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1 1 (November 15, 2017)

handle is hein.crs/govcfzy0001 and id is 1 raw text is: 01;ri E.$0 & Updated November 15, 2017 Key Issues in Tax Reform: Federal Subsidies for Interest Income Generated from Municipal Bonds Changes to tax expenditures have been a core component of several recent tax reform proposals. Tax expenditures are special provisions that move the tax code away from a theoretically normal tax system. In most cases, these special tax provisions result in a revenue loss for the federal government. Among the tax expenditures modified by tax reform proposals in the 115th Congress are the exclusions for interest income generated from certain state and local bonds. State and local (municipal) governments issue bonds to investors to finance investments in exchange for interest payments and the eventual repayment of the principal (amount borrowed). The federal government subsidizes state and local debt through three policies: (1) all interest income earned from public purpose bonds is excluded from federal income taxation; (2) a tax credit may be claimed on interest income in lieu of the exclusion in some cases; and (3) interest income earned from qualified private activity bonds (PABs) is excluded from federal regular income taxation. Table I. Estimated Combined Expenditures on Federal Bond Subsidies, FY2016-FY2020 (billions of dollars) Reduced Increased Revenues Outlays Total Tax-Exempt 194.7 - 194.7 Bonds Tax Credit 1.8 24.0 25.8 Bonds Qualified 60.8 - 60.8 PABs Source: JCT, Estimates of Federal Tax Expenditures for Fiscal Years 2016-2020, December 2016. Table 1 shows Joint Committee on Taxation (JCT) estimates of the budgetary effects of federal bond subsidies from FY2016-FY2020. The federal bond subsidies are projected to provide a total of $281.3 billion in benefits over five years. That annual subsidy represents roughly 2% of the current municipal debt stock: the Federal Reserve estimated that state and local governments had $3.05 trillion in debt issuances outstanding in the first quarter of 2017. Bonds are considered to be for a public purpose if they satisfy either of two criteria: (1) less than 10% of the proceeds are used directly or indirectly by a non- governmental entity; or (2) less than 10% of the bond proceeds are secured directly or indirectly by property used in a trade or business. Bonds that satisfy either test are termed governmental bonds and can be issued without federal restriction. The federal government subsidizes the cost of governmental bonds by excluding interest income earned by investors on those bonds from federal income taxation. The exclusion lowers the cost of debt for state and local governments by allowing them to borrow at lower interest rates than would otherwise apply if the interest income were taxable. The lower cost of capital arises because in most cases investors will be indifferent between taxable and tax- exempt bonds of equivalent risk if their after-tax return is identical. For example, consider a taxpayer in the 35% tax bracket who is considering investing in a taxable bond with a 10% interest rate and a tax-exempt bond with a 6.5% interest rate. The taxability of the bond with the 10% interest rate makes the investor's after-tax income identical to that of the tax-exempt bond with a 6.5% interest rate. Thus, state and local governments could raise capital from investors at an interest cost 3.5 percentage points (350 basis points) lower than a borrower issuing taxable debt. The direct cost to the federal government of tax-exempt bonds is the individual and corporate income tax revenue forgone. In the example above, the taxable bond with a 10% interest rate would have generated federal tax liability equal to 3.5% (or 35% x 10%) of the bond's principal value each year. Tax C ,n Tax credit bonds (TCBs) are an alternative to tax-exempt bonds. TCBs provide a tax credit or direct payment proportional to the bond's face value in lieu of the tax exemption. Unlike tax-exempt bonds, the value of the credit (and subsequent cost to the federal government) is not dependent on the investor's marginal income tax rate. Most TCBs are designated for a specific purpose. For example, TCBs have been used by issuers for financing 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 economic development purposes. All of the TCBs currently in circulation were established as temporary tax provisions. Many recent TCBs are not eligible for new issuances, due either to the expiration of issuing authority or to full subscription of the TCB issuing limit. Bonds that are no longer issued may still be held by .O 'T gognpo goo g , q 'S a X 11LULANJILiN,

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