The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity.

Since the early days of the federal income tax, state and local governments have been able to issue bonds at relatively low interest rates because the interest income received by the bondholders is generally not subject to federal taxation. For many decades, states and localities issued tax-exempt bonds primarily to finance the construction of traditional government projects such as roads, bridges, sewers and schools. By the early 1980s, however, the majority of long-term tax-exempt bonds were issued by state and local governments eager to serve as conduits for low-cost funds borrowed in the municipal bond market on the behalf of private entities. Dennis Zimmerman has written an important book that outlines the important economic and public policy issues involved when state and local governments borrow large amounts of money at federally-subsidized interest rates in order to support the private economic activities of individuals, firms, and nonprofit organizations. This comprehensive volume also chronicles and discusses the motivation behind the attempts made by the U.S. Congress since 1968 to limit this type of conduit borrowing. The author has written for a wide audience. Indeed, anyone interested in public economics, public administration, or economic development may want to read this book.

The primary intent of this book is not to question whether or not the federal tax exemption of municipal bond interest should exist. Instead, the author takes the exemption as given and emphasizes the importance of and the inherent difficulty in restricting the implicit federal subsidy to state and local projects that generate benefits that extend beyond the boundaries of the issuing jurisdiction. Students of fiscal federalism generally agree that allocative efficiency can be enhanced if the federal tax-exemption is provided only to projects that generate these spillover benefits. In Zimmerman's book, bonds issued to finance these projects are referred to as "public purpose" bonds. The tax-exemption should not be targeted toward bond-financed projects that do not serve public purposes.

The difficulty lies in the ability or inability of legislators to write laws that distinguish between public and private purposes. Zimmerman excels in his discussion of the attempts made by Congress over the last 25 years to clearly define what constitutes a private versus public purpose. The most restrictive legislation limiting the use of state and local borrowing for nongovernmental purposes was enacted as part of the Tax Reform Act of 1986, in which the term "private-activity" was coined to refer to the tax-exempt bonds issued in the conduit role of states and localities for such purposes as industrial development, mortgage subsidies, student loans, and a host of other allowable private projects. Despite the restrictions imposed in 1986, private-activity bonds still make up approximately one-third of all long-term tax-exempt bonds issued by states and local governments.

The book is divided into four well-organized parts and consists of sixteen chapters. The three chapters in Part One provide the foundation for the book as they discuss the history of state and local debt financing, the legal basis for the federal tax exemption, and the current institutional features of the demand and the supply side of the municipal bond market. Part Two presents an analysis of the economic issues involved in the area of tax-exempt borrowing policy. The chapters on fiscal federalism (Chapter 5) and on the allocative effects of the tax-exemption (Chapter 7) are of special interest to economists because they address the economic rationale for the federal subsidy of certain state and local government activities as well as the crucial issue of the distortive effects that private-activity borrowing has on relative factor prices. The author explains that it is appropriate for the federal government to limit the quantity and the particular uses of tax-exempt bonds for non-public purposes because by issuing private-activity bonds, state and local governments use what is basically an open-ended, (relatively) unrestricted capital grant to arbitrarily create differing rates of return across investments. This section also includes discussions of the effect of current tax-exempt bond policy on the federal deficit and on the distribution on income.

Part Three presents an economic evaluation of the federal legislation that has been enacted in order to limit the use of the tax-exemption for purposes that are not clearly public in nature. Finally, Part Four contains five chapters on a variety of issues that the author suggests are important for future tax-exempt borrowing policy. Zimmerman discusses the enforcement of federal controls on state and local borrowing and provides suggestions for alternative policies to control the use of tax-exempt financing. Chapter 15 describes the cap imposed by TRA 1986 on the volume of private-activity bonds issued by each state. Because annual data on the volume and the use across states of private-activity bonds were last repoiled in government statistics for the year 1986, the author provides a service to bond researchers by including survey data generated by the author (along with Advisory Commission on Intergovernmental Relations) concerning private-activity bonds issues by state in 1989.

The last section of the book also explores the effect of private-activity borrowing on public infrastructure, a topic that is especially relevant today given the ongoing Barro-Aschauer debate over the contributions of infrastructure to U.S. productivity and given the policies proposed by the Clinton administration. To the extent that large quantities of private-activity bond issues increase the costs of borrowing for public purposes, it is possible that restrictions on the use of tax-exempt bonds for private purposes will increase investment in public capital.

This new volume is stimulating and easy to read. Zimmerman's efforts to carefully outline the difficulties inherent in writing legislation that distinguishes between government activities that serve public purposes and those that serve private purposes (along with his convincing explanations of why the distinction is important) make this volume a valuable reference for readers with a variety of public policy interests.