Tax-exempt bonds are valid debt obligations of state and local governments. Under Section 103 of the Internal Revenue Code (I.R.C.), the interest earned on most bonds issued by state and local governments is tax-exempt. This means that the interest paid to bondholders is generally not included in their gross income for federal income tax purposes. The tax exemption lowers the bond issuer’s borrowing costs and may provide equivalent or higher after-tax yields to investors than alternative investments that are not tax-exempt. Tax-exempt bond financing can apply to different types of debt financing arrangements, including notes, loans, commercial paper, certificates of participation, and tax-increment financing. The tax-exempt status remains throughout the life of the bonds provided that all applicable laws are satisfied. IRS’s Tax-Exempt Bond Office in its Tax Exempt and Government Entities division is responsible for administering tax laws pertaining to tax-exempt bonds. Tax-exempt bonds can be characterized as new money and refunding issues. New money issues refer to bonds used to finance a new project. A refunding issue refers to any bond issue used to pay debt service on and retire an outstanding issue. Typically, refunding is done for reasons such as to reduce the interest rate and ease restrictions on the original bond contract. Refunding issues are either current or advanced based on the timing between the issuance of the new bonds and the maturity date of the outstanding bonds. Current refunding occurs when new bonds are issued within 90 days of the final payment on the prior issue and advance refunding occurs if the new bonds are issued more than 90 days before final payment on the prior issue. For federal tax purposes municipal bonds are classified as either governmental bonds or private activity bonds. In general, governmental bonds are tax-exempt and are used to build public capital facilities and serve the general public interest. The I.R.C. does not specifically define governmental bonds; rather, all municipal bonds that do not meet the criteria to be classified as private activity bonds are governmental bonds. Municipal bonds are classified as private activity bonds, which provide financing to private businesses, if they pass both the private payment and the private business use test. These tests specify that if more than 10 percent of the bond proceeds are used for private business purposes and more than 10 percent of the bond proceeds are secured by payments from property used for private business use, then the bond is a private activity bond. A bond that is classified as a private activity bond can be taxable or tax-exempt. Congress has specified certain private activities (see tables 4 and 5) that can be financed with tax-exempt bonds. Private activity bonds that receive tax-exempt status are called qualified private activity bonds. Private activities that are not “qualified” are taxable. Generally, qualified private activity bonds are subject to a number of restrictions that do not apply to governmental bonds, including a 2 percent limit on using proceeds of the bond sale to pay issuance costs, annual state-by-state limitations on the volume of bonds that can be issued, and the disallowance for advanced refunding. In addition, the interest income from qualified private activity bonds is an addition to income for purposes of calculating the alternative minimum tax (AMT) whereas the interest on governmental bonds is not. However, some exceptions to these restrictions exist for qualified 501(c)(3) private activity bonds issued by or on behalf of nonprofit entities. Qualified 501(c)(3) bonds do not count toward annual state-by-state volume limits; the interest income on these bonds issued after August 7, 1986, is not subject to AMT rules; and unlike other qualified private activity bonds, qualified 501(c)(3) bonds can be advance refunded. Tax-exempt bonds can be structured as general obligation or revenue bonds. General obligation bonds, also known as full faith and credit obligations, are secured by revenues obtained from the issuer’s general taxing powers, including sales taxes, property taxes, and income taxes. Most general obligation bonds are used to build public infrastructure, such as school buildings, jails, police stations, and city halls, and are classified as governmental bonds for tax purposes. In contrast, revenue bonds are issued to finance specific projects or enterprises and investors get paid from the revenues generated by the financed projects. Revenue bonds can be either governmental bonds or private activity bonds for tax purposes. In addition to issuing tax-exempt bonds directly, state and local governments may establish other entities to issue bonds “on behalf of” such governmental units, or any political subdivision thereof. For example, a specifically constituted nonprofit corporation acting on behalf of governmental units might own, operate, and issue debt to finance a local airport. In addition to issuing bonds for government operations and services, qualified governmental units are permitted to issue qualified private activity bonds to provide tax-exempt financing for certain private activities. In these cases, the qualified governmental unit generally acts as a conduit, meaning that the qualified governmental unit issues the bonds, but the nongovernmental entity receiving the benefit of tax-exempt financing is required to provide the funds to repay the bonds. Municipal governments incur costs to issue their bonds. Bond issuance costs include the underwriting spread, which is the difference between the price paid to the issuer by the underwriter and the price at which the bonds are reoffered to investors, and fees for bond counsel, financial advisors, public hearings, printing, and other costs. In addition, at the time bonds are issued, issuers may choose to purchase bond insurance or secure a line of credit to further ensure that principal and interest payments will be made on time. This additional security can improve the bond’s credit rating and result in lower interest costs over time for bond issuers. Bond insurance or other types of credit designed to ensure the timely repayment of bonds may not count as issuance costs for the purposes of calculating the 2 percent limit with which qualified private activity bonds generally must comply. Bond issuers have two principal avenues for marketing their bonds in the primary market—competitive bids and negotiated sales. In competitive bids, underwriters who sell the bonds compete against each other to market the bonds for the issuer, while in negotiated sales, the issuer selects the underwriter and negotiates the terms of the bond sale. The majority of tax-exempt bonds are issued through negotiated sales. Guidance issued in 1996 and revised in 2007 by the Government Finance Officers’ Association on the preferred method of sale emphasized that both methods offer advantages in different circumstances. Generally, competitive sales are favored in cases when the bond has a relatively high credit rating; the bond is secured by strong, long-standing revenue streams; and the structure of the bond does not include innovative financing methods that require explanation to the bond market. Negotiated sales may be preferred in cases where a bond with relatively complex features is to be issued during a time period with volatile interest rates, giving the underwriter and the issuer more flexibility in terms of the timing of the bond issue and the underwriter more time to search for investors better suited to more complex bonds. The revised guidance on the preferred method of sale puts more emphasis on the advantages for issuers to obtain financial advice that is independent from the underwriter. In offering bonds for sale, various documents may be prepared, including a preliminary (announcing the prospective bond sale) and final (after the bonds have been issued) official statement. Official statements contain information describing the bond issue, including the dollar amount, maturity dates, financing arrangements, and information on the types of facilities and activities being financed. A copy of the final official statement is required to be sent to the Municipal Securities Rulemaking Board (MSRB), a congressionally chartered organization that regulates securities firms and banks involved in underwriting, trading, and selling municipal securities. Based on IRS data, the dollar amounts of long-term tax-exempt bonds issued have been at their highest levels in recent years. Since 2002, the dollar amount of long-term, tax-exempt bonds issued has exceeded $395 billion annually. In only 2 earlier years from the period 1991 through 2001, did the annual amount of bonds issued exceed $350 billion. Furthermore, during this same period, municipal governments never issued more bonds than in recent years. Figure 1 shows the annual dollar amount of long-term, tax-exempt governmental and private activity bonds, including new money and refunding bonds, issued from 1991 through 2005. The recent increases in the dollar amounts of governmental bonds issued have been a leading factor contributing to the high volume of tax-exempt bonds issued since 2002. Figure 2 compares the annual dollar amounts of governmental and qualified private activity bonds issued from 1991 through 2005. In recent years, that is, 2002 through 2005, at least $295 billion of governmental bonds have been issued annually, or on average about $314.8 billion per year. In comparison, in the earlier years of 1991 through 2001, the average amount of governmental bonds issued annually was about $194.3 billion, or about 62 percent less than the average annual amounts from 2002 through 2005 after adjusting for inflation. Similar to governmental bonds, the amounts of private activity bonds issued annually has also been at peak levels since 2002. From 2002 through 2005, over $100 billion dollars in qualified private activity bonds were issued each year. About $116 billion of qualified private activity bonds were issued in 2005, more than in any other year since 1998. The average dollar amount of qualified private activity bonds issued annually from 2002 through 2005 was about $106.7 billion. In comparison, in the earlier years of 1991 through 2001, the average amount of qualified private activity bonds issued annually was about $86.1 billion, or about 24 percent less than the average annual amounts from 2002 through 2005 after adjusting for inflation. Thus, though not as large as the comparable increase for governmental bonds, there has been a noticeable increase in the amount of qualified private activity bonds issued recently. While both governmental and qualified private activity bonds reached historically high levels recently, the amount of governmental bonds issued annually has fluctuated to a greater extent. For example, from 1992 to 2005, the dollar amounts of governmental bonds issued annually either increased or decreased by an average of about 25 percent per year. In contrast, qualified private activity bonds fluctuated to a lesser extent, by an average of about 13 percent per year. The wider fluctuation in governmental bonds could be in part because governmental bonds are not subject to as many restrictions, including annual state-by-state volume caps, as qualified private activity bonds. Even if the volume cap for private activity bonds is not reached for all states, the volume cap can place constraints on the volume of private activity bonds issued because some individual states may reach their limits and this would restrict them from issuing any additional qualified private activity bonds that year. Another way to analyze the dollar amount of tax-exempt bonds is to compare new money bonds to refunding bonds. Although the amount of refundings substantially increased around 2002, new money bond issues were generally higher than refunding issues each year since 1991. Since 1991, the dollar amount of refundings has been greater than new money issues in only 3 years—1992, 1993, and 2005. From 2001 through 2005, the amount of new money tax-exempt bond issues has exceeded $200 billion annually (in constant dollars). This is greater than any year from 1991 through 2000. Table 1 shows the annual volume and percentage of long- term, tax-exempt bonds issued for new money and refunding purposes from 1991 through 2005. Tax-exempt bond issuers tend to issue more debt when interest rates decline. Since 1991, years when interest rates were at their lowest levels generally have corresponded with the years in which the amounts of tax- exempt bonds issued, including bonds for refunding, were the highest. For example, since 2002, average interest rates on tax-exempt bonds have fallen to their lowest levels since the early 1970s. During this same time period, the dollar amount of tax-exempt bonds issued has been at the highest level since 1993. Figure 3 shows how changes in interest rates have corresponded with the amounts of new money and refunding bonds. As the figure illustrates, generally, increases in the dollar amounts of bonds that were refunded have accompanied declines in interest rates. This indicates that municipal governments tend to take advantage of interest rate declines to restructure existing bond debt to obtain more attractive financing terms, such as obtaining a lower interest rate to reduce borrowing costs. On the other hand, changes in the dollar amounts of new bond issues do not appear to correspond as closely to interest rate changes as the amounts of refundings. One explanation for this could be that municipal governments tend to issue new bonds based on current needs to finance operations and activities, and decisions regarding new financing are likely to be less sensitive to interest rates. Because the interest earned by investors who purchase tax-exempt bonds is generally excluded from federal income taxes, the federal government incurs a revenue loss each year. Revenue loss estimates are based on the total dollar value of outstanding tax-exempt bonds and not on the dollar amounts of tax-exempt bonds issued in a given year. Both Treasury and JCT provide estimates of the revenue loss associated with tax-exempt bonds. Though calculated differently, both estimates show that the revenue loss is in the billions of dollars annually. According to our analysis of Treasury’s estimates, the revenue loss from excluding the interest earned on tax-exempt bonds from federal income tax is the ninth largest tax expenditure in the I.R.C. in 2007. Figure 4 shows our analysis of Treasury’s revenue loss estimates from 2000 to 2012. The estimates indicate that the federal government could lose about $37 billion in 2007—$25.4 billion from interest on governmental bonds and $11.6 billion from interest on qualified private activity bonds. As figure 4 shows, the estimated revenue loss from governmental bonds has fluctuated from a high of $30.1 billion in 2003 to a low of $23.6 billion in 2006. According to our analysis of Treasury’s estimates, the revenue loss is likely to be about $27.9 billion from governmental bonds and about $12.6 billion from qualified private activity bonds by 2012. JCT estimates also suggest a similar pattern of higher estimated revenue losses attributable to excluding the interest earned on tax-exempt bonds from federal gross income in future years. For example, in 2007, JCT reported that the federal government would forgo about $27.8 billion due to tax-exempt governmental bonds and projected that the revenue losses would grow to about $31.9 billion in 2011. For qualified private activity bonds, our analysis of JCT estimates shows the revenue loss increasing from $8.6 billion in 2007 to about $10.1 billion in 2011, an 18 percent increase. Tax-exempt governmental and private activity bonds are used to finance a wide range of facilities and activities, primarily in support of the entity responsible for paying the bond debt service. Information describing the types of facilities and activities that are financed with tax-exempt bonds is available from several sources. In addition, tax-exempt governmental bonds can be used to finance some facilities and activities for which most tax-exempt private activity bonds cannot, including some facilities that Congress specifically prohibited from being financed with qualified private activity bonds. To illustrate the wide range of purposes for which tax-exempt bonds are used, we reviewed the most recent information available on bonds in Thomson Financial’s Bond Buyer Yearbook and IRS’s SOI data. We also reviewed a limited sample of official statements to further illustrate the uses of tax-exempt bonds. Because most of the information is summarized by broad descriptive categories, it does not fully reveal the wide range of facilities and activities for which tax-exempt bonds can be used. Appendix II describes the primary sources for information on the facilities and activities financed with tax-exempt bonds. Over the last several decades, Congress has prohibited qualified private activity bonds from being used to finance certain projects. For example, the Tax Reform Act of 1986 prohibited the use of qualified private activity bonds to finance a number of specific facilities, including hotels adjacent to airports, professional sports stadiums, and private golf courses. Although qualified private activity bonds can no longer be used to finance such facilities, these types of facilities can be financed with tax-exempt governmental bonds because, as previously discussed, they fail either the private payments or private business use test. In addition, governmental bonds could be issued by authorities that directly operate facilities, such as golf courses, that qualify as general public use. Under current law, state and local governments have broad discretion to make decisions on the types of projects and activities they finance with tax-exempt bonds. Further, while the 1986 act prohibited qualified private activity bonds from being used to finance certain projects such as hotels, Congress did not prohibit such projects from being financed with governmental bonds. According to legislative history surrounding the 1986 change, Congress directed Treasury to liberalize guidelines regarding the treatment of third- party use pursuant to management agreements. The liberalization of the guidelines has permitted governmental entities to use third parties to operate facilities financed with tax-exempt governmental bonds under management agreements so that the third-party use of the bond-financed property is not treated as a private trade or business. Generally, the guidelines issued by Treasury in Revenue Procedure 97-13 provide that tax-exempt governmental bonds can be used to finance certain facilities provided ownership of the facility remains with the governmental entity issuing the bonds and that payments to the facility operator are not based on the facility’s net profits. The facility operator may be compensated based on the gross operating revenues of the facility, a per unit fee, or a per person fee. As you requested, we are providing information on newly constructed hotels and golf courses that were recently financed, at least in part, with some amount of tax-exempt bonds. Our information is limited because we could not identify any comprehensive lists of hotels and municipal golf courses that were financed with tax-exempt bonds. Neither the Bond Buyer Yearbook nor the SOI data had information on hotels and golf courses that were financed with tax-exempt bonds. We considered recent years for our analysis because information on financing would more likely be available than information for facilities financed in earlier years. For hotels, we limited our analysis to hotels that were financed with tax- exempt bonds issued from 2002 through 2006, and for golf courses we limited our analysis to municipal courses that opened in 2005. We found 18 hotels and 6 golf courses that we could confirm had some tax-exempt bond financing in those years. In general, the hotels were large, full-service hotels. Not all the hotels were yet rated by the American Automobile Association (AAA), but those with AAA ratings were all three- or four-diamond hotels, meaning that at a minimum the hotels provided multifaceted, comprehensive services and, in the case of four-diamond hotels, were considered upscale with extensive amenities. In 14 of the 18 cases, the hotels contained conference facilities or were located near convention centers. According to the official statements, the hotels that were built in connection with convention centers were usually intended to enhance the competitive position of convention center facilities, making the convention center a more appealing and convenient location to hold large meetings, and to contribute to economic development in the areas where they are being built. Table 6 summarizes information on the hotels we identified. In general, the six golf courses we identified and confirmed as being constructed, at least in part, with tax-exempt governmental bond financing were considered among the better golfing facilities in their respective regions. For example, in 2006, Golf Styles magazine recognized the Lorton, Virginia, course as one of the “100 Must Play Courses of the Middle Atlantic.” Additionally, Golf Digest recognized the publicly financed course in Patterson, Louisiana, as one of the best new public courses in 2006. Table 7 provides information on the municipal golf courses we identified. While tax-exempt governmental bonds are typically used to support traditional governmental functions with a public purpose, they are sometimes used for activities that are essentially private in nature, as illustrated by the hotels and golf courses we identified. Municipal governments have used their broad discretion to finance projects and activities, such as hotels, that are essentially private with tax-exempt governmental bonds on the grounds that the facilities and activities serve broader public purposes. Broader public purposes may include providing benefits to a community that extend beyond the purpose of the facility being financed by the bonds or providing certain services to those who would not otherwise be able to use them. It is not clear whether facilities like these provide public benefits to federal taxpayers that extend beyond the purposes of the facilities. The state and local governments that issued the bonds to finance hotels and golf courses generally justified the projects on the grounds that they would generate economic development, including new jobs and businesses. However, in some cases, it is not clear whether the facilities generate public benefits that would be underprovided by the private market or whether the facilities generally make services available to those who would not otherwise be able to use them. For example, in 2005, about 85 percent of existing golf courses had been financed privately, offering a range of fees and services often similar to those offered by publicly financed courses. As a result, the use of tax-exempt governmental bonds for facilities and activities like hotels and golf courses, which are routinely financed with private funds, raises questions about how much public benefit is produced at the local level and what, if any, benefits federal taxpayers receive for subsidizing these and other kinds of facilities that are essentially private in nature. The House Committee on Oversight and Government Reform’s Subcommittee on Domestic Policy recently held hearings that focused primarily on whether tax-exempt governmental bonds should be used to finance professional sports stadiums that are privately used. In 1986, Congress removed sports stadiums, along with other facilities, including certain hotels and golf courses, from the list of facilities eligible for tax- exempt private activity bond financing. Participants in congressional hearings leading up to the restrictions placed on tax-exempt private activity bonds in 1986 debated allowing stadiums and other facilities that were routinely financed with private funds from being financed with tax- exempt private activity bonds. However, stadiums and other facilities, including hotels and golf courses, continue to be financed with tax-exempt governmental bonds if they satisfy certain requirements for governmental bonds or safe harbors pertaining to private use. For example, according to Treasury’s Assistant Secretary for Tax Policy, under current law, the requirements to use governmental bonds for stadiums can generally be met when state and local governments subsidize the projects with governmental revenues or governmental sources of funds, such as generally applicable taxes. He also stated that from a tax policy perspective, the ability to use governmental bonds to finance stadiums with significant private business use when the bonds are subsidized with state or local governmental payments possibly represents a weakness in the targeting of the federal subsidy for tax-exempt bonds under the existing legal framework. A similar situation may exist with the continued financing of hotels and golf courses using tax-exempt governmental bonds. Borrowing costs paid by bond issuers include interest and issuance costs. Although study results varied, most studies that we reviewed indicate that bonds sold through competitive sales generally have lower interest costs than bonds sold through negotiated sales after taking other factors into account that might influence interest costs. Median issuance costs paid from bond proceeds as a percentage of bond proceeds vary by the size and type of tax-exempt bond. Slightly over half of the qualified private activity bonds issued from 2002 through 2005 had issuance costs paid from bond proceeds—with nearly half leaving the reporting line blank—and some of the bonds had issuance costs that exceeded statutory limits. For example, from 2002 to 2005, between 17 and 39 qualified private activity bonds annually—about 1 to 2 percent of qualified private activity bonds that reported issuance costs paid from bond proceeds—reported issuance costs that exceeded applicable statutory limits. Researchers have attempted to determine whether the method of sale (i.e., competition between underwriters or negotiation with underwriters) has an effect on the interest costs that bond issuers pay investors. From the federal government’s perspective, lower interest costs for municipal governments may be preferable because this might result in less forgone federal tax revenue and better target the subsidy to its intended beneficiaries. However, even if the competed method of sale generally yields lower interest costs to municipal governments, the negotiated method of sale may still be preferable in some instances. We reviewed studies published from 1996 through 2007 that address whether there is a difference in interest costs for bonds sold on a competitive basis versus bonds sold on a negotiated basis. The studies we reviewed generally used statistical analysis techniques to identify the effect that the method of sale (i.e., competitive or negotiated) has on the interest cost paid by bond issuers. In addition to the method of sale, a number of other factors in the municipal bond market could affect interest costs, and the studies we reviewed attempt to control for these factors to isolate the effect that the method of sale has on interest costs. Other factors that could affect a bond issuer’s borrowing costs include marketwide factors, such as the average level of tax-exempt interest rates and the recent volatility of these rates; issuer-specific factors, such as economic characteristics of the issuing jurisdiction and the amount of experience the issuer has in issuing bonds; and bond-specific factors, such as the number of years until the bond matures, the amount of the bond, the purpose of the bond, the funding source that backs the bond, the bond’s credit rating, and whether the issuer purchased bond insurance or other credit enhancers. In general, after controlling for other factors that may affect interest costs, research suggests that bonds issued on a competitive basis will likely have lower interest costs than bonds sold on a negotiated basis because bond issuers are likely to benefit from multiple underwriters bidding on the right to sell the bonds. In addition, several of the studies suggested that as the number of competitive bids on a bond issue increase, the interest costs that state and local governments pay decline further. However, one of the studies we reviewed found no significant differences in interest costs for competitive and negotiated sales and one found some advantage for negotiated bonds. The studies included in our literature review had several limitations. Because of limited data availability, some key variables are not available to be included in the study. No study that we reviewed had data on the extent to which issuers that used a negotiated sale searched among several underwriters before making a selection. Also, none of the studies we reviewed included a comprehensive, recent review of competitive and negotiated bond sales for the entire municipal bond market. Most of the studies we identified were limited to certain states for certain time periods or focused on a particular market sector, such as bonds issued specifically for hospitals. See appendix V for a list of the studies we reviewed addressing whether interest costs vary by method of bond sale. IRS requires qualified private activity bond issuers to report issuance costs paid from bond proceeds on the Form 8038, and for most types of private activity bonds, issuance costs that can be paid from bond proceeds are limited to 2 percent of bond proceeds. From 2002 to 2005, bond issuers reported issuance costs paid from bond proceeds on slightly more than half of the filed Form 8038s. For example, bond issuers reported issuance costs paid from bond proceeds between 51 percent and 59 percent of the time annually for 2002 to 2005. Bond issuers for the remaining bonds left the line for issuance costs paid from bond proceeds blank. Issuers of smaller bonds, meaning those with bond proceeds of less than $1 million, reported issuance costs less frequently than issuers of larger bonds; however, issuers of large bonds, meaning those with proceeds over $100 million, also did not report issuance costs about 35 percent of the time. According to the Director of IRS’s Tax-Exempt Bond Office, IRS would need to contact the issuer to determine whether a tax-exempt bond information return that a bond issuer submitted to IRS reporting no issuance cost is a problem. He said that there may be legitimate reasons why issuance cost was not reported on the form, such as when issuance costs are paid from other sources or special funds. Currently, IRS does not have mechanisms in place to routinely determine whether unreported issuance cost is a compliance problem or a bond issuer’s mistake. IRS’s instructions for Form 8038 require bond issuers to enter the amount of proceeds that will be used to pay bond issuance costs, including underwriters’ spread and fees for trustees and bond counsel. However, the instructions do not provide any guidance for instances when issuance costs are not paid from bond proceeds. For qualified private activity bonds with reported issuance costs, the median issuance costs as a percentage of bond proceeds varied by the size and type of the bond. For all qualified private activity bonds that reported issuance costs paid from bond proceeds, the median issuance cost as a percentage of bond proceeds ranged from a low of 1.6 percent in 2005 to a high of 1.8 percent in 2002. For bonds under $10 million, the median issuance cost as a percentage of bond proceeds reached or came close to the 2 percent limit annually from 2002 to 2005. Larger bonds reported lower issuance costs as a percentage of bond proceeds, possibly indicating that issuance costs include fixed fees or other payments that are not based on the size of the bond. When considering bond purposes, the median issuance costs as a percentage of bond proceeds for qualified private activity bonds issued reached or came near the 2 percent statutory limit for numerous categories of bonds. Table 8 shows median issuance costs paid from bond proceeds as a percentage of bond proceeds for long-term qualified private activity bonds issued from 2002 to 2005. Of the qualified private activity bonds with reported issuance costs, we identified 38 bonds in 2002, 39 bonds in 2003, 25 bonds in 2004, and 17 bonds in 2005 that reported issuance costs as a percentage of bond proceeds that exceeded statutory limits. This accounts for 1 to 2 percent of qualified private activity bonds issued annually. According to the Director of IRS’s Tax-Exempt Bond Office, IRS does not routinely check to determine if all issuers of qualified private activity bonds are complying with the statutory 2 percent limit on using proceeds for issuance costs. He said that if the limit is exceeded, it may be a potential compliance issue. During its examinations of tax-exempt bonds, IRS routinely assesses whether issuance costs exceed legal limits. The Director recognized the importance of bond issuers adhering to the statutory issuance cost limit; however, he also stated that because of resource constraints, IRS places more emphasis on tax-exempt bond compliance examinations and checks that have the most impact. He stated that in considering how best to address potential compliance issues regarding issuance costs, IRS would want to ensure that these inquiries are not automatically construed as audits. Once IRS initiates an audit, it is precluded from auditing the same return again in the same tax year even if more substantial compliance issues arise. The Director indicated that IRS has plans to conduct more special initiatives to monitor compliance with tax-exempt bond rules than it has in the past, such as starting to provide “soft notices” to certain bond issuers that could be used to identify potential issues related to compliance. Soft notices alert taxpayers to potential errors they made and encourage them to correct such errors. In a number of cases, IRS has found many taxpayers do take corrective actions. Because soft notices do not require taxpayers to send IRS any information from their books and records, they are not considered audits. Although it would need to be tested, the Director thought it might be cost- effective to begin using soft notices, when appropriate, to inform bond issuers that they reported issuance costs paid from bond proceeds that exceed statutory limitations. Unlike qualified private activity bonds, issuance costs for governmental bonds are not subject to any limits; however, like qualified private activity bonds, they vary based on the type of bond and the size of the bond issue. For all governmental bonds issued from 2002 through 2005 where bond issuers reported issuance costs on the Form 8038-G, median issuance costs paid from bond proceeds as a percentage of bond proceeds ranged from 1.51 percent in 2005 to 1.67 percent in 2003. For bonds with reported issuance costs, from 34 to 39 percent indicated that issuance costs exceeded 2 percent of bond proceeds, the statutory limit for most qualified private activity bonds. Governmental bonds issued for housing generally had the highest median issuance costs paid from bond proceeds as a percentage of bond proceeds while bonds issued for education and health and hospital purposes generally had the lowest median issuance costs paid from bond proceeds as a percentage of bond proceeds. Table 9 shows the median issuance costs paid from bond proceeds as a percentage of bond proceeds for long-term governmental bonds issued from 2002 to 2005 by bond purpose and size of bond. Like qualified private activity bonds, smaller governmental bonds generally had higher median issuance costs as a percentage of bond proceeds. For example, for bonds under $1 million, the median issuance cost paid from bond proceeds as a percentage of bond proceeds exceeded 2.5 percent in all years for 2002 through 2005. Median issuance costs as a percentage of bond proceeds for governmental bonds issued for amounts greater than $100 million were about 0.6 percent from 2002 to 2005. State and local governments have broad discretion in deciding which activities and facilities to finance using tax-exempt bonds. In particular, the broad discretion afforded to state and local governments allows them to use tax-exempt governmental bonds to finance facilities and activities that cannot be financed with private activity bonds. Recently, the dollar amount of tax-exempt governmental bonds reached peak levels as municipal governments issued bonds for a wide variety of purposes ranging from traditionally public facilities, such as schools, fire stations, and roads, to facilities that are essentially private in nature, such as sports stadiums. Congressional policymakers have recently shown interest in whether certain facilities providing benefits that are essentially private in nature, such as stadiums, should be financed with tax-exempt governmental bonds. However, similar attention has not been given other types of facilities, like hotels and golf courses that also provide benefits that are essentially private in nature. As Congress continues to hold discussions on whether sports stadiums are appropriate uses of tax-exempt governmental bonds, it should also consider whether other facilities that are privately used, such as hotels, should continue to be financed with tax-exempt bonds. However, if Congress still views these and other facilities that are essentially private in nature as appropriate uses of tax-exempt governmental bonds, then legislative changes would not be necessary. Issuers of qualified private activity bonds must adhere to the limits on using bond proceeds for issuance cost that are imposed by law. In part, this helps to ensure that the federal subsidy afforded to issuers of bonds for private uses is appropriately targeted to the purposes for which the bonds were issued. This is equally important to ensure that the bonds’ tax- exempt status remains intact. In addition, it would be more beneficial to IRS if its forms and instructions included specific directions to bond issuers that did not use bond proceeds for issuance costs to indicate this on the form. Although this may require that IRS revise Form 8038, we believe that it would be beneficial for IRS to know positively whether issuers used bond proceeds for issuance costs and, if so, how much was used. This would better equip IRS to determine if there are any compliance issues that need to be addressed. We believe that if the Form 8038 is revised, the benefits to IRS would likely outweigh the costs. As Congress considers whether tax-exempt governmental bonds should be used for professional sports stadiums that are generally privately used, it should also consider whether other facilities, including hotels and golf courses, that are privately used should continue to be financed with tax- exempt governmental bonds. To better ensure that IRS can routinely and cost effectively determine whether issuers of qualified private activity bonds are complying with the statutory limits on using bond proceeds for issuance costs, we recommend that the Commissioner of Internal Revenue take the following two actions: Clarify IRS’s forms and instructions for reporting issuance cost paid from bond proceeds to require that bond issuers clearly designate on the form instances when bond proceeds were not used to pay issuance costs. Develop cost-effective methods to address apparent noncompliance with the statutory limits on using bond proceeds for issuance costs in such a manner that it would not preclude IRS from examining the bonds for more substantive compliance issues in the future. We provided a draft of this report to IRS and Treasury for comment. The Acting Commissioner of Internal Revenue provided comments on a draft of this report in a February 7, 2008, letter, which is reprinted in appendix VI. IRS said that it agreed with our recommendations. Regarding our recommendation that IRS clarify its forms and instructions for reporting issuance cost paid from bond proceeds to require that bond issuers clearly designate on the form instances where bond proceeds were not used to pay issuance costs, IRS said that it will clarify instructions for IRS Form 8038 to require that bond issuers clearly indicate when no bond proceeds were used to pay issuance costs. Concerning our recommendation that IRS develop cost-effective methods to address apparent noncompliance with the statutory limits, IRS said that it will develop a compliance project to address apparent noncompliance with the issuance cost requirements for the fiscal year 2009 tax-exempt bonds work plan that will likely incorporate sending soft-contact letters similar to ones previously used with success in other areas. In a February 8, 2008, letter, Treasury’s Assistant Secretary for Tax Policy commented that the use of tax-exempt governmental bonds to finance stadiums and other projects with significant private business use is arguably a structural weakness in the targeting of the federal tax expenditure for tax-exempt bonds under the existing legal framework. Treasury pointed out that while the existing framework might have a tax policy justification in giving municipal governments flexibility to use governmental bonds for a range of public-private partnerships, it may also be debatable in certain cases, such as for certain stadium financings. Treasury noted its recent testimony that outlined several options to address the possible structural weakness in the targeting of tax-exempt bond subsidy relative to tax-exempt governmental bonds for stadium financings. Treasury’s comments are reprinted in appendix VII. As arranged with your offices, unless you publicly announce the contents of this report earlier, we plan no further distribution of it until 30 days after its date. At that time, we will send copies of this report to the Commissioner of Internal Revenue and the Secretary of the Treasury and other interested parties. We will also provide copies to others upon request. In addition, the report will be available at no charge on the GAO Web site at http://www.gao.gov. If you or your staff members have any questions about this report, please contact me at (202) 512-9110 or brostekm@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made contributions to this report are listed in appendix VIII. The objectives of this report were to (1) describe recent trends in the dollar volume of tax-exempt bonds; (2) provide information on the types of facilities and activities that are financed with tax-exempt bonds, in particular, information on hotels and municipal golf courses that were recently financed with tax-exempt bonds; and (3) provide information on borrowing costs that bond issuers pay when issuing bonds by summarizing relevant research on whether bond interest costs vary by the method of sale, considering characteristics of the bond and bond issuer and provide information on how bond issuance costs vary between governmental and private activity bonds, including the extent to which private activity bond issuers exceed the statutory limit for issuance costs as a percentage of bond proceeds. To provide information on trends in the volume of tax-exempt bonds, we relied primarily on data from the Internal Revenue Service’s (IRS) Statistics of Income Division (SOI), which collects statistical data from information returns that tax-exempt bond issuers are required to file with IRS. We used SOI data from 1991 through 2005, the most recently available data, to provide information on the overall volume of tax-exempt bonds issued, the volume of governmental and private activity bonds issued, and the volume of new money versus refunding bonds issued. We also relied on the 20-Bond Index in the 2007 Bond Buyer Yearbook, which presents average interest rates on a set of 20 investment grade general obligation bonds maturing in 20 years, to compare interest rate changes from 1992 through 2005 with the volume of new money and refunding tax-exempt bond issues. We used data from the Technical Appendix of the President’s Budget for fiscal years 2002, 2004, 2006, and 2008 and data from the Joint Committee on Taxation’s 2007 Estimates of Federal Tax Expenditures to provide estimates of the amount of forgone revenue resulting from the exclusion of interest earned on tax-exempt bonds from federal income taxes. To describe the types of activities and facilities that are being financed with tax-exempt bonds, we relied on data in the 2007 Bond Buyer Yearbook, IRS’s SOI data, and a limited random sample of official statements. We used Bond Buyer Yearbook information because it provided us with more information about the purposes of tax-exempt bonds than other private data sources we identified. Data in the 2007 Bond Buyer Yearbook provide summary information on the uses of municipal bonds in 10 main categories and 48 subcategories. Information in the Bond Buyer Yearbook is obtained from Thomson Financial’s municipal bond database, one of the most comprehensive data sources on tax-exempt bonds. One limitation of the Bond Buyer Yearbook is that it does not provide separate breakouts of the uses of governmental and private activity bonds and includes taxable bonds. Taxable municipal bonds generally account for less than 10 percent of all municipal bonds. We used SOI data to provide information on the uses of governmental and private activity bonds. IRS’s SOI collects data on the purposes of governmental and qualified private activity bonds as reported on Form 8038-G and Form 8038, respectively. The information is summarized into broad categories for governmental bonds and by allowable uses for qualified private activity bonds. IRS generates summary tables on tax- exempt bond uses that are posted on IRS’s Web site and published in regularly issued bulletins. We used IRS’s SOI tax-exempt bond data for 2002 through 2005 to analyze the other category for governmental bond purposes and the nonhospital 501(c)(3) category for qualified private activity bond purposes. In some cases, information from the Bond Buyer Yearbook and information from the SOI database differ for similar types of bonds and for statistics about similar bond characteristics. Several possible reasons exist for the difference between summary information from SOI and the Bond Buyer Yearbook. For example, SOI relies on bond issuers to timely and accurately report bond information while Thomson Financial relies on automated reporting systems from the financial marketplace to develop reports in the Bond Buyer Yearbook. Even though the amounts differ in some instances for SOI and Bond Buyer data, our testing of these data allowed us to conclude that both sources were sufficiently reliable for providing information on tax-exempt bonds used in this report. We reviewed a limited random sample of official statements to provide more detailed information about the specific uses of tax-exempt governmental bonds than can typically be found in other data sources, such as the Bond Buyer Yearbook and the SOI data. The sample was not designed to provide projectable data on the uses of tax-exempt bonds. We drew the sample using the Municipal Securities Rulemaking Board’s (MSRB) database of official statements that it received in calendar year 2006. MSRB is a congressionally chartered organization that regulates securities firms and banks involved in underwriting, trading, and selling municipal securities, and based on its rules, bond issuers are required to send a copy of their final official statements to it. We reviewed the randomly ordered official statements until we identified five official statements that we determined would likely be included in each of the eight categories in the SOI data. For providing information on hotels that were financed with tax-exempt bonds, we could not find a comprehensive, reliable source with information on the numbers of hotels financed with tax-exempt bonds. Thus, we provide some limited data from the best available sources we could find for hotels financed with tax-exempt bonds from 2002 through 2006. We used these recent years because information on financing for these hotels would more likely be available than information for hotels financed in earlier years. To identify the hotels, we used information from a previous GAO report; HVS International, a global consulting services firm that focuses on hotel and hospitality services; and Bond Buyer daily publications that provide additional information on municipal bonds. From these sources we identified a number of hotels that may have been financed with tax-exempt bonds. However, we were only able to confirm that the 18 hotels identified in our report were financed, at least in part, with tax-exempt bonds by reviewing official statements and government financial reports and contacting local officials. The list of hotels we present likely is not a comprehensive list of all hotels financed with tax- exempt bonds. For providing information on municipal golf courses that were financed with tax-exempt bonds, we could not find a comprehensive, reliable source with information on the number of municipal golf courses financed with tax-exempt bonds. Thus, similar to our review of hotels, we provide limited data from the best available sources we could find. We used the National Golf Foundation’s database to identify municipal golf courses that opened in 2005. We identified nine municipal golf courses that opened in 2005. However, the National Golf Foundation’s database did not have information on whether the golf courses were financed with tax-exempt bonds. To confirm whether these nine municipal golf courses were financed with tax-exempt bonds, we contacted city, county, and golf course officials. From these contacts, we determined that six of the nine municipal golf courses were financed with tax-exempt bonds, and we obtained the official statements for those municipal golf courses. To provide information on borrowing costs, we conducted a literature review of previous studies that reviewed whether bond issuance costs vary by method of sale, including characteristics of the bond and bond issuers, and we analyzed IRS data on issuance costs. We reviewed studies published in peer-reviewed academic journals from 1996 through 2007. Because the studies we reviewed had several limitations, including that they were limited to certain states for certain time periods or focused only on certain market sectors, we initially attempted to conduct original research on this topic by obtaining a broad set of data on tax-exempt bonds and developing similar econometric analysis to the studies we reviewed that would have covered a wider range of bonds over a longer time period. However, we determined that the available data were not sufficiently reliable for our purposes. As a result, we confined our review of bond issuance costs to a summary of previous studies that attempt to address the same issue, but not on as wide of a scale as we had initially intended. We analyzed IRS’s SOI data on tax-exempt bonds from 2002 to 2005 to identify how issuance costs vary between governmental and private activity bonds. We reviewed issuance costs as a percentage of total bond proceeds for the various categories of governmental and qualified private activity bonds and by bond size. We also used IRS data to identify the extent to which issuance costs for qualified private activity bonds exceed the statutorily required 2 percent limit and the extent to which bond issuers do not report issuance costs on the IRS Forms 8038 and 8038- G. We interviewed officials in IRS’s Tax-Exempt Bond Office in its Government Entities and Tax-Exempt Division and Treasury’s Office of Tax Policy and other experts in taxation and government finance, such as representatives of the Government Finance Officers’ Association, the Securities Industry and Financial Markets Association, and the Congressional Research Service, to gain an understanding about the volume and uses of tax-exempt bonds. We determined that the data we evaluate in this report were sufficiently reliable for our purposes. We performed our work from December 2006 through January 2008 in accordance with generally accepted government auditing standards. Information on the types of facilities and activities that are financed with tax-exempt bonds is available from several sources, including the official statements prepared by underwriters to market the bonds, IRS, and private vendors, such as Thomson Financial. Specific information on what tax- exempt bonds are used for varies by source. Overall, the official statement generally contains the most detailed descriptive information. However, because there are no standard guidelines on the format and content of official statements, the level of detailed information they contain on the facilities and activities financed with tax-exempt bonds varies. For example, an official statement for a bond issued in 2006 stated that the bond was to be used to construct and improve the water facility for a municipality. Another official statement for a bond issued the same year showed that the bonds were to be used for various capital improvements. While in the first instance, the official statement more clearly discloses what the bond is to be used for, it is not fully apparent from the other example what specific capital improvements were financed by the bond. The information IRS collects on tax-exempt bonds is transcribed from information returns bond issuers are required to send IRS. By law, bond issuers are required to file IRS Form 8038-G, Information Return for Tax- Exempt Government Obligations for Governmental Bonds for bonds with an issue price of $100,000 or greater, or IRS Form 8038, Information Return for Tax-Exempt Private Activity Bonds. In filling out the form, a bond issuer checks boxes that best describe the types of facilities and activities to be financed with the bonds. For governmental bonds, the form has eight broad categories, including education, transportation, public safety, and other. If the other category is checked, the bond issuer is also asked to write in information that describes the intended use of bond proceeds. While the information that IRS collects from the form is useful in presenting summary information on the facilities and activities financed with governmental bonds, it only presents a very broad picture of the facilities for which the bonds are used. For example, if the bond issuer checked education, it is only apparent that the bonds were intended for educational facilities and activities. However, the specific nature of the educational facilities and activities is unknown based on the type of data IRS collects. For instance, it would not be apparent whether the bonds were used to finance new educational facilities, such as public and charter schools; fund teachers’ pension plans; construct a college athletic field; or pay for computer equipment used in a school. Likewise, issuers of private activity bonds are required to send IRS a similar form wherein they check boxes that broadly describe the facilities and activities financed with the bonds. IRS publishes descriptive statistics from these forms. Another source of information on the facilities and activities financed by tax-exempt bonds that we used was the Bond Buyer Yearbook, a publication by Thomson Financial that summarizes information on municipal bonds on a yearly basis. Information in the Bond Buyer Yearbook is obtained from several sources and provides one of the most comprehensive sources of information describing the facilities and activities financed by municipal bonds. The Bond Buyer Yearbook categorizes the facilities and activities financed by municipal bonds based on 10 broad categories and 48 subcategories. Even though the Bond Buyer Yearbook categorizes municipal bonds into many categories, the information only presents a general picture of the range of facilities and activities for which the bonds are used. For example, the Bond Buyer Yearbook development category has 3 subcategories—industrial, economic, and office buildings. From this summarized information, it is not apparent whether facilities such as hotels financed with tax-exempt governmental bonds are included as economic development. It is also important to note that Bond Buyer Yearbook information on the uses of bonds does not distinguish between tax-exempt governmental, qualified private activity, and taxable municipal bonds. However, according to Bond Buyer Yearbook information, generally less than 10 percent of all municipal bonds issued annually are taxable. Despite that, the Bond Buyer Yearbook is a useful source for summarized information on the types of facilities and activities that are financed using municipal bonds, including tax-exempt bonds. Dollars in thousands (constant 2007 dollars) Gershberg, Alec Ian, Michael Grossman, and Fred Goldman. “Competition and the Cost of Capital Revisited: Special Authorities and Underwriters in the Market for Tax-Exempt Hospital Bonds.” National Tax Journal, vol. 54, no. 2 (2001): 255-280. Kriz, Kenneth A. “Comparative Costs of Negotiated versus Competitive Bond Sales: New Evidence From State General Obligation Bonds.” The Quarterly Review of Economics and Finance, vol. 43 (2003): 191-211. Leonard, Paul A. “An Empirical Analysis of Competitive Bid and Negotiated Offerings of Municipal Bonds.” Municipal Finance Journal, vol. 17, no. 1 (1996): 37-66. Peng, Jun and Peter F. Brucato, Jr. “Another Look at the Effect of Method of Sale on the Interest Cost in the Municipal Bond Market—A Certification Model.” Public Budgeting and Finance, vol. 23, no. 1 (2003): 73-95. Robbins, Mark D. and Bill Simonsen. “Competition and Selection in Municipal Bond Sales: Evidence From Missouri.” Public Budgeting and Finance, vol. 27, no. 2 (2007): 88-103. Simonsen, Bill, Mark D. Robbins, and Lee Helgerson. “The Influence of Jurisdiction Size and Sale Type on Municipal Bond Interest Rates: An Empirical Analysis.” Public Administration Review, vol. 61, no. 6 (2001): 709-717. Simonsen, William and Mark. D. Robbins. “Does It Make Any Difference Anymore? Competitive versus Negotiated Municipal Bond Issuance.” Public Administration Review, vol. 56, no. 1 (1996): 57-64. In addition to the individual named above, Charlie Daniel, Assistant Director; Terry Draver; Thomas Gilbert; Nancy Hess; Larry Korb; John Mingus; Ed Nannenhorn; David Perkins; Cheryl Peterson; Katrina Taylor; and Walter Vance made key contributions to this report.

Summary: The outstanding amount of state and local government tax-exempt bonds has increased over the years. Congress is interested in whether the bonds are used for appropriate purposes since the federal government forgoes billions in tax revenues annually by excluding the bonds' interest from investors' federal gross income. Questions also exist over the bonds' borrowing costs as they can divert funds from the funded projects. This report (1) describes recent trends in tax exempt bonds, (2) provides information on the types of facilities financed with tax-exempt bonds, and (3) discusses borrowing costs considering the methods of selling bonds and compares issuance costs paid from bond proceeds for governmental and qualified private activity bonds. In addition to interviewing relevant officials, we analyzed IRS's Statistics of Income (SOI) data and data from Thomson Financial to address these objectives. In recent years, the volume of tax-exempt bonds issued annually for both governmental and private activity bonds has reached historically high levels. Generally, the volume of new money bond issues has been greater than bonds issued for refunding purposes. The volume of tax-exempt bonds issued, particularly bonds issued for refunding, tends to be highest when interest rates decline. Because the interest earned by investors who purchase tax bonds is generally excluded from federal income taxes, the federal revenue losses amount to billions of dollars annually. Tax-exempt governmental and private activity bonds are used to finance a wide range of projects and activities, with bonds issued for "educational purposes" generally being the largest category of governmental bonds annually. Nonprofit organizations are the largest issuers of qualified private activity bonds. Previous legislation prohibited using qualified private activity bonds for certain facilities, including professional sports stadiums, hotels, and private golf courses. However, many of these types of facilities are still being financed with tax-exempt governmental bonds. Congress has held hearings on this issue primarily focusing on sports stadiums. Although the evidence is not definitive, studies have generally shown that interest costs are lower for bonds sold when competition between underwriters exists compared to when bond sales are negotiated with underwriters after controlling for other factors. About half of all issuers of qualified private activity bonds reported paying issuance costs from bond proceeds from 2002 to 2005. IRS's guidance does not indicate what to report when no issuance costs are paid from bond proceeds. Of those reporting issuance costs, some private activity bond issuers reported paying issuance costs from bond proceeds that exceed statutory limits.