Happy New Year to all. When we last spoke, we were all breathing a sigh of relief that tax-exempt private activity bonds were spared the sword in the final tax reform legislation, and we poured out a little eggnog for our old friend, the tax-exempt advance refunding bond, gone too soon.

But based on comments from House Ways & Means Committee Chairman Kevin Brady, and the insights of those who hear the whispers in D.C., tax-exempt private activity bonds aren’t safe yet. Indeed, the House leadership likely hasn’t changed its mind about tax-exempt private activity bonds in the short time between November 2, when the Ways and Means committee released its proposal, and the enactment of the Tax Cuts and Jobs Act.

The question is: why?

Although it would be easy to view the House’s proposal to eliminate tax-exempt private activity bonds as an aggressive opening offer, a chit to be traded away as the two chambers bargained to get to the final bill, rather than a serious and continuing policy view, we ought to take the House at its word and address the House’s rationale.

The problems (“problems”) that the House bill cites as the reason for getting rid of tax-exempt private activity bonds are not new insights. Like the Moog synthesizer, people have been making these noises since the ‘60s. The law already recognizes the potential that tax-exempt private activity bonds may inappropriately transfer the benefits of tax-exempt financing to private entities. In response to the proliferation of tax-exempt private activity bonds in the past, the legislative answer has never been “eliminate them entirely.” Surely that should not be the response now, when there have been no significant changes in the landscape to justify it. Things are better on this front than they were in 1986, not worse.

To address the House bill’s rationale for eliminating tax-exempt private activity bonds, it’s worth reviewing the legislative history. The legislative history notes that “the volume of long-term tax-exempt obligations for private activities” had increased more than ten-fold in terms of dollars and had also sharply increased “[a]s a share of total State and local government borrowing,” growing so much that more State and local government borrowing, as a percentage, was being undertaken for private activities than public. When thinking about the House bill, we should also note that the legislative history states that “the large volume of nongovernmental tax-exempt bonds increased the interest rates that State and local governments were required to pay to finance their activities. As the total volume of tax-exempt bonds increases, the interest rate on the bonds must increase to attract investment from competing sources. The additional bond volume caused by nongovernmental use thus increases the cost of financing essential government services.” In addition, the legislative history notes that “tax-exempt financing for certain activities of nongovernmental persons resulted in a misallocation of capital. Efficient allocation of capital requires that the return from a marginal unit of investment be equal across activities. This can result, in turn, only if there is no preferential treatment for investment in certain activities.” Finally, when we consider the rationale of the House bill, we should note that the legislative history highlights that tax-exempt private activity bonds damage “the equity of the tax system,” by allowing high net-worth bondholders to benefit because “the large volume of nongovernmental tax-exempt obligations” meant that “tax-exempt yields were often close to taxable yields.”

This is what the legislative history says – the legislative history of the Tax Reform Act of 1986.[1]

In response to this roster of indictments (which also included “mounting revenue losses”), Congress in 1986 did not eliminate tax-exempt private activity bonds. Instead, it imposed new limits on these private activity bonds (including a state-by-state limitation on the volume of certain tax-exempt private activity bonds, to help ensure local control of the federal subsidy), which did not apply to governmental bonds. These limits were designed to account for the fact that tax-exempt bonds for private activities can transfer the benefits of tax-exempt bonds to private activities, while recognizing that certain private activities provide sufficient public benefit to justify tax-exempt financing.

The limits on tax-exempt private activity bonds generally do not apply to qualified 501(c)(3) bonds, which the ’86 Act placed somewhere in between governmental bonds and other tax-exempt private activity bonds. (Under prior law, bonds for 501(c)(3) bonds were treated the same as governmental bonds.) This was a recognition that the same policies that justify an income tax exemption for 501(c)(3) organizations also justify federally subsidized debt financing through tax-exempt bonds for these organizations, because, to a large extent, 501(c)(3) organizations provide services that state and local governments would otherwise have to provide, or at least fund. As Congress took care to note in 1986, “[t]he use of the term private activity bond to classify obligations for section 501(c)(3) organizations in the Internal Revenue Code of 1986 in no way connotes any absence of public purpose associated with their issuance.”[2]

In contrast, in support of its proposal to eliminate all tax-exempt private activity bonds – for airports, sewage plants, solid waste facilities, water furnishing facilities, your local charitable hospital, 501(c)(3) higher educational institutions, and all the rest, the House bill in 2017 offered this, and nothing more: The Federal government should not subsidize the borrowing costs of private businesses, allowing them to pay lower interest rates while competitors with similar creditworthiness but that are unable to avail themselves of PABs must pay a higher interest rate on the debt they issue.”

As the kids say these days: Wut?

The provisions governing tax-exempt private activity bonds do discriminate based on broad classes of activities (i.e., airports vs. Pilates studios or Tex-Mex restaurants). But they don’t discriminate within those classes of activities among competitors (i.e., Delta can benefit from tax-exempt airport bonds, but United can’t). The one rationale that the House bill offered in support of repealing tax-exempt private activity bonds (1) misstates the law on tax-exempt private activity bonds and (2) pales in comparison to the concerns described in 1986. As noted above, the more thoughtful and extensive rationale set forth in 1986 was offered as support not for outright repeal of tax-exempt private activity bonds, but rather for limitations that are proportional to the potential for abuse.

Perhaps the single sentence from the House bill leaves you unsatisfied. There are other clues as to what else might be behind this. Although not a part of the House bill legislative history, Chairman Brady has noted that private activity bonds, in general, have “drifted far afield from their original mission.” (Not “slightly afield,” mind you; far afield.) We are not aware, however, of any studies that prove out this claim. In addition, the “field” of private activity bonds is already pretty well fenced-in; these cows aren’t free-range. The world of tax-exempt private activity bonds is restricted mostly to specific types of projects. These rules therefore don’t really allow for much drifting afield, far or near.

The possibilities for this sort of drift are restricted to “qualified small issue bonds,” which are strictly limited to “manufacturing” activities, or qualified 501(c)(3) bonds to the extent that the 501(c)(3) organization’s exempt purpose differs from what the layperson thinks is an appropriate purpose of a 501(c)(3). (In this latter case, that mismatch is a commentary not on the proper scope of private activity bond financing, but on the scope of section 501(c)(3).) Qualified small issue bonds are further restricted by dollar limitations that, because they aren’t indexed for inflation, cause these bonds to become less cost-effective as the years go by. Because these bond issues are so small, the fact that a few of them finance projects of questionable legality isn’t enough to justify scrapping the entire world of tax-exempt private activity bonds. But in general, for all tax-exempt private activity bonds, because of the strict limits on facilities eligible for tax-exempt private activity bond financing, any “drifting” is likely a result of violations of these limits. This should be addressed by IRS audits, not legislation.

Although we have not seen any specific examples, the gossip is that Chairman Brady has in mind certain isolated financings for esoteric projects, such as butterfly museums and wineries. We are not aware, however, of any data demonstrating that all of a sudden these sorts of projects are now predominating over college dorms, hospitals, and airports. It is easy to see this question as a “simple test,” as Chairman Brady has said: “What are those uses that should be subsidized by every taxpayer in America?”[3]

Our response is that this question was litigated for decades, and that Congress reached an acceptable compromise in 1986. There have been no seismic changes since then to justify going even farther than the 99th Congress went, when it placed special limitations on tax-exempt private activity bonds, to minimize the extent to which taxpayers in one part of the country are forced to subsidize private activities elsewhere. Before Congress throws out the baby, the bathwater, the claw-foot tub, the newly-renovated colonial house, and the entire subdivision, it should take a breath and review whether a few isolated deals that offend its sensibilities, or the naked need for “pay-fors” truly outweigh the benefits of tax-exempt private activity bonds in the preponderance of the other, more worthy cases.