Proposals: Basic Income
From The Shelf Project
Repeal Tax Exemption for Municipal Bonds (Basic Tax) Version 1.03 (Nov. 6, 2007).
by Publius*
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Overview
The proposal would repeal for future years the exemption for interest on state and local bonds. While the exemption is supposed to help state and local borrowers, only a small fraction of the federal cost of the exemption is captured by the borrowers. What is captured, in the form of lower interest paid, does harm by inducing public ownership of projects that should not be undertaken. For outstanding bonds, the interest would be taxable in future years but holders would get a tax credit in the amount of the reduced interest they have accepted from municipal bonds. State and local government would get a direct subsidy exceeding their benefit under current law.
Current Law.
Under section 103 of the Internal Revenue Code, gross income does not include interest on state or local bonds. Most (83%) of the bonds that are tax-exempt under section 103 are general obligation bonds in which the proceeds are used by the state and local governments and repayment is from general tax revenues. However, 9.4% of section 103 bonds are issued on behalf of nonprofit organizations for specified qualified purposes and 7.3% of section 103 bonds are private activity revenue bonds, issued for the use of private businesses. For private activity bonds the state or local government is merely a conduit and repayment is available only out of the revenue provided by the true private borrower. Interest from private activity revenue bonds is now subject to alternative minimum tax of up to 28% for individuals and 20% for corporations, unless the borrowing is by a charitable organization for its charitable purpose. A state or local government may also purchase computers or other office equipment pursuant to a lease-purchase agreement or an ordinary written agreement of purchase and sale and interest on such lease-purchase or installment sales is tax exempt.
Eligibility for section 103 tax-exempt borrowing, beyond general obligation bonds, is specified by statute with great complexity. Among the specified borrowings eligible under section 103 are certain voluntary fire departments (section 150(e)), qualified scholarship funding bonds (section 150(d)), private activity bonds that are exempt facility bonds, qualified mortgage bonds, veteran’s mortgage bonds, small issue bonds, qualified student loan bonds, qualified redevelopment bonds, and qualified section 501(c)(3) bonds. IRC §141(e). Private activity bonds must meet a volume cap on how much any one state or state agency can offer. IRC§146. However, Congress has exempted certain private activity bonds from the volume caps, including, for instance, borrowing for airports, for docks and wharves, and for construction in the New York Liberty Zone below Canal Street in New York City. A qualified borrowing can not be an arbitrage bond, that is, a bond expected to be used to purchase an investment yielding a rate higher than the interest on the section 103 bonds, with certain specified exceptions. A prospective issuer may ask for a letter ruling on qualification for exemption (Rev. Proc. 96-16, 1996-1 C. B. 630) and may appeal an adverse ruling. Rev. Proc. 99-35, 1999-2 C.B. 501.
Interest incurred to buy or carry tax exempt bonds is matched to the exempt income and it is, therefore, not deductible. IRC §265(a)(2). Allocation of the interest expense to the exempt income is complicated and ineffective to prevent deduction of extra interest that would be avoided if the exempt bonds were not carried. The combination of exempt income and deducted costs, when allowed, allows unrelated income to be sheltered from tax.
Interest paid by the federal government on its own bonds is not exempt from federal income tax.
Reasons for Change.
The purpose of section 103 is to subsidize certain borrowing, but the exemption wastes most of the federal cost because the intended beneficiaries can not capture the cost. The exemption for interest on state and local bonds arose, not from a well engineered subsidy program, but because of doubts about the constitutionality of a tax on state bonds. It has now been settled that Congress may tax, on a nondiscriminatory basis, interest from whatever source derived. With the disappearance of the constitutional grounds, the only remaining ground for the exemption is its delivery of a subsidy to qualified borrowers. On that ground, justification for the exemption fails because state and local borrowers capture so little of the federal cost and because the borrowing should not be subsidized without a budget-imposed discipline.
Delivery efficiency of tax exemption. If a municipality could sell its bonds only to 35%-bracket investors and they had no tax-advantaged alternatives, the municipality could capture whatever the federal government lost. If prevailing taxable interest were 10% for some term and risk rating, for instance, municipalities offering tax exempt bonds would need to pay only a jot over 6.5% interest to attract lenders because taxable investors in a 35% bracket would get only 6.5% from their taxable bonds alternative after tax. Under those circumstances, the federal government would lose 35% of prevailing taxable interest by forgoing tax and the municipalities would achieve a benefit of almost 35%, by a discount or drop measured from the same prevailing interest. The federal cost, and the state and local benefit, both measured from the baseline of interest on taxable bonds, would be nearly the same.
The difficulty with the exemption is that there are too many tax-advantaged alternatives offered on the market so that state and local borrowers can not attract investors who will accept a 35% discount. Currently, the discount on long-term AAA state and local bonds is between 2% and 9%. Long term bonds have the lowest discount, because taxable investors find it easier to avoid tax on competing long term investments than on shorter term investments, and are willing to bear reduction in interest on long term bonds. The supply of tax advantaged investments floods the market. State and local long-term borrowers must offer, not 65% of prevailing taxable interest rates, but 91-98% of prevailing taxable interest rates.
Under a set of assumptions, including the assumption that bonds are held pro rata to overall wealth, the weighted-average tax rate of investors in municipal bonds is 31%. On long term borrowing, accordingly, the federal government gives up tax of approximately 31% of fair market taxable interest in order to give municipalities benefits of 2-9% of fair market value taxable interest. OMB estimates the total cost of the municipal bond exemption to be $25.4 billion. If the long term bonds were typical of all issues, the federal government would be spending $25.4 billion to deliver a benefit to state and local governments of between $1.6 to $7.3 billion. That ratio of cost to benefit – between 72% and 93% of the federal cost is wasted -- makes section 103 a most wasteful government program.
The implicit tax also creates a maximum tax on capital that any taxpayer needs to bear. Municipal bonds compete at the margin with all investments in the economy and taxpayers can flee to section 103 bonds by paying a modest 2-9% fee. Congress must then look to other less optimal taxpayers and sources to raise the revenue it needs.
Municipal bonds also bear premium interest rates because the resale market for municipal bonds is very thin and because the market knows too little information about the various issuers. It would be cheaper for the federal government to borrow directly, at its rock bottom interest rate, and subsidize state and local governments directly because that would avoid the waste caused by illiquidity and unsatisfactory market information. Indeed under some conditions, it would be cheaper for the municipalities to borrow on the robust market for taxable bonds, because the premium arising from a thin and uninformed tax-exempt market exceeds the reduction in interest they achieve from section 103.
The waste in the delivery of the benefits of municipal bonds has gotten worse over time. The amount that taxpayers are willing to pay for explicit section 103 tax exemption, by accepting lower interest rates, has declined over the last 10 years, as taxpayers have found ever more generous ways to avoid tax. Implicit taxes were just over 20% in 1996 and are now at 2-9%. The tax base is assaulted continuously by very clever tax planners and the legislative process. Taxpayers with many alternatives are not willing to take and do not need to take very much reduction in interest to get fully legal section 103 tax exemption.
Section 146 of the Code imposes a volume cap on the amount of private activity revenue bonds that can be issued by a state, but the volume cap has been ineffective to ensure that the exemption is not swamped. An effective cap would prohibit any borrower from paying more than 65% of applicable federal rates for the term, and the quantity of bonds issued would drop until borrowers captured the entire foregone federal tax.
Currently, with so little of cost of the exemption being captured by borrowers, defenders of the exemption are speaking primarily for the unintended beneficiary, the middleman investors. The purported beneficiaries, state and local governments, are receiving only a very modest sliver of the expense.
Harm in the intended incentive. Even when state and local borrowers capture benefit from section 103, the exemption does harm. The exemption allows capital projects to go forward that could not be justified if they had to pay the full going interest costs. The competitive market for capital filters out projects with only modest value, and lets through only those uses of capital that pass over the threshold of being able to meet the prevailing interest costs. The tax exemption in section 103, however, lowers the cost of capital for some projects without requiring that they prove special merit. Capital directed to the lesser projects is pulled from better projects that would otherwise be funded.
The exemption also shifts some capital projects from private hands to public hands so that that the project can get access to the lower financing costs on municipal borrowing. The shift thus moves projects from presumably efficient profit-making enterprises to presumably inefficient political entities. We are now a net-capital importing country, borrowing our marginal capital from China and other foreign sources, and we should not waste precious capital on lesser projects.
The game-theory situation of state and local borrowers already provides incentive for states and localities to push off public costs. Politicians trying to get elected will provide benefits to current voters, but try to shift the costs of those benefits to the future, because the future taxpayers do not vote. The tax incentive compounds the problem of shifting costs to the future. State and local governments ought to be able to borrow, but not necessarily at preferred rates.
The decision as to which meritorious projects will receive a subsidy should be made by a competitive budget process. The federal budget is the tool by which the federal government judges the rationality of expenditures in a highly competitive environment. If a program is off budget, there is no alternative mechanism to force competition for limited resources or application of government rationality. These off-budget costs are not justified by the democratic process because they are hidden, and not justified by a reasoned, competitive budget process.
Section 103 and other tax incentives also have no limits on quantity issued. The uncontrolled expansion of tax exempt and competing tax-favored investments swamp the market and make all tax incentives a wasteful mechanism.
Proposed legislation
End of exemption and grant instead. The proposal would repeal the tax exemption for municipal bonds issued, extended or renewed after the date of the announcement of the proposal. The proposal would replace the $24.5 billion tax expenditure cost of tax exempt bonds with a $8 billion annual direct grant to state and local governments, and other currently eligible borrowers in proportion to their outstanding bonds on the announcement of the proposal. The net revenue gain from the proposal would thus be approximately $16.5 billion.
While the $8 billion grant would be to current borrowers prorata to their outstanding bonds, the grants would have to be used to reduce outstanding section 103 bonds. It is inappropriate to give incentive to greater borrowing. The grants would encourage contraction of borrowing rather than expansion. When no pre-existing section 103 bonds remain outstanding, the grants would cease. Congress would, however, be at liberty to continue the grants at the $8 billion level or higher, with or without conditions as to their use.
Because the implicit tax on section 103 bonds is currently so low, the $16.5 billion revenue gain can be achieved while simultaneously giving the eligible borrowers more benefit they are getting from implicit tax. The implicit tax is so low that the annual grants can even be increased to the point that current borrowers are active supporters of the change.
The federal government can be expected to save $25.4 billion a year lost to tax exemption, less the cost of the replacement grants to current borrowers. Investors now holding tax exempt bonds will flee to other low effective tax rate investments. As long as the quantity of low effective tax rate investments is not allowed to expand, however, those fleeing from section 103 bonds will in turn displace other investors and send them into taxable sources.
Existing Bonds. Already-issued state and local bonds can also equitably bear tax. All tax increases reduce investor income and resources. When taxes increase, however, it is more equitable to increase taxes on those who start with a windfall position of paying nothing beyond implicit tax, rather than to increase the taxes for their peers who start from paying 35% rates. Well informed private investors, in general, bear risks of tax increases in the ordinary course of their business and indeed are better bearers of the risks of tax increases than is the government. If the government sets a norm that 35%-tax-bracket taxpayers keep 65% of prevailing interest rates, that norm can and should be maintained consistently for all 35% bracket investors. Since current implicit taxes are modest and even insubstantial, existing investors have received windfalls, measured from the amount that they could expect from taxable bonds of like term and risk, and they have received more than necessary to induce them to buy tax exempt bonds.
To the extent of the implicit tax, however, the federal government has received the benefit of the bargain from the section 103 grant of exemption. Thus the proposal would tax interest on existing bonds that now qualify under section 103 as to interest paid in future years, but allow a credit for implicit tax borne by the investor. Both the credit and the taxable amount would be computed from the equivalent fully taxable rate on bonds of like term, risk and date of issue. For example, assume that the interest rate on a taxable bond identical to a municipal bond in term, risk and time of issuance, was 10%, and the municipality had to pay 9% to attract investors to its like tax- exempt bonds. Ordinarily a 35% tax bracket lender could expect to keep only 65% of the interest on federal or corporate bonds after tax, or here 6.5% interest. After enactment of the proposal, that lender would still get 65%.of comparable taxable interest after tax. The taxable income would be 10%, computed either directly from the equivalent taxable bond, by “grossing up” from the municipal bond. The tax would be 3.5%, but the 1% implicit tax on the bond when issued, would be a credit against that 3.5%, so the investor would pay only 2.5% to the federal government. The investor would start with a 9% interest receipt, owe 3.5% tax, get a 1% credit for implicit tax, and would end with 6.5%, the same as would be achieved from the taxable bond alternative.
A 10%-interest rate bond is now worth much more than face amount, assuming investment-grade risks and given the drop in general interest rates, but the holder would keep the capital gain on his bond caused by change in interest rates, whether the bond is taxable or tax exempt.
A state and local bond issued after the announcement date would not be entitled to credit against tax, whatever the state and local interest rate, and interest would be fully taxable to investors.
It should also be possible to allow a small cushion above actual implicit tax to ease administration. Thus taxpayer would be allowed to round up the implicit tax to the nearest one-half percent of interest. On audit and in litigation, however, the credit allowed would be the actual implicit tax borne by the holder. Eventually, the IRS should be required to publish implicit taxes tables, for every term, date of issuance, and risk measured by credit-rating. To forgo expensive litigation, those tables would be rounded up to the nearest ½% interest and would be binding on all holders as to the amount of their taxable income and credit.
Without a tax on interest on existing bonds, holders of existing bonds can expect a windfall on top of their windfall tax-exempt interest rates, as tax exempt bonds become rarer. Assume, for example, that bonds with an implicit tax of 5% of prevailing rates become so rare that purchasers are willing to take 35% discounts on interest, that is, the burden of normal ordinary income tax rates, to acquire the bonds. Assume a 5% prevailing taxable interest rate. The following, chart 1, shows how much more valuable the bond is under a 35% implicit tax than 5% implicit tax:
Chart 1: Capital gain for term of years remaining with 5% fmv interest, and 5% implicit tax growing to 35%.
term remaining (years) appreciation capital gain
30 128% 28%
25 125% 25%
20 122% 22%
15 118% 18%
10 113% 13%
5 107% 7%
If Congress were to adopt added transition relief for existing bonds (beyond the credit for implicit tax proposed here), the added transition relief would need to take away the windfalls such as those shown in Chart 1. Even for investors who do not in fact sell, the appreciation illustrated in Chart 1 offers a potential to sell or borrow that is not invisible, and investors hold the bonds in the face of appreciation only because holding is more valuable to them than realization of the appreciation.
