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17 IRET Congressional Advisory 1 (1993)

handle is hein.taxfoundation/iretcgadv0016 and id is 1 raw text is: Advisor June 3, 1993 No. 17 HOUSE TAX BILL PROVISION ON MARKET DISCOUNT BONDS: ASSAULT ON TAX EXEMPT BONDS; DOUBLE TAX ON SAVING Bonds are generally issued at face value and pay explicit interest on the face amount. If interest rates rise after the bond is issued, the price of the bond will fall. A new buyer will receive the higher market interest rate in the implicit form of a gradual rise in the price of the bond toward face value at maturity plus the explicit interest payment in force at the time of issue. The In the case oj gradual rise in price is called interest is n accrued market discount. taxed. If tht discount to fa In the case of original as the House issue zero coupon bonds, the should be not bond is originally issued at a if the bond i discount - the original issue discount, or OID - and all from chani interest is paid in the form of gt ins treatmi a rise toward face value at to ordinary maturity - accrued OD. In adjustment is this case, a market discount gains from tal from the accrued OID value due to a subsequent rise in interest rates provides added interest to the new buyer over time. The accrued market discount in this case is any gain in excess of the rise due to the accrued OID that constitutes the implicit interest payments in force at the time of issue. Under current law, when a bond purchased at market discount is later sold or reaches maturity, the accrued market discount is treated as interest income, taxable at ordinary rates. (A rise in price in excess of the implicit interest - as would occur if interest rates subsequently fell - is considered a capital gain.) There are two exceptions to the interest treatment of accrued market discount. Gains on bonds issued before July 18, 1984 (when current law treatment began) and gains on tax exempt bonds are treated as capital gains when the bonds are sold. (Note that this component of the interest on tax exempt bonds is not tax exempt under current law.) The House tax bill would eliminate these two exceptions, and treat any gain resulting from purchase at a market discount as ordinary income. It is correct to consider as interest the rise in the price of a bond from a discounted level at time of purchase towar c tax exempt bonds, ot supposed to be rise from market ce valute is inter-est, admits, then there ax at all on the tise tax exempt. Far, Sthe curr-ient cap~ital it of such incr-eases nwome, the corriect to exempt such centirely. the House bill *d face value at maturity. Bonds may pay interest explicitly by coupon or implicitly by accrual from a discounted price. There is no economic difference between the two methods. What is at issue is not whether the price increase due to accrued market discount is interest or a capital gain. What is at issue is the correct tax treatment of interest however it is paid. Under current law, some interest is treated correctly, and some incorrectly. Instead of moving toward the correct tax treatment of all interest, would increase uniformity by treating all accrued market discount interest incorrectly. In the process, the House bill would move the tax code in the wrong direction, and would worsen the current tax bias against saving. Institute for Research on the Economics of Taxation IRET is a non-profit, tax exempt 501(c)(3) economic policy research and educational organization devoted to informing the public about policies that will promote econornic growth and efficient operation of the free market economy. 1730 K Street, N., Suite 910, Washington, D.C. 20006 Voice 202-463-1400 e Fax 202-463-6199 0 Internet www.iret.org

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