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Tuesday, June 26, 2012

Tax-Exempt Bonds: A Description of State and Local Government Debt

Steven Maguire
Specialist in Public Finance

This report provides information about state and local government debt. State and local governments often issue debt instruments in exchange for the use of individuals’ and businesses’ savings. This debt obligates state and local governments to make interest payments for the use of these savings and to repay, at some time in the future, the amount borrowed. State and local governments finance capital facilities with debt rather than out of current tax revenue in order to match the time pattern of benefits from these capital facilities with the time pattern of tax payments.

The federal government subsidizes the cost of most state and local debt by excluding the interest income from federal income taxation. This tax exemption of interest income is granted because it is believed that state and local capital facilities will be under provided if state and local taxpayers have to pay the full cost. The federal government also provides a tax preference through tax credit bonds (TCBs). With TCBs, the federal government either provides investors with a federal tax credit in lieu of interest payments or a direct payment to the issuer. Qualified Zone Academy Bonds and Build America Bonds are examples. For more on TCBs, see CRS Report R40523, Tax Credit Bonds: Overview and Analysis, by Steven Maguire.

State and local debt is issued as bonds, to be repaid over a period of time greater than one year and perhaps exceeding 20 years, and as notes, to be repaid within one year. General obligation bonds are secured by the promise to repay with general tax revenue, and revenue bonds are secured with the promise to use the stream of revenue generated by the facility built with the bond proceeds. Most debt is issued to finance new capital facilities, but some is issued to refund a prior bond issue (usually to take advantage of lower interest rates). Tax-exempt bonds issued for some activities are classified as governmental bonds and can be issued without federal constraint because most of the benefits from the capital facilities are enjoyed by the general public. Many tax-exempt revenue bonds are issued for activities Congress has classified as private because most of the benefits from the activities appear to be enjoyed by private individuals and businesses. The annual volume of a subset of these tax-exempt private-activity bonds is capped. For more on private activity bonds, see CRS Report RL31457, Private Activity Bonds: An Introduction, by Steven Maguire.

Arbitrage bonds devote a substantial share of the proceeds to the purchase of assets with higher interest rates than that being paid on the tax-exempt bonds. Such arbitrage bonds are not tax exempt because Congress does not want state and local governments to issue tax-exempt bonds and use the proceeds to earn arbitrage profits. The arbitrage profits could substitute for state and local taxes.

One major policy issue in this area is tax reform proposals that would modify the tax treatment of state and local government bonds. Another policy issue is whether constraints should be relaxed on the types of activities, such as infrastructure spending, for which entities can issue tax-exempt debt. The list of activities that classify tax-exempt private-activity bonds—and whether they should be included in the volume cap—is another area of potential change or reform. This report will be updated as new data become available.

Date of Report: June 19, 2012
Number of Pages: 12
Order Number: RL30638
Price: $29.95

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