Bonds, Notes and Public Finance

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Bonds and Infrastructure: $2 Trillion Infrastructure Gap and Tax-Exempt Bonds

State and Local Government Securities 

Classifying State and Local Debt Instruments: 

  • Maturity: Short-Term vs. Long-Term
    • Long-term debt instruments are “bonds,” with maturities in excess of one year; short-term debt instruments are “notes,” and carry maturities of 12 months or less. Long-term borrowing dominates state and local debt activity in most years. Click here and See Figure 1 on page 5)
    • TANS – Tax Anticipation Notes: notes  to be paid from specific taxes due in the near future.
    • RANS – Revenue Anticipation Notes: notes to be paid from anticipated intergovernmental revenue.
    • TRANS (acronym for Tax and Revenue Anticipation Notes as a group)
    • BANS – Bond Anticipation Notes: notes to be paid from from long-term borrowing (i.e. from bonds).
    • ARSs – Auction Rate Securities are long-term debt obligations with variable interest rates and issuers go to auction periodically to reset the rates; however, no ARSs have been issued since 2007.
  • Security:  General Obligation vs. Revenue Bonds
    • General Obligation (GO) bonds are backed by the full faith and credit of the State or local governments that issue them and are repaid from general tax revenue.
    • Revenue Bonds (non-guaranteed debt) are repaid from money generated by the project being financed, such as a toll bridge; long-term market continues to be dominated by revenue bonds which have fluctuated between 61% and 72% of the market from 1992 through 2015.
    • Lease Rental Revenue Bonds (municipal leasing): An authority or nonprofit issues bonds, builds a facility with the proceeds, and leases the facility to a municipality, with the lease payments serving as security for the bonds.
  • Use of Proceeds:
    • New-Issue Bonds are used to finance new capital facilities.
    • Refunding Bonds usually are made to replace outstanding bonds with bonds that carry lower interest rates or other favorable terms. Low interest rates since the Great Recession have increased refunding bond issues.
  • Type of Activity:
    • Public Purpose/Governmental (no limits): 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 of these tests are termed “governmental” bonds and can be issued without federal limit.
    • Qualified PABs (capped): activities that fail the two tests but provide both public and private benefits are known as Qualified Private Activity Bonds. With Qualified PABs, selected activities can be financed with tax-exempt bonds, but are subject to limits. The annual dollar value of all bonds issued for most of these activities by all governmental units within a state is limited to the greater of $100 per resident or $302.88 million in 2016.  The annual volume cap applies to total bonds issued primarily for multi- and single-family housing, industrial development, exempt facilities, student loans, and electric utilities.  In recent years, Congress has expanded the types of private activities eligible for tax-exempt financing including: qualified public educational facility bonds in 2001; NY Liberty Zone bonds after 9/11; qualified green building and sustainable design projects in 2004; transportation transfer facilities and Gulf Opportunity Zone bonds in the wake of Hurricane Katrina in 2005; qualified mortgage bonds and residential rental projects during the housing crisis; and recovery zone facility bonds during the Great Recession. (For background, see pages 11-13)
Federal Tax Expenditure in FY 2015
for Selected Private Activities Financed
with Tax-Exempt Bonds (source: OMB)
2015 Tax
(in millions)
of Total
Total Selected Activities: $10,020 100.00%
 Energy Facilities $20 0.20%
 Water, Sewerage, and Hazardous Waste Disposal $450 4.49%
 Small-Issues $170 1.70%
 Owner-Occupied Mortgage Subsidy $1,250 12.48%
 Rental Housing $1,050 10.48%
 Airports, Docks, and Similar Facilities $740 7.39%
 Student Loans $490 4.89%
 Private Nonprofit Educational Facilities $2,270 22.65%
 Hospital Construction $3,570 35.63%
Veterans’ Housing $10 0.10%

Federal Tax Subsidies for State and Local Debt

  • Tax-Exempt Bonds:  The federal government subsidizes the cost of most state and local debt by excluding the interest income from federal income taxation (except where bonds are determined to be taxable arbitrage bonds).
    • Lower Cost of Borrowing for States and Cities: In general, due to the federal tax exemption, state and local governments can raise capital from investors at an interest cost 3.5 percentage points (350 basis points) lower than a borrower issuing taxable debt (assuming that taxable bond interest is taxed at a rate of 35%)..
    • “Yield spread”:  is the difference between the interest rate on taxable bonds (corporate bonds or U.S. Treasury bonds) and the interest rate on tax-exempt municipal bonds of equivalent risk.  However, the spread between tax-exempt and taxable bonds has declined as underlying interest rates have declined.
    • “Yield ratio:”  average rate on tax-exempt bonds divided by average rate on a taxable bond of like term and risk);  as the ratio approaches one, the advantage of tax-exempt borrowing declines.
    • Cost to the federal government: The amount of forgone tax revenue from the exclusion of interest income on public-purpose tax-exempt bonds is estimated to be $30 billion for 2017.  (See FedWeb Docs, Federal Budget, Analytical Perspectives, Tax Expenditures)
  • Tax Credit Bonds (TCBs) offer an investor a federal tax credit or the issuer a direct payment; they are usually designated for a specific purpose, location, or project. Recent examples include: qualified zone academy bonds (QZABs); clean renewable energy bonds (CREBs); qualified forestry conservation bonds (QFCBs); qualified energy conservation bonds (QECBs); Midwest disaster bonds (MWDBs); qualified school constructions bonds (QSCBs); recovery zone economic development bonds (RZEDBs).

Tax Reform Issues

  • In general, “legislative interest has typically focused on altering the tax treatment of state and local debt to provide a more economically efficient subsidy with a lower federal revenue cost.”
  • Of recent interest are proposals to incentivize financing for infrastructure.