State and local governments issue debt for most large public capital projects such as new schools, public buildings, and roads. On occasion, state and local governments will issue debt for projects whose purpose is less public in nature, such as privately owned and operated multifamily residential housing. Nevertheless, these projects are often afforded the same tax privilege as debt issued for strictly government owned and operated projects. Congress limits the use of tax-exempt bonds for private activities because of concern about the overuse of tax-exempt, private activity bonds. The tax-exempt bonds issued for qualified private activities are limited by the type of activity financed and the volume of debt used for such activities. The federal tax code classifies state and local government bonds as either governmental bonds or private activity bonds. Generally, the interest on state and local governmental bonds is exempt from taxation whereas the interest on private activity bonds is not tax-exempt. However, the federal tax code allows state and local governments to use tax-exempt bonds to finance certain projects that would otherwise be classified as private activities. The private activities that can be financed with tax-exempt bonds are called "qualified private activities." The current tax exemption for qualified private activities has evolved over time. Two events, however, critically shaped the current treatment of private activity bonds. First, in 1968, Congress passed the Revenue and Expenditure Control Act of 1968 (P.L. 90-364), which established the basis for the current definition of private activity bonds. Second, after persistent challenges to the right of the federal government to restrict state and local government debt following the 1968 act, the Supreme Court agreed to hear a case in 1988 that changed the nature of the federal tax treatment of state and local government debt. In that case, the state of South Carolina challenged the Tax Equity and Fiscal Responsibility Act of 1982 ( P.L. 97-248 ). The 1982 act required that state and local government tax-exempt debt must be registered. The registration requirement was viewed by the states, South Carolina in particular, as an unconstitutional intrusion on the ability of states to issue debt. The Supreme Court held that the registration requirement for nonfederal government debt, though federally tax-exempt, was constitutional. In somewhat of a surprise to observers at the time, the Court went beyond the registration ruling and also held the following: The owners of state [and local] bonds have no constitutional entitlement not to pay taxes on income they earn from the bonds, and states have no constitutional entitlement to issue bonds paying lower interest rates than other issuers. The ruling confirmed that Congress can restrict issuance of state and local tax-exempt debt and could even rescind the tax exemption altogether. Nevertheless, outright repeal of the tax exemption is unlikely. Instead, Congress has used legislative action to modify the existing rules and definitions governing tax-exempt bonds for private activities. Generally, Congress limits the amount of tax-exempt debt that can be used for private activities and restricts the type of private activities that can be financed with tax-exempt bonds. Congress can, and does, encourage selected private activities by exempting the activity from the volume cap or by allowing tax-exempt financing for the private activity. As noted above, Congress uses two primary means to restrain the use of state and local debt for private activities: an annual state volume limit (or separate national aggregate limit) and restrictions on the type of qualified private activities. The private activity bond volume limit, which originated in the Deficit Reduction Act of 1984 ( P.L. 98-369 ), was implemented because "Congress was extremely concerned with the volume of tax-exempt bonds used to finance private activities." The limit and the list of qualified activities were both modified again under the Tax Reform Act of 1986 (TRA 1986, P.L. 99-514 ). At the time of the TRA 1986 modifications, the Joint Committee on Taxation identified the following specific concerns about tax-exempt bonds issued for private activities: the bonds represent "an inefficient allocation of capital"; the bonds "increase the cost of financing traditional governmental activities"; the bonds allow "higher-income persons to avoid taxes by means of tax-exempt investments"; and the bonds contribute to "mounting [federal] revenue losses." The inefficient allocation of capital arises from the economic fact that additional investment in tax-favored private activities will necessarily come from investment in other public projects. For example, if bonds issued for mass commuting facilities did not receive special tax treatment, some portion of the bond funds could be used for other government projects such as schools or other public infrastructure. The greater volume of tax-exempt private activity bonds then leads to the second Joint Committee on Taxation concern listed above, higher cost of financing traditional government activities. Investors have limited resources, thus, when the supply of tax-exempt bond investments increases, issuers must raise interest rates to lure them into investing in existing government activities. In economic terms, issuers raising interest rates to attract investors are analogous to a retailer lowering prices to attract customers. The higher interest rates make borrowing more expensive for issuers. The final two points are less important from an economic efficiency perspective but do cause some to question the efficacy of using tax-exempt bonds to deliver a federal subsidy. Tax-exempt interest is worth more to taxpayers in higher brackets, thus, the tax benefit flows to higher-income taxpayers, which leads to a less progressive income tax regime. The revenue loss generated by tax-exempt bonds also expands the deficit (or shrinks the surplus). A persistent budget deficit ultimately leads to generally higher interest rates as the government competes with private entities for scarce investment dollars. Higher interest rates further increase the cost of all debt-financed state and local government projects. Supporters of tax-exempt bonds for private activities counter that the benefit from tax-exempt bonds exceeds both the explicit (the revenue loss) and implicit (the inefficient allocation of capital) costs of the tax exemption. The debate surrounding use of tax-exempt bonds will continue well beyond the current Congress. Proponents and opponents of tax-exempt bonds generally, and private activity bonds specifically, both explore methods of modifying the rules for private activity bonds to advance their respective positions. Because the rules and definitions for private activity bonds are complex, uncertainty about the potential effects of the proposed modifications to those rules is common. This report will not attempt to either justify or criticize the existence of or use of tax-exempt private activity bonds. Instead, the report provides a brief review of bond fundamentals and a more detailed examination of the rules and definitions surrounding private activity bonds to help clarify the impact of the of those modifications. Tax-exempt bonds for governmental purposes and for qualified private activities are special because, unlike corporate bonds or U.S. Treasury bonds, the bond buyer does not have to include the interest income from the bond in federal gross taxable income. The bond buyer is willing to accept a lower interest rate because the interest income is not subject to federal income taxes. The lower interest rate arising from the tax-exempt status subsidizes state and local investment in capital projects. For example, if the taxable bond interest rate is 5.00%, the after-tax return for a taxpayer in the 37% income tax bracket who buys a taxable bond is 3.15%. Thus, a tax-exempt bond that offers a 3.15% interest rate would be just as attractive to the investor as the taxable bond, all else equal. Researchers can derive an implied marginal tax rate based on current market data for taxable and tax-exempt debt. For more on tax-exempt bonds generally, see CRS Report RL30638, Tax-Exempt Bonds: A Description of State and Local Government Debt , by [author name scrubbed]. The "interest rate spread" is the difference between the interest rate on tax-exempt bonds and some other taxable bond. Table 1 below compares tax-exempt bonds to high-grade corporate bonds over the past 35 years. The difference between the two interest rates is smaller empirically than the previous example because a large share of tax-exempt bond buyers is below the 37% marginal income tax bracket. Individuals in income tax brackets below 37% would require a higher tax-exempt bond interest rate because lower tax rates mean less tax savings from tax-exempt bonds. The lower tax bracket taxpayers bid up the tax-exempt bond interest rate closer to the taxable bond interest rate. Generally, the two rates move in tandem, with the taxable corporate bond interest rate always higher than the tax-exempt municipal bond interest rate. In December of 2008, during unprecedented turmoil in financial markets and the economy, the average high-grade corporate bond rate was 5.05% and the average high-grade municipal (tax-exempt) bond rate was 5.56%. The lower interest rate for taxable corporate bonds than for tax-exempt bonds in December 2008 was a short-lived phenomenon that can be traced to the interaction of at least two factors. First, the Federal Reserve Bank (Fed) was injecting as much liquidity into the economy as possible, setting interest rates at their lowest level ever. This tended to keep market interest rates on taxable debt low. Second, state and local governments were facing significant fiscal stress and the bond market reacted by requiring a risk premium on its debt. The risk premium means a higher interest rate for municipal debt. In addition, the municipal bond insurance market collapsed, further elevating the perceived risk of municipal bonds. Since then, the spread has moved closer to historical levels with average tax-exempt bond interest rates at 3.00% and taxable bonds at 3.67% for 2016. The ratio of tax-exempt debt to taxable debt is still very high at 0.82. Before enactment of a temporary provision in the American Recovery and Reinvestment Act of 2009, (ARRA; P.L.