Tax-Exempt Bonds: A Description of State and Local Government Debt

Publication Date: October 2001

Publisher: Library of Congress. Congressional Research Service


Research Area: Banking and finance



This report provides basic information about state and local government debt. State and local governments often issue debt instruments in exchange for the use of individuals' and businesses' savings. This debt obligates state and local governments to make interest payments for the use of these savings and to repay, at some time in the future, the amount borrowed. State and local governments finance capital facilities with debt rather than out of current tax revenue in order to match the time pattern of benefits from these capital facilities with the time pattern of tax payments.

The federal government subsidizes the cost of state and local debt by excluding the interest income from federal income taxation. This tax exemption of interest income is granted because it is believed that state and local capital facilities will be under provided if state and local taxpayers have to pay the full cost.

State and local debt is issued as bonds, to be repaid over a period of time greater than one year and perhaps exceeding 20 years, and as notes, to be repaid within one year. General obligation bonds are secured by the promise to repay with general tax revenue, and revenue bonds are secured with the promise to use the stream of revenue generated by the facility built with the bond proceeds. Most debt is issued to finance new capital facilities, but some is issued to refund a prior bond issue (usually to take advantage of lower interest rates). Tax-exempt bonds issued for some activities are classified as governmental bonds and can be issued without federal constraint because most of the benefits from the capital facilities are enjoyed by the general public. Many tax-exempt revenue bonds are issued for activities Congress has classified as private because most of the benefits from the activities appear to be enjoyed by private individuals and businesses rather than the general public. The annual volume of these tax-exempt private-activity bonds is capped.

Arbitrage bonds devote a substantial share of the proceeds to the purchase of assets with higher interest rates than that being paid on the tax-exempt bonds. Such arbitrage bonds are not tax exempt because Congress does not want state and local governments to issue tax-exempt bonds and use the proceeds to earn arbitrage profits. The arbitrage profits could substitute for state and local taxes.

The major policy issue in this area is the effort to use tax-exempt bonds to increase federal financial support for a variety of public facilities. Another policy issue is whether constraints should be relaxed on the types of activities for which state and local governments can issue tax-exempt debt. This is illustrated by the debate about whether governmental bonds should be used to finance sports facilities for professional sports teams. The extent to which the current arbitrage bond rules prohibit what some consider legitimate state and local financial behavior is a related area of dispute. The list of activities that classify tax-exempt private-activity bonds - and whether they should be included in the volume cap - is another area of controversy.

A list of readings is provided for the reader who wants to know more about taxexempt bonds. This report will be updated as new data become available.