Positives and Negatives for Public Finance

On April 10, 2013, President Obama released his FY 2014 budget proposals. The budget includes $1.8 trillion of deficit reduction proposals, including $580 billion in additional revenue from closing federal tax loopholes and reducing federal tax benefits.

Among the president’s proposals to reduce tax benefits is one that would hit the public finance community particularly hard. Mr. Obama has again proposed to limit to 28 percent the benefit of certain tax preferences, including tax-exempt interest. There is no grandfathering exception — the proposal is to reduce the benefit of tax-exempt interest on bonds regardless of whether they are issued after the enactment of the budget or were issued 5, 10 or 20 years ago. This proposal will almost certainly drive up borrowing costs for state and local governments and 501(c)(3) hospitals, schools and similar borrowers. It will also leave the holders of tens of billions of outstanding fixed-rate tax-exempt bonds without any recourse to obtain the full benefit of the bargain they made by buying an instrument with a rate lower than was readily available in the taxable market.

However, the proposed budget is not all bad news for public finance. The president has also proposed a new direct-pay bond program called America Fast Forward (AFF) bonds. The permissible uses of AFF bonds include nearly all the projects that can currently be financed with tax-exempt bonds, including projects that may only be financed on a tax-exempt basis with qualified private activity bonds.

A list of the president’s FY 2014 budget proposals of particular interest to the public finance community appears below:

  1. Limit the value of all deductions and exemptions (including tax-exempt interest) at 28 percent.
  2. Create a new program of direct pay bonds called America Fast Forward bonds for nearly all the purposes for which tax-exempt bonds can be used. The reimbursement rate would be 28 percent, except that AFF bonds for school construction (including 501(c)(3) higher education) would be reimbursed at 50 percent for calendar years 2014 and 2015.
  3. Institute the “Buffet Rule.” This would require that upper-income taxpayers pay a minimum of 30 percent of their adjusted gross income (AGI) in federal income tax. The tax would begin at $1 million of AGI and would be fully phased in at $2 million AGI. The rate is imposed on AGI and thus would not include tax-exempt interest.
  4. Provide uniform rules to enable the current refunding of all state and local governmental bonds, regardless of whether they are or were issued in the form of tax-exempt bonds, Build America Bonds, AFF bonds or qualified tax credit bonds such as qualified school construction bonds.
  5. Repeal the $150 million limitation on “nonhospital” qualified 501(c)(3) bonds.
  6. Increase the volume cap for qualified highway or surface freight transfer facilities private activity bonds.
  7. Eliminate the volume cap for water and sewer exempt facility bonds.
  8. Allow more flexible research arrangements for purposes of the private business use limits.
  9. Repeal the governmental ownership requirement for airports, docks and wharves and mass-commuting facilities financed with exempt facility private activity bonds.
  10. Increase the 25 percent limit on land acquisition applicable to certain tax-exempt private activity bonds to 35 percent.
  11. Establish the National Infrastructure Bank.
  12. Simplify the private business tests and arbitrage restrictions by, among other things, repealing the 5 percent disproportionate and unrelated private business use rule and unifying the yield restriction and rebate requirements to rely principally on the rebate requirement.

The president has tried and failed to get Congress to enact several of these proposals (for example, the 28 percent cap and the National Infrastructure Bank) and some of the new proposals appear to be little more than bargaining chits. However, members of the Public Finance department of McGuireWoods LLP believe that some of the proposals must be taken seriously because of the likelihood that they will be included in a deficit reduction and/or tax reform “grand bargain” that may arise this summer out of the negotiations to increase the debt limit. Therefore, over the next several weeks we intend to publish a series of articles that will examine certain of the above-described proposals in more detail.