 

determined, the lowest brac~et buyer is indifferent between 

holding tax-exempt and taxable assets, while the higher 

bracket buyer receives a higher rate than needed to attract 

him to the tax-exempt asset. 

In recent years, the interest rate differential betwee n 

equiva lent quality tax-exempt and taxable bonds has been 

equal to approximately 30 percent of the taxable interest 

rate. This means that any taxpayer with a marginal tax rate 

of above 30 percent would obtain a higher after-tax yield 

from t a x-exempt bonds than from t axable bonds. In effect, 

the high i ncome investor will pay an implicit tax, refl e ct ed 

in a lower gross int e rest rate, of 3 0 percent on tax-exempt 

securities rather than the rate that would othe rwise be 

determined by his margin al tax bracket. 

If the rel a tive supply of tax-exempt bonds continue s to 

incr e ase by the issuance of more pollution control IDBs, the 

interest r a t e diffe r ential be tween t a xable ?nd tax-ex~mpt 

bonds will fall, lowering the implicit tax on owners of 

tax-exempt bonds and incr easing their windfall gain. The 

effective progressivity of the tax system will decrease, 

moving another ste p away from the nominal progressivity 

reflected in the statutory schedule of tax rates. 

Eliminating the use of tax-exempt TDBs to finance 

pollution control inve stments will increase the amount of 

interest income subject to t a x. The windfall ga ins to high 

income l enders from t~x-exempt interest would f all , making 

the tax system mor e progressive r ela tive to curr ent law. 

Economic Efficiency . It may be ge ne r a lly viewec as 

improper to allow priva t e borrowe rs to a vai l themselves of 

the tax-exempt ma rket. While this view is based on a c ommon 

notion of f ai rness, a llowing some firms to borrow at 

privileged ra tes also c?n have ve ry ha rmful effects on 

economi c effici e ncy by ncouraging mis2llocation of s c a rcP 

cepital r esources. More specifi c?lly, any special incentive 

- 242 -
for investment in pollution control equipment has 

undesirable efficiency effects in the context of legisl ated 

environmental standards. 

The efficiency losses from such subsidies are of two 

kinds. First, because any definition of pollution control 

investment is necessarily arbitrary, only c limited number of 

the alternative ways of reducing pollution are subsidized. 

For example, a firm may reduce pollution by changing 

production processes or inputs used. Bowever, under current 

law, only the installation of specifically designated 

"pollution control" equipment would be eligible for 

subsidized financing through ross. 

Secondly, even if firms were to choose to purchase the 

same type of equipment without the subsidy, the subsidy still 

causes an efficiency loss through a misallocation of economic 

resources. The efficiency loss in this case occurs because 

the subsidy lowers the total cost of production in industries 

where significant outlays for environmental controls are 

required, thereby leading to relatively lower prices and 

relatively higher output in those industries as compared to 

what market forces would determine. The resource 

misallocation results from a failure to transmit to the 

consumer the appropriate economic signals which would induce 

him to purchase relatively less of those products involving high pollution control costs. 

The proposed elimination of tax-exempt pollution control 

financing will provide firms with an incentive to select the 

lowest cost alternative among methods of pollution control 

consistent with existing Federal regulations. It will end 

the bias towards the de fined eligible investments such as 

"end of the line" types of pollution control equipment 

fostered by present law tax incentives, rnd move in the 

direction of requiring consumers to pay the full cost of 

pollution control. 

Furthermore, efficiency losses from providing a tax 

subsidy for pollution control facilities are much greater for 

new plants than for existing plants. Frequently, with 

existing plants, addition of pollution control equipmen t 

eligible for a tax subsidy is either the only f ea sible way of 

achieving environmental standards or the lowe st cost method 

even in the 2bsence of a subsidy. 

It may also be argued that mandated pollution control 

investments for plants alr eady in xist nce should not be 

fully borne by the firm and the consumers of its prod ucts. ~t the time the plant was initially built the firm may not 

ha ve cnticipated these extr a capita l requir ements . The 

original investment vas presumably mad~ on the ass umption 

that society did ~ot pla ce a high cost on emissions and would 

not compel firms to r ed uce pollution. 

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Current ta x l nw doe s provid0 such subsidies for old 

plants. In addi tion to t a x-exemp t I DB finan c ing, pollution 

control equipment instal led in pl?nts in use before J anua ry 

1, 1~/6 i s e ligible for 5-yea r amo rtization an d ~ 5 perc ent 

investment credit . 

To provide continued ?ssistance for e xist ing ?lrnts, it 

is p ropos ed elsewhere in the Administration's tax program to 

r a i se the invest ment c r ed i t from 5 per c e nt to 10 p~rccnt for 

pollution con tro l f a cilities amortized over five yea rs (see 

RBVISIONS TO THE INVESTMENT CREDIT.) Such inve stments may 

a lso be eligible for tax-exempt IDB status un der present law. 

The proposed increase in the investment cr ed it to 10 perc~nt 

will typically more than compensate the investor for the loss 

of the inter e st savings r eal ized by borrowing in t he 

tax-exempt ma rket. 

~neth r proposal in the Administration's t~x program is 

to provide Sta tes and localities with the o~tion of issuing taxable bonds with a Fede ral subsidy in a ll cases whe re 

tax-exempt borrowing is currently allowed. (See T~XABLE OOND 

OPTION.) The efficiency losses from continuing to all ow 

tax-exempt borrowing for pollution control equipment would ~ 

even greater under this plan for a t a xable bond option (TBO) 

than under current law. TBO will lower the interest r a t e on 

tax-exempt borrowing from about 70 percent to 60 percent of 

the taxable r a te. Because the subsidy rate to t a x-exempt 

borrowe rs is thereby increased, the e fficiency losses 

resulting from providing tax exemption for pollution control 

lOBs are a lso incre?sed. Thus, while it is desircble to 

remove pollution control bonds from the tax-~xempt market 

under current law, it is even more import~nt uno~r TaO. 

St?te and Loc ? l Borrowin! Costs. Allowing 9rivate firms 

to use tex-exempt IDBs for po lution control equipment raises 

the cost of borrowing to State and local gove rnments. As the 

supply of tax-exempt bonds incr ea ses, their price must fall 

to a ttract additional investors in lower mar~in l t ?. x 

brackets. Thus, the expansion of the use of IDBs in r e cent 

years has had the effect of r a ising the inte r e st r a te paid by State and local borrowe rs. It is for this r ea son that the 

National League of Citie s and the Municipal Finance Officers 

Association have consistently opposed the financing of 

pollution control investment through the tax-exempt market. 

ll 

Recent studies have estimated that for each extra 

billion dollars of t e x-exempt borrowing, inter e st rate s on 

tax-exempt issues rise by 5 to 20 basis points. (~ basis 

point equals .01 percent.) !/ In 1977, tax-exempt borrowing 

for pollution control IDBs was eqpal to e lmost S3 billion 

(See Table IIIB-1). Thus, the resea rch findings imply that 

tax-exempt interest rates in 1977 we r e from 15 to 60 ba sis 

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points higher than they would have been if there were no 

pollution control JOBs. Using a conservati ve estimate of 25 

ba sis points or l/4 of 1 pe rcent, the additional 2nnual 

interest cost on the $41 . 5 billion of non-IDB St2te ano local 

obligations issued in 1977 can be estimated to be in e xcess 

of $100 million. This additional cost will occur for e ach of 

the 20 or more yea rs the se bonds will be outstand ing. 

Savings of this magnitude will occur upon r emova l of these 

bonds from the tax-exempt marke t. 

Anoth e r wa y of viewing this s a ving is to note that at 

prevailing levels of tax-exempt interest r a t e s, 25 ba sis 

points is equal to a reduction in inter e st costs of slightly 

over 4 percent. At current levels of debt service ( about $9 

billion annually), this amounts to an annua l interest savings 

of $360 million when a ll outstanding obligations have bee n 

issued under the new rules. 

Elimin a tion of x- mpt IDBs for pollution control 

e quipment would, t he refor e , lower the cost of financing State 

and local public services. The potenti a l loss to State and 

local governments from continuing this tax-exemption is 

likely to become grcPter in future years , because borrowing 

for pollution control equipment is like ly to increase. 

The above analysis of the interest savings to State and 

local governments does not take into account the effects of 

the proposal to provide State and loc~l qov rn~ nts with the 

option of issuing subsidized taxable bonds (See Taxable Bond 

Option). Under the taxable bond option, the t a x-exempt 

interest rate will be a fixed proportion of the tax?ble rate. 

In this case, the increase in IDB tax-exempt fin ancing would 

increase the volume of municipal bonds shifted from the 

t a x-e xempt i nto the subsidized taxabl e rket, but the r a tio 

of tax-exempt interest r a tes to t a xa ble r ates would r emain 

unch anged. 

The cost to the Treasury, however, of provid ing the 

subsidy to t a xable municipal bonds would be incr eased by 

allowing pollution control IDBs to remain in t he tax-e xempt 

market . Since a relatively larger supply of ~unicipals or 

tax-exempt lOBs impli e s a l a rger volume of subsid izQd t a xa ble 

issue s, gr ea ter subsidy payments are r equired of t he 

Treasury. Removing pollution control bonds from the 

tax-exempt market will, therefore, reduce the Peder al costs 

of maintaining the t a xable bond option. 

Other Industrial Development Bone Provis ions 

Small Issue lOBs. Th e $1 million nd SS million sma ll 

issue lOBs are fr e quently used by Sta t es nd localities to 

promote economic development by attr~cting new plants . If 

their use is available to everyone , however , then any potential ben ef it to on e locality in 2ttracting ?lants is 

- 245 -
cancelled by the use of IDBs by other localities. For this 

reason, it is proposed here to retain the use of small issue 

ID9s only for those areas most in need of relief. In those 

areas of economic distress, it is proposed to extend the 

dollar limit on the amount of c apital expenditures eligible for tax-exempt financing from $5 million to $10 million. For 

areas which do not qualify as economically distressed, the 

use of tax-exempt small issue ID8s will be disallowed 

entirely. 

This proposal will recluce the losses in tax equity associ a ted with tax-exempt financing, while at the same time 

channeling the tax subsidy to areas currently experiencing 

economic distress (for example, urban areas with very high unemployment r a tes) and requiring special assistance. 

Industrial Parks. The tax-exempt financing of 

industrial parks allowed under current law also represents an 

unwarranted extension of the privilege of tax-exempt 

borrowing for purely private purposes. It raises the same 

issues of tax equity ano economic efficiency already 

discussed. It also contributes to higher costs of State and 

local borrowing for public facilities. 

Hospital Bonds. Finclly, it is desirable to limit the 

use of tax-exempt bonds in financing hospital construction. 

Under present law, the definition of a taxable industrial 

development bond generally does not include an obligation 

issued to finance a trade or business carried on by a 

private, non-profit charitable organization. Thus, many 

bonds issued by State and local governments to finance 

facilities for private non-profit hospitals are not 

considered to be taxable IDBs and are e ligible for tax 

exemption on the grounds th?t they have been issued directly 

or indirectly by States and localities. 

The Administration is concerned that excess expansion of 

hospit c l facilities is incr e asing costs of medical cere and 

has, therefore, proposed, in its Hospital Cost Containment 

Act, that the number of certific t~s of need for hospital 

construction be drastically reduced. In order further to 

reduce incentives for construction of excess hospital 

facilities, the Administration proposal will not a llow 

tax-exempt IDB financing for hos~itals operated by charitable 

organizations for which a certif1cate of need has not been 

issued. 

Effective Da te 

In general, the proposed change s will apply to 

oblige tions issued after the date of e nactment. The proposed 

changes will also apply to obligations issued aft e r February 

1, 197 8 unl e ss it is reasonably 0xpe cted on the date of 

issu3nce of the obligations that a t l ea st 85 percent of the 

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"spendable proceeds" (as de fined in Proposed Tr e asury 

Regulation 1.103-14(b) (iii)) will have been expended within 

three years of the date of issua nce of the obligations. 

Revenue Estimate 

Change In Tax Liability 

($ millions) 

Calendar Years 

1979 1980 1981 : 1982 

26 80 13B 198 

Technic?! Explanation 

1983 

260 

The tax exemption for sma ll issues of lOBs provided by 

sect ion 103 (b) ( 6) of the Code will be amended to provide 

~xemption only for issues the proceeds of which a re use d for 

the acquisition or construction of land or depr e ciable 

property located in an economically distresse d area. For 

this purpose economically distressed areas will be defined by 

reference to such factors as (1) an ave rage annual 

unemplo ent rat e i n e xcess of the national vera~e rate and 

(2) an average annual growth ln employme nt be low the 

corr

~ 

e SE.,.On rng-natfonal rate. These criteria identify those 

wi1:11Cnroni c - unemp oyment problems which a re 

attributable to an in ability to ~bsorb employable r e sident 

worke rs. 

In addition, the proposals will be impl emented by 

amending section 103(b) (6) (D) of the Code to substitute 

$10,000,000 for a ll references to $5,000,000, and by deleting 

sections 103(b) (4) (F) (relating to pollution control 

facilities) and 103 (b) (5) (relating to industri c l parks). Finally, section 103 (b) (3) (B), which generally provide s an 

mption from indu~tri l de velopme nt bone trea tme nt for 

obligations issued to raise funds for non-profit, chnritable 

organizations, wil l be amend~d to deny the e xemption to (and 

thus treat as taxable) obliga tions issue d t o fin anc e hospital 

faciliti e s for such organizations, unl e ss a certifica t e of 

- 247 -
need for the facilities has been issued under section 1523 of 

the Public Health Services Act or construction of the 

facilities has been approved under section 1122 of the Social 

Security Act. 

Footnotes 

!/ Congressional Record, Volume 114, Part 7, March 28, 1968, 

p. 8148. 

~/ Federal and State regulation issued under authority in 

Clean Air Act 42 u.s.c. 1857 et. seq. (1970) (prior to 1977 

amendments), and Federal Water Pollution Control ~ct 

Amendments of 1972, 33 u.s.c. 1341 - 1345 (1972) 

3/ See, for example, Municipal Finance Officers ~ssociation 

Policy Resolution adopted ~pril 30, 1975 in Montreal, Canada: 

and National Municipal Policy, official policy positions of 

the National League of Cities, most recently adopted in San 

Francisco, in December, 1977. 

4/ John E. Peterson, The Tax-Exempt Pollution Control Bond, 

Municipal Finance Officers Association, March 10, 1975: 

Peter Fortune, "Impact of Taxable Municipal Bonds: 

Policy Simulations With a Large Econometric Model," 

Federal Reserve Bank of Boston, 1974: John E. Peterson, 

"Changing Conditions in the Market for State and Local 

Government Debt," Joint Economic Committee Study, ~pril 

16, 1976: and George E. Peterson and Harvey Galper, "Ta x 

Exempt Financing of Private Industry's Pollution Control 

Investment," Public Policy, Volume XXIII, Winter 1975, 

Number 1. 

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