Nearly all state and local governments sell bonds to finance public projects and certain qualified private activities. The federal government subsidizes state and local bond issuances through a number of policies. The mostly widely utilized policy instrument is the tax-exempt bond, which excludes bond interest payments received from the investor's federal taxable income. In contrast, interest payments from other types of bonds, such as corporate bonds, are included in federal taxable income. Because of the difference in taxability, state and local government tax-exempt bonds—often referred to as municipal bonds—offer a lower pre-tax interest rate than corporate bonds, which reduces the interest costs owed by state and municipal governments. Tax credit bonds (TCBs) offer an alternative to municipal bonds, providing a tax credit or direct payment proportional to the bond's face value in lieu of the tax exemption. Most TCBs are designated for a specific purpose. TCBs have been used by issuers to finance public school construction and renovation; clean renewable energy projects; refinancing of outstanding government debt in regions affected by natural disasters; conservation of forest land; investment in energy conservation; and for economic development purposes. The relative appeal of TCBs and municipal bonds is dependent on issuer and investor characteristics and on economic conditions. Many recent TCBs are not eligible for new issuances under current law, due either to the expiration of issuing authority or to full subscription of the TCB issuing limit. Bonds that are no longer being issued may still be held by the public. In the 114 th Congress, multiple bills have been introduced to extend or modify certain TCB programs. The Consolidated Appropriations Act, 2016 ( P.L. 114-113 ) extended the issuing authority of QZABs for the 2015 and 2016 tax years, and provided for $400 million of issuing capacity for each year. Other legislation, including H.R. 2676 and S. 1515 would extend the BAB program indefinitely. Additionally, the President's FY2017 Budget included a number of proposals related to TCBs, including the creation of a new TCB for certain infrastructure programs. There are several types of TCBs, most of which are provided for a specific purpose, location, or type of project. Issuers of Qualified Zone Academy Bonds (QZABs) are required to use the proceeds to finance public school partnership programs in economically distressed areas. Clean Renewable Energy Bonds (CREBs) are designated for clean renewable energy projects. Midwestern Disaster Bond (MWDB) proceeds were for the refinancing of outstanding government debt in regions affected by the Midwestern storms and floods in the spring and summer of 2008. Qualified Forestry Conservation Bonds (QFCBs) are intended to help non-profits or government entities purchase and conserve forest land. Qualified Energy Conservation Bonds (QECBs) are for investment in capital projects that improve energy conservation. Qualified School Construction Bonds (QSCBs) are for school construction, Build America Bonds (BABs) are for any governmental purpose, and Recovery Zone Economic Development Bonds (RZEDBs) are for economic development purposes. Table 1 summarizes the acronyms for the bonds examined in this report. TCBs offer a tax credit that may be used to directly reduce federal income tax liability. The credit available from a TCB depends on the bond principal and credit rate. The method of determining the credit rate differs across types of TCBs: the credit rate for investor and issuer credit TCBs depends on a national credit rate set by Treasury, while the credit rate for direct payment TCBs is dependent on interest rate negotiations between the issuer and investor. Unlike interest on municipal bonds, which does not create a taxable income stream, the credit amount is included in the bond holder's gross income. The credit is limited to the bondholder's current tax liability and is therefore "non-refundable." Unused tax credits may be carried over to the succeeding tax year. The credit rate for investor and issuer credit TCBs is dependent on a national credit rate set by the Secretary of the Treasury. That national credit rate is intended to allow issuers of TCBs to sell their bonds at par (face value) without additional interest expense. The rate calculation is based on its [the Treasury Department's] estimate of the yields on outstanding bonds from market sectors selected by the Treasury Department in its discretion that have an investment grade rating between A and BBB for bonds of a similar maturity for the business day immediately preceding the sale date of the tax credit bonds. The credit rate published (by the U.S. Bureau of the Fiscal Service) on the issue sale date is the bondholder's annual rate of credit. The relationship between the national credit rate set by Treasury and final credit rate applied to a bond issue is dictated by the federal tax code, and differs across types of investor and issuer TCBs. The credit on what are known as 100% credit TCBs provides for a benefit equal to the product of the national credit rate and the bond principal. For example, the annual tax credit rate for investor credit TCBs was 3.92% on September 8, 2016 (the term was 45 years). The bonds sold on that day would allow the taxpayer to claim a federal tax credit equal to 3.92% multiplied by the face value of the bond. Thus, a $100,000 bond issued on September 8, 2016, would yield an annual tax credit of $3,920 for the bondholder. However, other credit rates may be reduced for some TCBs. CREBs and QECBs allow for a credit equal to 70% of the national credit rate. Thus, for these bonds, the investor receives 70% of the annual tax credit described above, or $2,744 (70% of $3,920). The method for determining the tax credit rate for investor tax credit TCBs is generally the same for 100% and 70% credit TCBs. Unlike investor credit TCBs, the benefit claimed for issuer direct payment TCBs depends on the interest rate established between the buyer and issuer of the bond, not the Secretary of the Treasury. The issuer and investor agree on terms either as a result of a competitive bid process or through a negotiated sale. As with investor credit TCBs, the relationship of the final credit rate and the negotiated interest rate may differ across types of TCBs. BAB and RZEDB credits are 35% and 45%, respectively, of a market-determined taxable bond interest rate for the specific issuer, not the Secretary of Treasury. For example, if the negotiated taxable interest rate is 8%, on $100,000 of bond principal, then a bond with 35% credit amount would produce a credit worth $2,800 (8% times $100,000 times 35%). The issuer has the option of receiving a direct payment from the Treasury equal to the credit amount or allowing the investor to claim the credit. The issuer would choose the direct payment option if the net interest cost was less than traditional tax-exempt debt of like terms. The interest cost to the issuer choosing the direct payment is $8,000 less the $2,800, or $5,200. If the tax-exempt rate of the bond is greater than 5.20% (requiring a payment of greater than $5,200), then the direct payment is a better option for the issuer. So long as the marginal tax rate of investors in the municipal bond market is lower than the credit rate of the direct payment TCB, then municipal issuers would likely chose the direct payment option. However, as the marginal tax rate rises, the alternative to direct payment TCBs, traditional tax-exempt bonds, is relatively more attractive to issuers and investors alike. Increases in statutory marginal tax rates would likely induce such an outcome, reducing the attractiveness of direct payment TCBs relative to traditional tax-exempt bonds. The direct payment TCB, in cases where the issuer claims the direct payment, is modeled after the "taxable bond option," which was first considered in the late 1960s. In 1976, the following was posited by the then president of the Federal Reserve Bank in Boston, Frank E. Morris: The taxable bond option is a tool to improve the efficiency of our financial markets and, at the same time, to reduce substantially the element of inequity in our income tax system which stems from tax exemption [on municipal bonds]. It will reduce the interest costs on municipal borrowings, but the benefits will accrue proportionally as much to cities with strong credit ratings as to those with serious financial problems. The taxable bond option has been well received by issuers and investors. A U.S. Department of the Treasury report on BABs, a direct payment TCB, estimated that over the lifetime of the program over $181 billion in BABs were issued. The implementation of annual sequesters, as provided for by the Budget Control Act of 2011 ( P.L. 112-25 ), diminished the credit rates of certain issuer direct payment TCBs. In FY2016, sequestration reduced the credit rates for issuer direct payment BABs, QSCBs, QZABs, new CREBs, and QECBs by 6.8%. The credits on TCBs are "strippable," or separable from the underlying bond. Allowing the separation of the credit from the underlying bond improves the attractiveness and marketability of the TCBs to issuers, investors, and financial intermediaries. Generally, a financial intermediary could buy the TCB, sell the principal to an investor looking for a longer-term investment, and sell the stream of credits to another investor seeking quarterly income. For example, assume a financial intermediary buys the $100,000 TCB presented above.