Group: Rethink Subsidizing States Through Tax-Exempt Bonds

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WASHINGTON – Instead of subsidizing state and local governments for using tax-exempt bonds, the federal government should increase direct spending programs for states, the Tax Foundation recommended in a report on tax expenditures.

The report, called "Corporate and Individual Tax Expenditures 2016" and authored by Alan Cole, cites the Office of Management and Budget's Analytical Perspectives budget document for fiscal 2017 in stating that the tax revenue lost from corporations that hold tax-exempt bonds is expected to total $187 billion from 2016 to 2025.

"However, this measure is typically defined as a measure of aid to state and local governments, not as aid to lenders," Cole wrote in the report.

"In practice, bondholders have to pay a premium for these tax-exempt bonds – that is, they are willing to accept lower interest rates. The money lost by the federal government, then, is given in the form of lower borrowing costs."

Cole added, "While many states and municipalities rely on federal aid, it may be better to fold this kind of aid into an existing spending program for all states, rather than subsidizing states for explicitly using debt financing."

The report characterizes the federal tax exclusion for interest on state and local public purpose bonds as the third largest corporate tax expenditure.

Cole said tax exemption is both an individual and a corporate tax expenditure. "Many corporations own state and local bonds and they also get the tax-free treatment," he said.

The total cost of tax expenditures from 2016 to 2025 is $17 trillion, including $2 trillion in corporate expenditures and $15.1 trillion in individual expenditures, according to the report.

It divides the tax expenditures up into three categories. The first, and generally the largest in value, modernizes the tax code and moves it toward some of the tax systems of our trading partners," Cole wrote. These "should be taken very seriously" and in some cases, "should not be considered tax expenditures at all," he added.

The second category involves tax expenditures such as those relating to children and health care. They are "spending provisions reflecting a legitimate governing priority," Cole wrote. However, the way in which the tax code provides for these priorities "should be up for debate," he added.

The third category involves tax expenditures that subsidize specific industries and "deserve outright elimination," Cole wrote in the report.

Muni market participants scoffed at Cole's suggestions.

"The suggestion to fold muni interest tax expenditures into direct federal spending for states and localities sounds like a version of the old revenue sharing," said Chuck Samuels, a lawyer at Mintz Levin. "Whatever its merits, it's totally politically impractical which is probably why it's suggested. In any case, new, bureaucratic federal spending programs cannot effectively supplant thousands of decentralized, targeted decisions made at the state and local levels."

Emily Brock, director of the Government Finance Officers Association's federal liaison center, said, "The estimated cost to the federal government pales in comparison to the historical average of saved borrowing costs realized by state and local governments – ranging around 100-200 basis points – on more than three trillion. That's a significant saving to taxpayers that far exceeds the cost to the federal government."

She added, "I think though that the farthest stretch of the passage is that instead of the tax exemption on municipal bond interest, the federal government should appropriate funds through some existing spending program. It's an odd assertion that is based on mischaracterizing the partnership between federal, state and local governments."

The very first version of the tax code included a tax exemption for state and local governments as an agreement between governments, not as "aid," Brock said.

"This is a paper which fundamentally misunderstands and misrepresents our unique form of federalism and reciprocal immunity," agreed Frank Shafroth, director of the Center for State and Local Leadership at George Mason University. "The steady diminution of federal aid to state and local governments has reversed the financing of the nation's physical foundations: today the nation's infrastructure is far more dependent on state and local capital investment than federal funds," he added.

Justin Underwood, federal policy advisor at Bond Dealers Association, said, "Municipal bonds are an effective means of borrowing for state and local governments that are used to finance 75% of the infrastructure in the U.S. The true beneficiaries are the local tax and ratepayers (voters) who maintain control over their community projects and ultimately receive interest savings in the form of reduced utility rates, property or sales taxes, or increased infrastructure needs."

Michael Decker, managing director and co-head of munis at the Securities Industry and Financial Markets Association, also disagreed with Cole's suggestions.

"The tax exemption is a proven and efficient way for the federal government to assist states and localities in financing investments in infrastructure," Decker said. "The country faces a noted infrastructure deficit that costs the economy billions of dollars in inefficiency and threatens our competitiveness. Curtailing or eliminating the tax exemption would result in less infrastructure investment at the state and local level, something our country simply cannot afford."

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