The Hidden Entitlements

4. Tax-exempt bonds

Individuals and corporations that lend money to states and localities pay no federal income tax on

the interest they earn. This allows states and cities to pay reduced interest rates--what in today's jargon might be called a"funded unmandate." But not surprisingly, the money that state and local governments save in lower interest payments is considerably less than the cost of the tax break to the federal government--which is expected to be $255 billion over the next seven years.

Over the past year or so, interest rates on long-term state and local tax-exempt bonds have averaged about 5.8%. That's about 1.8 percentage points--or 24%--lower than the taxable interest paid on comparable Treasury and corporate bonds,which have paid about 7.6%.⁸Most interest on state and local bonds, however, goes to lenders in federal tax brackets considerably higher than 24%. That

means that the federal tax subsidy for state and local bond interest costs the federal government considerably more than state and local governments save in interest payments. In fact,since about a third of the tax breaks for tax-exempt bonds go to 35%-bracket corporations (banks and so forth), and almost 90% of the remaining tax subsidies go to individual taxpayers making more than $100,000, about a quarter of the federal subsidy ends up as a windfall to well-off investors.

For example, a top-bracket individual would pay about $40,800 in federal taxes on $100,000 in interest earned from investing in taxable bonds. But if the person invests in tax-exempt bonds instead, the federal government loses the $40,800 while the state or local government issuing the bond saves only about $24,000 in reduced interest expense. Thus, two-fifths of the federal tax subsidy ends up as a windfall to the investor.

Likewise, a bank or other 35% bracket corporation that invests $100,000 in tax-exempt bonds gets a federal tax subsidy equal to about $35,000. Since the local government saves only $24,000 on the interest it pays, however,the bank's windfall is equal to $11,000--about a third of the cost of the subsidy to the federal government.

Why is the market for tax-exempt bonds so inefficient? The apparent reason is that, while most tax-free bonds are held by high-bracket individuals and corporations, on the margin states and localities find it necessary to make their bonds attractive to taxpayers in lower brackets--primarily the 28% rate. In addition, because the subsidy is tax-bracket dependent,states have to provide a cushion for bondholders who might fall into a lower bracket in a given year.

It's bad enough that the federal subsidy for tax-exempt bonds is so inherently inefficient and wasteful. But on top of that, in many circumstances, private companies and individuals can "borrow" the ability to issue tax-free bonds from state and local governments. Thus, states and cities have extended the right to borrow tax free to businesses building airports, rental housing and electric plants, to individuals taking out mortgages and student loans,and on and on. Indeed, before reforms in the mid-eighties, there was almost no limit on what states could authorize tax-exempt financing for--and since the federal government was picking up the bill, there was no internal fiscal constraint on the states' going hog wild. Reforms now generally limit the total amount of such private misuse of tax-free financing--through a state-by-state volume cap--but it still remains a major drain on the federal Treasury.In fact, $92 billion or more than a third of the $255 billion total tax expenditure for tax-exempt bonds, stems from tax-free non-governmental bonds used to finance private projects. This not only seems like an inappropriate use of scarce federal resources, but by increasing the quantity of tax-free bonds, it probably drives up the interest rates that states and cities have to pay on their normal public-purpose bonds.⁹

In the late seventies, the Treasury Department suggested replacing the tax exemption for state and local bonds with a direct federal subsidy for state and local interest payments. If that subsidy were set at, say, 25% of the interest paid, both the federal government and state and local governments would come out ahead. Indeed, the value of the subsidy to states and cities would increase by 3 percent, while the cost to the federal government would fall by almost a quarter.

States and cities resisted this proposed reform, despite its apparent benefits to them, for two major reasons.

First, they feared the loss of the "entitlement" nature of their cur rent interest subsidy. That is, they worried that future Congresses might find it easier to scale back a direct subsidy for interest than a tax entitlement, however inefficient the latter might be.
Second, states and cities wondered whether their much-criticized, but politically attractive practice of "lending" their tax exemptions to private businesses could survive under the heightened scrutiny that applies to direct federal spending programs.

With governments at all levels in dire financial straits today, however,it might be time for a second look at federal subsidies for tax-exempt bonds.Making these subsidies more efficient and limiting them to truly public borrowing could save governments tens of billions of dollars and make the federal tax code fairer at the same time.

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