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.