By permitting the issuance of tax-advantaged bonds, the federal government has provided an economic subsidy to state and local governments and other issuers of such bonds.   In other words, the federal government is foregoing revenue in order to allow the issuers or conduit borrowers of tax-advantaged bonds to borrow at a lower cost.  In December, the Joint Committee on Taxation reported to Congress that it estimates the federal government will be losing $187.7 billion between its 2015 and 2019 fiscal years as a result of tax-advantaged bonds.  That is a lot of revenue.  So, my first inquiry is why does the federal government do it?

The best answer I found to my first inquiry was in a Congressional Research Service Report (“CRS Report”) published on January 9, 2015.  The Report, which is entitled Tax-Exempt Bonds: A Description of State and Local Government Debt, is written by Steven Maguire and Jeffrey M. Stupak.  The authors point out that neither the Tenth Amendment to the U.S. Constitution nor the doctrine of intergovernmental tax immunity prohibit the federal government from taxing the interest on state or local bonds.  Rather, the reason that Congress decided to statutorily prohibit the federal government from taxing interest on certain state and local bonds is economic.   The economic theory behind the federal subsidy is that certain goods and services should be provided by governmental entities because the private sector will not provide goods and services that are consumed by the general public.  The example the authors give of such a good or service is a street light.  In addition, the authors point out that state and local governmental entities prefer to provide goods and services to their taxpaying residents.  Apparently, they are not so interested in providing goods and services to non-taxpaying nonresidents.  Thus, in order to incentivize state and local governments to provide the optimal number of goods and services (e.g., the optimal number of street lights for the public good), the federal government subsidizes the borrowing costs of state and local governments.   Makes sense to me.

My second inquiry relates to why the federal government is not considered a “governmental unit”  for purposes of the tax-exempt bond rules.  One of the primary disadvantages to this lack of qualification is that if a state or local government or conduit borrower permits the federal government or an agency thereof to utilize its tax-exempt bond financed facilities, such use counts as private business use (i.e., bad use).  Since state or local governmental entities and conduit borrowers generally want to limit private business use, the tax-exempt bond rules discourage an issuer or conduit borrower from permitting the federal government or any agency thereof to utilize the tax-exempt bond financed space.   So the federal government first decides to subsidize state and local government borrowing at a significant cost to itself.  Then, the federal government establishes rules that discourage the beneficiaries of the subsidies from permitting the federal government or any agency thereof to use such subsidized facilities.  Sort of like shooting yourself in the foot.  So my second inquiry (which is very similar to my first inquiry) is why does the federal government do this?

The answer is not clear to me, even after doing some research.  I did discover, however, that the federal government was not always so disfavored.  For example, proposed regulations that were issued on June 5, 1971 provided that industrial development bonds did not qualify for the Section 103 exclusion.  An industrial development bond was defined in the proposed regulations as an issue the proceeds of which were primarily used in a trade or business by a person who was not an “exempt person”.   For this purpose, an exempt person included “the United States of America (or an agency or instrumentality of the United States of America)”.   However, when the final regulations were issued on August 3, 1972, the definition of “exempt person” included the federal government “but only in the case of obligations issued on or before August 3, 1972”.  Then, approximately one year later, the IRS issued Rev. Rul. 73-516.  In this ruling, the IRS concluded that the interest on bonds issued by a state political subdivision, to finance a building that would eventually be sold to the United States in an installment sale, did not qualify for tax-exemption.  In reaching this conclusion, the IRS noted that in 1917 Congress had enacted legislation that prohibited interest on U.S. obligations from qualifying for an exemption from federal income tax.  Thus, based upon the 1917 legislation, the IRS reasoned that Congress was not interested in providing tax-exempt financing for facilities to be used by the U.S. government or instrumentalities thereof.   So, maybe that line of reasoning explains why the use by the federal government of facilities financed with state or local government tax-exempt bonds (at a cost to the federal government) results in private business use.    Sort of makes sense to this enquiring mind, but seems like an odd result, especially when it comes at a cost of $187.7 billion over five years.