RENT-SEEKING AND TAX EXEMPT FINANCE: KILLING THE GOLDEN GOOSE

Policy Studies Joumai, Vol. 17, No. 3, Spring, 1989

RENT-SEEKING AND TAX EXEMPT FINANCE:KILUNG THE GOLDEN GOOSE

Matthew R. MariinDuquesne University

in Aprii of 1988, the Supreme Court ruied in South Carolina vs.Baker that Congress may deny tax exempt status to state and iocaigovernment lx>nds that do not meet the federally mandated registrationrequirements imposed by the Tax Equity and Fiscai Responsibility Actof 1982 (TEFRA). The ruiing threatens the doctrine of reciprocaiimmunity and impiies that Congress has the power to deny tax exemp-tion for other reasons as weii. This deveiopment represents a cuimi-nation of Congressionai actions in the 1980s that dramaticaiiy reducediocal governments' abiiity to finance privateiy owned capitai with tax-exempt bonds. Prior to 1983, uniimited numbers of tax exempt bondscouid be issued to finance virtuaiiy any public or private project thatiocaiities deemed to be in the iocai pubiic interest. As of 1988, theiist of private projects quaiifying for tax exempt finance and thepermitted voiume of issues have been reduced significantiy.

The subsidy provided through tax exemption is a tax expenditurewith no overt Congressionai allocation of funds: it is therefore hiddenfrom view and protected from much pubiic scrutiny and potentiai pro-test. Accordingly, it provides an exceiient opportunity for what pubiicchoice theorists refer to as "rent-seeking": efforts by private groupsand individuais to use pubiic poiicy to gain a financial advantage atthe expense of others (Gwartney and Wagner, 1986). The purpose ofthe present analysis is to demonstrate that unrestricted tax exemptfinancing for private purposes provided an ideal vehicie by which iocaigovernments and their agencies could pursue rent-seeking opportuni-ties, and that such an arrangement was too advantageous to surrenderit easiiy. Despite the fact that iocai ieaders and potentiai users havestrongiy protested the recent limitations imposed on tax-exemptfinance, it has been their rent-seeking actions that ied to the recentrestrictions, in essence, iocaiities have kiiied the goose that iaid thegolden tax exempt eggs.

THE ADVANTAGES OF TAX EXEMPT RNANCE

'Traditionai" pubiic use tax exempt bonds (PUBs) are issued andsecured by communities in order to finance pubiidy owned capitaiprojects. They can be either general obligation bonds backed by the

Differing Perspectives on Economic Development 673

taxing power of the iocaiity or revenue bonds backed by projectedrevenues fi'om the project being financed, in contrast, private activitybonds (PABs) are neariy aii revenue bonds issued by communities withthe proceeds used and secured by a private firm. The Tax Reform Actof 1986 (TRA) distinguishes six categories of PABs defined by the useof the bond proceeds:

Small Issue Industrial Development Bonds (SIDBs)-used byany private firm to finance investment that contributes toiocai industriai or economic deveiopment;

Exempt Facility Bonds (EFBs)-use6 to finance a specifiediist of projects exempted from certain size restrictionsimposed on SiDBs in 1968;

Multi-Family Rental Projects-used to finance apartmentsthat set aside a certain percent of the units for iow incomehouseholds;

Student Loan Bonds (SLBs)-used to finance student loans;

Mortgage Revenue Bonds (MRBs)--used to finance singie-famiiy residentiai mortgages; and

501(c)(3) Bonds-used to finance projects for non-profitinstitutions.

in addition to the obvious benefit of iower interest rates on taxexempt bonds, the use of PABs instead of conventionai financing hasother benefits for borrowers. Whereas conventionai financing is oftenrestricted by state laws to a percentage of the total value of aninvestment project, PABs can be used for 100 percent financing. Forfirms with sufficient credit, this implies no front end expenses.Moreover, prior to 1986, up to 10 percent of the bond proceeds couidbe used for items not directly related to the investment project, i.e.,working capitai or inventory. Finaiiy, prior to 1985, firms receivingtax exempt funds from PAB proceeds were iegaiiy entitied to re-investthese funds in short term securities before aii construction biiis camedue, thus aiiowing them to eam arbitrage profits.

The benefits of PAB finance are not limited to borrowers. Lend-ers, primariiy iocai commerciai banks, profit from tax exempt incomewhen the tax exempt retums exceed tiie after-tax returns on conven-tionai ioans. As most banks faced the maximum marginai corporate taxrate of 48 percent prior to 1986, a PAB yielding more than 52 percentof the return on conventional taxable ioans or bonds resuited ingreater net income, in the aggregate, yieids on PUBs (as rtneasured bythe Bond Buyer 20 Bond Index) averaged between 65 and 80 percent of

674 Policy Studies Joumai

the yieids on comparable taxable securities prior to 1986, impiying thati3anks could make substantiai gains by substituting the former for theiatter in their portfoiios. Aithough no index of PAB yieids exists, it isgeneraiiy accepted that they carry interest rates somewfiat higher thanthose on PUBs, resuiting in even greater net retums to banks.

Most banks protect themseives from changes in yieids and possi-bie changes in the tax treatment of PABs through provisions in thebond document. For example, many PAB interest rates fioat at a fixedpercent of the prime rate. Aiso, banks reserve the right to increasethe rate to a comparabie taxabie rate in the event a specific PAB oraii outstanding PABs are denied further tax exemption. Finally, priorto 1984, i}anks were permitted to deduct the fuii interest cost ofacquiring funds with which to purchase tax exempt bonds. This aiiowedthe opportunity for substantiai arbitrage profits.

The third party involved in PAB finance, the iocaiity issuing thebonds, stands to gain because it aiiows them to subsidize iocai invest-ment with virtuaiiy no iocai costs. Because PABs are revenue bondssecured by the credit and revenues of a private business, communitiesundertake virtuaiiy no risk when issuing them. The cost of bond issueand administration are shifted to the business through the use ofvarious fees and charges, so local budget outlays are also negiigibie.As with PUBs, the primary costs of the subsidy are borne by the fed-erai government through reduced tax revenues. By issuing PABs, iocaii-ties desiring to subsidize private enterprise in an effort to promotetheir economic deveiopment can therefore do so by giving away some-one eise's money. Aithough states possess the power and authority tolimit iocal use of both public and private tax exempt debt, oniy aiiandfui exercised the authority to restrict revenue-backed PAB use.Most ieft total contrd and discretion to their iocai governments.

Prior to 1983, federai ruies aiiowed PABs to be issued in un-iimited amounts by appointed iocai industriai deveiopment authorities(IDAs) independent of elected officiais or the community at large,although some states did require pubiic notice or hearings. No datadescribing the professionai affiliations of iDA members exist, but it isreasonaiDle to assume that the boards are composed of locai businessieaders with a financial interest in iocai economic growth.

The actuai objectives of iocai decision makers has been the sub-ject of extensive debate (Sonsteiie and Portney, 1978). Locai ieadersmay be described as maximizing either sociai weifare or their own sdfinterest, but given the free good nature of PABs, it is reasonabie toassume that their use is consistent with any of the proposed objec-tives at the iocai ievei, aithough the magnitude of private versussociai benefits may differ. Without an anaiysis that indicates other-wise, it is aiso reasonabie to assume that the objectives of iDA


members are consistent with the objectives of eiected ieaders and thecommunity at iarge. Confiicts between the interests of iDA membersand the community's well being may occur, perhaps due to congestionstemming from overdeveiopment, but estabiishing such a reiationshipgoes beyond the scope of the present anaiysis.

LEADING TO TEFRA

Before 1983, the oniy federai restriction on the use of PABs wasa provision of the Revenue and Controi Act of 1968 (RECA) thatiimited the size of industriai deveiopment bonds (iDBs) to $1 millionper investment project with two exceptions. First, an IDB could belarger provided that the user's totai capitai expenditure within thesame poiiticai jurisdiction did not exceed $5 miiiion for a period fromthree years before to three years after the bond issue (this was raisedto $10 miiiion in 1979). Hence the name "smaii issue" iDBs. This iimitwas designed to stop the increasing use of muiti-miiiion doiiar iDBs bymajor corporations. Unintentionaiiy, however, this provision changedthe nature of SiDBs from industrial to commerciai deveiopment bondsbecause industrial projects tend to require more capitai thancommerciai projects. At the same time, it ieft a iarge window ofopportunity for geographicaiiy dispersed retaiiers that required iessthan the limit for each outlet in each town. Second, exceptions to thesize iimit were aiiowed for "exempt faciiities," inciuding sport,convention, and trade show structures, mass transit and parkingfaciiities, poiiution controi, airports, iocal pubiic utilities, sewage andwater projects, docks and wharves, residentiai mortgages (MRBs), andany project for a 501 (c)(3) non-profit institution.

The aiiowed iocai iatitude in tax exempt bond use coupied withthe free good nature of SIDBs ied to an expiosion in bond issues inthe iate 1970s, in the 1981 Congressionai Budget Office study, SmaiiIssue Industriai Development Bonds, it was estimated that totai PABactivity in the following year wouid reach $42.8 biiiion, about 48 per-cent of totai tax-exempt activity, and tiiat SiDBs alone would total$12.7 biiiion. The CBO estimated that totai outstanding PAB issueswouid cost the Treasury $13 billion per year if activity continued atthese ieveis.

The credibiiity of the SiDB program was undermined by the CBOstudy documenting the use of tiie bonds to finance such projects asaduit book stores, corporate aircraft, private country dubs, andspecuiative reai estate investment in office buiidings and shoppingcenters. Miiiions of doiiars of SiDBs were used by major retaii cor-porations such as K-Mart, McDonaids, and Kroger Supermarkets. Asnoted above, this shouid have come as no surprise: such a bias in iDB

676 Policy Studies Journal

use was a direct resuit of the provisions induded in RECA. in addi-tion, in many areas the bonds were used to finance the movement ofbusinesses fi'om reiativeiy depressed inner city areas to more affluentsuburbs: this at the same time that other federai subsidies were beingused in an effort to retard this trend (Mariin, 1984).

it seems a safe assumption tfiat such projects wouid not iiavebeen subsidized if the community h£id to use its own scarce resourcesto provide the subsidy. When a community's own resources are aiio-cated, costs are apparent and must be weighed against benefits. Wheniocai costs are zero, as with PABs, any project generating non-negative benefits wiii rationaiiy be subsidized. Although iocai leadershad the abiiity to iimit the use and vdume of SiDBs and other PABs,they faiied to exercise their power in a manner consistent with Con-gressionaiiy perceived nationai poiicy objectives, in particufar.Congress was motivated to act to limit SiDB finance because of threeconcerns: the use of SiDBs by iarge firms that did not need subsidiza-tion, a iack of geographic targeting to economicaiiy distressed areas,and use of the bonds to subsidize projects "iess deserving" of federaicredit subsidies (Reams, 1985). To the extent that the iast concemincluded the use of iDBs to subsidize commerciai investment, the ill-advised cfianges inciuded in RECA impiy that Congress was aiso tobiame for iocai poiicies.

TEFRA-INTEI^IT

The Tax Equity and Fiscai Responsibiiity Act of 1982 containedsix major provisions regarding PABs, primariiy aimed at the SiDBmarkets. First, tax exempt SiDBs were scheduled for sunset as ofDecember 31, 1986. Outright abdition of tax exemption was not castin stone and subsequent Congressionai review was intended to evaiuatefuture activity. Second, private capitai financed with tax exempt bondswas denied the use of acceierated depreciation (ACRS) for federalincome tax purposes. Designed to reduce the demand for PAB finance,this measure was essentially impotent because tax exemption has agreater financiai v£ilue than ACRS to the firm. The action wouid, how-ever, reduce federai tax losses. Third, TEFRA reduced the deductibleamount of commerciai bank interest costs from 100 to 80 percent ofthe totai costs incurred when obtaining funds used to buy tax exemptbonds. This action was intended to reduce bank arbitrage profits andconsequentiy aiso the demand for tax exempts. Under the fourthTEFRA provision, certain projects were deciared ineiigibie for taxexempt financing. The so-caiied "whorehouse iist" induded goifcourses, country dubs, massage pariors, tennis ciubs, skating faciiities,racquet ciubs, hot tub faciiities, suntan pariors, and racetracks. Tax


exemption was partiaiiy removed for restaurants, automobile deaier-ships, beverage services, and any other recreationai facility. Fifth,registration and reporting of aii PAB issues to the federal govemmentwas required beginning in 1983. Finaiiy, beginning in 1983, aii PABissues wouid require advanced public notice, a pubiic hearing, andapprovai by an eiected body of iocai officiais (e.g., city councii). Thepurpose of this finai requirement was ostensibiy to force iocai govern-ments and their agencies to exercise more "prudence" in their use ofPABs. Together with the reporting requirements, locai PAB activitywouid now be under both increased iocai and nationai scrutiny.

it is interesting that the TEFRA iimits induded no absoiutevoiume iimits nor any generai restrictions on the types of projectseligibie for tax exempt financing, in essence, the primary means ofvolume and "quaiity" contrd was pubiic scrutiny at the iocai andnational ievei. i-lowever, locai scrutiny wouid contribute to a change inissuing befiavior oniy to the extent that residents' and eiected offi-ciais' benefit/cost caicuiations differed from those of the economicdevelopment agency's. Because the benefits remained at the iocal leveiwhiie the costs continued to be shifted to the federai ievei, there wasno reason to expect a significant difference in caicuiations orbehavior.

The reason for Congress's reiativeiy "timid" approach to PABiimitations in TEFRA is unciear, but three possibie expianations maybe offered. First, Congress may have beiieved that federai scrutinywouid cause iocai ieaders to issue the bonds in a manner consistentwith a nationwide sociai wdfare function. While private firms couidrationaiiy be expected to pursue profit maximization through the useof PAB finance, public sector entities couid have been expected totake a more coiiective view and be more sympathetic to the "spirit" ofthe iaw. Second, Congress may have been unwiiiing to radicaily aiterthe status quo so abruptiy as to create confusion and unexpectedlosses at the local level. Finaiiy, Congress may simpiy have beeninfiuenced by the weii organized iobbying efforts seeking to avoid anynew restrictions (see Reams, 1985)

Despite the means of impiementation, the intent of Congress inestabiishing the new guidelines was ciear: PAB voiume was increasingtoo rapidiy, especially in an era of increasing budget deficits, andproject sdection was dubious. Communities had demonstrated iittieindination to restrain PAB issues, rationaiiy opting instead to promoteiocai objectives with "free" subsidies. After TEFRA, locai decisionmakers were subject to two confiicting forces. First, the new Congres-sionai iimits and future review of the data now being reported in-formed them that their activity was being doseiy scrutinized andsubject to further controi. Second, pressure for economic deveiopment

678 Policy Studies Joumal

and competition for new capitai with other iocaiities encouraged themto continue rent-seeking behavior and continue to issue SiDBs andother PABs to a iarge degree just as they had in the past.

Table 1

Norfolk-Virginia Beach SIDBs by industry

Agricuiture &Mining

Construction

Manufacturing

Transporation& Utiiities

Whoiesaie &Retaii Trade

Finance &insurance

Reai Estate

Services

Dollar Volume($ miiiion)

1980

0.0%

3.1

39.7

11.7

22.8

1.1

14.2

7.5

$30.0

1981

0.0%

0.9

21.0

0.0

25.9

2.1

17.1

33.0

$107.7

1982

0.0%

0.3

19.8

5.7

18.2

1.4

14.1

40.4

$155.2

1983

0.2%

0.4

11.7

0.7

10.6

0.9

32.9

42.6

$194.2

1984

0.0%

0.9

7.3

3.5

6.6

1.6

42.3

37.9

$268.4

1985

0.0%

1.5

24.9

3.9

12.6

1.6

34.5

21.0

$90.4

1986

0.0%

1.4

22.8

3.4

18.8

2.3

21.5

29.8

$47.7

Source: Economic Deveiopment Agencies of Noridk, Portsmouth,Suffoik, Chesapeake, and Virginia Beach.

TEFRA-OUTCOMES

Evaiuation of the iocai reaction to TEFRA cannot be done at thenationai ievei because, as noted above, comprehensive data did notexist prior to 1983. However, pre- and post-TEFRA SiDB data havebeen compiied for one specific region-the Norfoik-Virginia Beach,Virginia SMSA. Tabie 1 aggregates these data by percentages per in-dustry for the region, in 1980 and 1981, totai SiDB voiume was $30


and $107.7 miiiion, respectiveiy. in 1982 voiume grew to $155.2 miiiion,with roughly half this total occurring in the fourth quarter after thepassage of the Act in June 1982. Because the new restrictions did notbecome effective until 1983, Iocaiities had ampie time to "rush tomarket" before TEFRA became law. During TEFRA's first year inforce, 1983, vdume grew to $194.2 miiiion, neariy doubiing the pre-TEFRA totai in 1981. in 1984, voiume soared to $268.4 miiiion. Muchof this increase, however, again occun'ed in the fourth quarter in arush to issue before new 1985 restrictions created during the Summerof 1984.

Ciassifying the categories of Agricuiture, Construction, Manu-facturing, and Transportation as "industriai" uses and aii others as"commerciai," the data show that industriai activity feii from a peakof over 50 percent of the totai in 1980 to iess than 12 percent in1984. in absoiute doiiar vdume, industriai uses averaged about $27miiiion per year prior to TEFRA and $28 million after the Act (1983-84). The dramatic growth in SiDB voiume was therefore concentratedin commerciai uses-primariiy Real Estate and Services.

The iargest vdume of SiDBs in the region were issued to financeService reiated activities, predominantiy hoteis and physicians' offices,and the percentage in this sector averaged about 40 percent of SiDBactivity from 1982 to 1984. The voiume of SiDBs used to finance ReaiEstate deveiopment (office buiidings and shopping centers) showed themost dramatic post-TEFRA growth, accounting for over 40 percent ofthe vdume in 1984. Reai estate deveiopment is generaiiy characterizedas being capitai rather than market driven, i.e., it is more sensitive tointerest rates than it is to demand. Deveiopers are therefore attractedto interest subsidies such as SiDBs (Coin, 1983; DeMaagd and White,1985). Aithough the SMSA demonstrated significant growth in the eariyto mid-1980s, and did need additionai office space, vacancy rates inthe region were near 20 percent in 1982 and continued lo grow withthe addition of the subsidized buiidings. Whiie new office buiidings docontribute to iocai capitai infrastructure, it has been suggested thattheir net contribution to community economic deveiopment is at bestmarginai. New tenants often represent intra-urban reiocations of exist-ing businesses that are ieaving depressed inner city areas (Patton,1988). The wiiiingness of the iocai govemments in the region to subsi-dize such activity supports the contention that SiDBs continued to betreated as a zero cost proposition at the iocai ievei.

The Norioik-Virginia Beach SMSA may or may not be representa-tive, in addition, it cannot be determined whether the observed pat-tern of SiDB use wouid have been more or iess biased towards "non-essentiai" projects, or whether voiume would have grown as rapidiy inthe absence of the Act. However, it does seem safe to conciude that


the reaction of iocai decision makers to TEFRA was to continue rent-seeking l3ehavior as they used SiDBs to subsidize projects tiiat in alliikeiihood wouid not have been subsidized with iocai funds. Onceagain, this resuit shouid come as no surprise given the design of theTEFRA restrictions. The desired Congressionai outcomes wouid oniyiiave occurred if iocaiities compiied with the "spirit" rather tfian the"letter" of the law; and it was in the local self-interest to complywith the iatter.

Table 2

National SIDBs by industry

1983 1984 1985 1986

Agnculture &Mining

Construction

Manufacturing

Transporation& Utilities

Whdesaie &Retaii Trade

Finance &insurance

Reai Estate

Services

Other/Unknown($ miiiion)

1.88%

0.88

28.40

2.20

14.94

1.85

19.25

21.60

9.01

1.68%

0.99

32.46

2.49

13.60

1.80

22.44

17.04

7.49

2.13%

0.99

33.57

3.13

13.35

2.36

21.69

18.59

4.20

1.24%

1.28

24.94

3.54

13.80

1.50

23.36

29.92

0.42

Source: internai Revenue Service, Statistics on income Buiietin, variousissues.

Descriptive nationai SiDB data for 1983-86 is shown in Tabie 2.Using the same dassifications as above, the percentage devoted toindustriai uses increased from 33.3 percent in 1983 to 37.6 percent in1984, impiying some sensitivity to the implicit Congressionai preference


for industriai projects. Nonetheless, commerciai use dominated at thenational level and Real Estate activity accounted for roughly 20percent of the total volume. Table 3 shows total nationai PAB activityfor the same years, and indicates that SIDB and PAB volume increasedby 23 and 32 percent, respectively, between 1983 and 1984. The tableaiso reveals that although SIDBs received the most attention in boththe media and the Congress, they accounted for oniy about one fourthof aii private tax exempt financing.

Table 3

Private Activity Tax-Exempt Bonds: 1963-1966($baion)

Smaii issue iDBs

Student LoanBonds

501 (c) (3)Organizations

Singie FamiiyMortgages

Multi-FamiiyRental Units

Exempt FaciiityBonds

Totai

1983

$13.8

3.1

8.2

10.8

5.3

8.7

$49.9

1984

$17.0

1.4

9.0

13.9

5.4

19.2

$65.9

1985

$16.5

2.8

26.1

13.4

24.8

15.8

$99.4

1986

$6.8

1.5

2.5

1.3

1.5

3.2

$16.8

Source: 1983-85, intemai Revenue Service, Statistics on income Bui-ietin, various issues. 1986, internai Revenue Service information.

THE DEnCrr REDUCTION ACT OF 1964-INrENT

Congressionai hearings on PABs continued in 1983 and 1984.Debate centered on mortgage revenue bonds (MRBs) as well as SiDBsas they were scheduied for sunset at the end of 1983 (Sunset was

682 Policy Studies Joumal

repealed). A review of the testimony reveais that it breaks along linesconsistent with the theory of rent seeking. The Congressionai BudgetOffice, the Generai Accounting Office and other organizations with anationai perspective urged the maintenance of the 1986 Sunset pro-visions of TEFRA for SiDBs. The primary arguments were that thePAB subsidies for industry and private home mortgages were piacingincreasing pressure on the federai budget at a time when the 1981 taxcuts were aiready providing a significant subsidy to business, and thattax exemption was an inefficient means of subsidization (Kopke andSyron, 1978; Rasmussen et ai., 1982).

Those arguing for a repeai of the Sunset provisions and a contin-uation of PAB financing inciuded those who represented iocai interestsand stood to gain whiie costs were passed onto the nation as a whoie.Proponents induded the U.S. Conference of Mayors, the NationaiAssociation of Counties, the Councii for Economic Deveiopment, theU.S. Chamber of Commerce and the Nationai Governors' Association.They were joined by speciai interest lobbying groups induding theNational Committee on Small issue industriai Deveiopment Bonds, theNationai Coaiition to Preserve iDBs, the internationai Councii ofShopping Centers, the Nationai Association of industriai and OfficeParks, and representatives from numerous state and local economicdeveiopment agencies. Their primary arguments were the usefuiness ofiDBs for economic deveiopment, job creation, and the financiai piightofthe cities (Reams, 1985).

Regardiess of the arguments presented by proponents, the datacompiied under the TEFRA guideiines indicated that PAB use wasacceierating and that the primary iocai use of SiDBs was to subsidizecommerciai investment, especiaiiy reai estate deveiopment. As aconsequence, new restrictions were imposed by Congress within theprovisions of the Deficit Reduction Act of 1984 (DEFRA). Effectivebeginning in January, 1985, the most significant change was theestabiishment of volume caps on specified PAB activity. First, thevoiume of SiDBs pius SLBs was restricted to $150 per capita, perstate. For the first time decision makers wouid need to treat SiDBs asa scarce resource and aiiocate the bonds accordingiy. Second, privatefirms were iimited to a totai of $40 miiiion in tax exempt financing.This provision addressed PAB use by nationai franchise and chainoperations. Not subject to the cap were exempt faciiity bonds (EFBs),bonds for muiti-famiiy rental units, and bonds for 501 (c) (3) institu-tions. (MRBs were not subject to this cap, but were subject to a capof 9 percent of their state's totai singie famiiy mortgages or $200miiiion, whichever was iarger.)

A third provision of DEFRA added to the "whorehouse" iist ofprojects estabiished by TEFRA. No ionger eiigible for tax exempt


financing were airpianes, iuxury boxes in stadiums, casinos and iiquorstores. Despite the Congressional wamings inherent in TEFRA, locali-ties apparently continued to use their SiDBs to finance such projects.The fourth major change contained in DEFRA extended the Sunsetdate for SIDBs to 1988, but only for manufacturing facilities. Thisprovision codified the previousiy impiied Congressionai preference forsubsidizing industriai rather than commerciai projects and indicatedconcern about the dominance of the latter. Finaiiy, DEFRA iimited theabiiity of borrowers to earn arbitrage profits by investing tax-exemptloan proceeds in higher yidding taxabie securities while constructionprojects were in progress. As defined, arbitrage profits were requiredto be rebated to the Federai Treasury.

DEFRA-OUTCOMES

Despite the restrictions inciuded in DEFRA, totai PAB voiumeincreased by 51 percent in 1985 (Tabie 3). The totai volume reached$99.4 biiiion, more than doubie the estimated 1982 volume of $42.8biiiion that precipitated Congressionai action in the first piace. Simiiarto 1984, activity was heaviest in the fourth quarter as issuers andusers "rushed to issue" in order to beat the 1985 vdume caps andanticipated further Congressionai restrictions for 1986. it is significantthat the iargest increases in 1985 occurred in issues for muiti-famiiyhousing and 501 (c)(3) institutions, two of the categories exciuded fromthe cap. The increases were 360 and 190 percent, respectiveiy. Thethird category exduded from the cap, exempt faciiity bonds, experi-enced a deciine in vdume from 1984 to 1985; however EFB voiume in-creased by 121 percent between 1983 and 1984 while the other twocategories showed oniy modest increases, it may be that a rush toissue EFBs in 1984 refiected activity that would have occurred in 1985.Apparentiy rent-seeking behavior continued and accelerated in thoseareas where it was stiii aiiowed.

SiDB voiume ieveled off in 1985 and SiDBs no ionger were theiargest PAB category, apparentiy because of their voiume cap.interestingly, the 1984 totai for the capped bonds, SIDBs and SLBs,was only $18.4 biiiion, but the $150 cap would technicaiiy aiiow anannuai totai of $33 biiiion based on a U.S. popuiation of 220 miiiion.This wouid, of course, oniy occur if every state issued the bonds tothe limit, and this had not been the experience prior to DEFRA. Thosestates that were in excess of the cap (e.g., Virginia, Pennsylvania,Texas, Illinois, Florida, and others) would need to reduce theirvolumes. Other states would be abie to increase their issues under theguideiines. The ievding off of activity in 1985 indicates that this iswhat happened, as SiDB and SLB voiume increased siightiy to $19.3


biiiion despite the cap. Nonethdess, the seemingiy high ddiar iimit ofthe cap relative to historicai experience is puzziing, and once againindicates that Congress approaclied PAB voiume contrd in a reiativeiytimid manner.

The 1985 break-down by industry (Tabie 2) reveais that SiDBs forcommerciai use, especiaiiy for the Reai Estate sector, continued todominate iocai issues despite the now overtly stated Congressionaipreference for industriai projects, in the Norioik-Virginia Beach SMSA(Tabie 1), where per capita issues had been weii in excess of $150,SiDB voiume tumbied from $268 miiiion in 1984 to $90 miiiion in 1985.Again, however, commerciai use dominated aithough industriai activityin 1985 did return to pre-TEFRA ieveis at about 30 percent. Overaii,the pattern of intent and reaction to DEFRA was simiiar to that ofTEFRA: Congress granted localities a long rope and, as explainedbeiow, they finaiiy hung themseives.

TRA-INTENT

Despite both TEFRA and DEFRA, the data indicate that PABvoiume continued to increase and that SiDB issues continued to bedominated by commercial issues. As a resuit. Congress again changedthe rules governing PAB issues as a part of the Tax Reform Act of1986 (TRA). This time, however, the changes were effective. First,they affected both the demand and supply of PABs in areas beyond thereach of iocai pubiic pdicy. Second, they dictated which type ofprojects couid be financed by with tax-exempt bonds rather tiiandictating which types of projects were ineiigibie. Project controi wasthus shifted from iocai to nationai pdicy makers.

On the demand side, interest earned on aii PABs except thoseissued by 501 (3) (c) organizations was ciassified by the Act as a taxpreference subject to the aitemative minimum tax. This reduces effec-tive yieids to both individuai and institutional investors and thereforereduces the demand for such securities. Second, the abiiity of commer-ciai banks to deduct interest costs associated with raising funds withwhich to purchase PABs was completely eiiminated. As banks had beenthe largest purchasers of PABs, this aiso had a major impact onmarket demand.

On the suppiy side, one of the more subtie, yet effective changesrelated to the proportion of PAB proceeds that must actuaiiy be usedfor capitai investment. Prior to TRA, up to 10 percent of PAB pro-ceeds couid be used for purposes not directiy reiated to the faciiitybeing financed. Bond issuance costs (bond counseis, underwriting fees,printing, public notices, etc.) were excluded from this requirement.TRA reduced the unreiated amount to 5 percent including issuance


costs, and issuance costs themselves were iimited to 2 percent of thebond issue. These costs averaged 2.8 percent in 1985, thus the newrestriction severely impeded the abiiity of iocaiities to bring new PABsto the market and discouraged bon'owers from pursuing PAB financing.Other changes affecting the suppiy of aii PABs were tightened arbi-trage restrictions on borrowers and extended depreciation iives forPAB financed capitai.

As noted above, the TRA aiso made substantial changes in theruies regarding specific types of PABs. Reiterating the Congressionaipreference for industriai projects, sunset for SiDBs was extendedthrough 1989, but only for manufacturing projects. However, for pur-poses of per capita voiume caps, MRBs wouid be combined with SiDBsand SLBs beginning in 1987. The cap was set at $100 per capita in1987 and $50 per capita for subsequent years, in addition, a new typeof PAB was created-the "quaiified redeveiopment bond" (QRB). Ai-though subject to the voiume cap, tax exempt finance is permitted forprivate acquisition and rehabilitation of non-manufacturing faciiities inspeciaiiy designated "blighted areas." To avoid abuse, the definition of"blighted areas" limits them to contiguous areas not exceeding 20 per-cent of a community's area. Projects induded on the "whorehouse iist"are not eligibie for QRB financing.

TRA aiso changed the definition of quaiifying EFBs. No iongerexempt are sport faciiities, convention or trade show faciiities, parkinggarages, hydroeiectric generating piants, poiiution control devices,industriai park deveiopment, or mass commuting vehides. Eiigibie foruniimited tax-exempt financing are airports, docks and wharves, waterand sewage faciiities, soiid waste disposai faciiities, and faciiities forthe locai distribution of dectricity, but oniy if the faciiity is ownedby the iocai government or one of its agencies. This restriction mayhave been inspired by the past use of EFBs to finance private drydocks for ship repair firms, ioading docks for export firms, etc.

Finaiiy, tax exempt financing for muiti-famiiy residential projectswas severeiy restricted by tightening the eligibiiity requirements forresidents. Prior to TRA, developers were eiigibie for tax ekempt finan-cing if at ieast 20 percent of the units in the project were set asidefor famiiies with incomes less than 80 percent of the area mediangross income (AMGi). The new act changed the requirement to either20 percent of the famiiies having incomes iess than 50 percent of theAMGi or 40 percent of the famiiies having incomes iess than 60 per-cent of the AMGi. Together with other restrictions regarding deprecia-tion and treatment of quaiified famiiies whose incomes increase, theAct makes tax-exempt financing of multi-family residential projectsaimost economically infeasible.


it shouid be noted that one significant difference between TRAand the prior attempts to reduce PAB voiume was that TRA changes inthe tax code became effective as of August 15, 1986 although the Actwas not passed untii October 22, 1986. This preciuded the "rush toissue" response that cfiaracterized the fourth quarter reactions toTEFRA and DEFRA.

The oniy PABs to escape reduced caps or other specific restric-tions under TRA are tax-exempt bonds issued for 501 (c) (3) institutions.Consistent with the implied Congressionai desire to restrict tax-exempts to "traditionai" purposes, these institutions were exciudedfrom the iimitations because of the beiief that they provide "merit"goods or positive externai effects in the iocai economy.

TRA-OUTCOMES

Tabie 3 reveais that TRA was effective in reducing the nationaivoiume of aii types of PABs, and Tabie 1 shows that it aiso restrictedthe SiDB market in the Norioik-Virginia Beach region. As the $150 capwas in effect in both 1985 and 1986, the impiication is that thegenerai suppiy and demand restrictions on the market were moreeffective than reiiance on iocai government wiiiingness to reduce thevdume of issues. By making the new provisions effective immediateiy,the rush to issue response that characterized 1982 and 1984 wasprecluded.

Although TRA was successfui in iimiting PAB voiume, Tabie 2shows that it had iittie impact on the distribution of SiDB uses. Theshare of bonds used to finance commercial activity at the nationailevei actuaiiy increased in 1986 to a four year high of 69 percent.Reai Estate activity increased siightiy to over 23 percent of the totaiactivity. On one hand this is not surprising as the TRA changes for1986 were directed toward vdume controi rather than project seiec-tion. The restriction of SiDBs oniy to manufacturing projects beginningin 1987 will limit project seiection directiy but cannot be documenteduntil that data become avaiiabie. On the other hand, it remained clearto iocaiities that the Congressionai preference for the use of thisfederai subsidy was strongiy biased towards industriai investment.

SUMMARY

Two conciusions can be drawn from this review of the recenthistory of tax exempt bond finance for private purposes. First, themarket for private tax exempt financing for commerciai devdopment issubstantially greater than the market for industriai investment.Commerciai activity, especiaiiy real estate deveiopment, is more sensi-


tive to interest rate ieveis and naturaliy will be more responsive tointerest subsidies such as tax exempt financing, in addition, the 1968Tax Act that limited the size of individuai bonds to $5 ($10) miiiioniimited their usefuiness to industriai faciiities that are typicaiiy iargerthan commerciai projects, in a very reai way, this Congressionai dic-tate transfomned the bonds fi'om industriai to commerciai deveiopmentbonds. Subsequent iegisiation seeking to reverse this trend has been anexercise in confiicting pdicy.

The reduction in marginai tax rates inciuded in the 1986 Tax Acthas had a major impact on the tax exempt bond mari<et. Because oflower tax rates, tax exempt interest rates have risen reiative to tax-abie rates. Aithough this impiies smaiier savings for PAB users, it aisoimpiies smaiier tax iosses for the Federai Treasury. Because the costof tax exempt financing has been reduced. Congress may wish to "re-iiberaiize" its use sometime in the future as a substitute for someexisting urisan grant programs. The advantage of PAB finance is two-foid: it aiiows fiexibiiity at the iocai ievei and it aiiows subsidizationwith a minimum of governmentai administrative costs. Continuation ofthe restrictions on voiume and use whiie removing the $10 miiiion perproject cap wouid make PAB finance feasibie for industriai uses andcomplete its evolution to a more meaningful economic developmentinstrument.

The second conciusion is that the unrestricted use of privateactivity tax exempt bonds provided iocai governments with an ideaiopportunity to engage in rent-seeking behavior, and this opportunitywas rationaiiy expioited. TEFRA, and to a lesser extent DEFRA, reliedtoo much on localities' wiiiingness to forego such behavior and accord-ingiy faiied in their objectives. These Acts can be interpreted aswarnings to iocaiities to aiter their behavior in regards to PAB issues,and the data indicate that these warnings were ignored. As a conse-quence, the provisions inciuded in the Tax Reform Act of 1986 essen-tially removed a substantial amount of locai controi over tax-exemptbond issues, and the recent ruiing in South Carolina vs. Baker rein-forced Congressionai authority to do so. Aithough it is debatabie, itcan be argued that the post-TEFRA iegisiation wouid not have beenforthcoming, or wouid not have been so severe, if comrriunities hadreacted to the spirit of the iaw rather than the ietter of the iaw.

Despite protests from local governments and other speciai inter-ests, it is doubtfui that iosing the abiiity to finance commerciaibuiidings with tax exempt bonds wiii severeiy damage iocai economicdeveiopment. Tax exempt financing remains avaiiabie at this time forprojects consistent with economic deveiopment that serve the pubiicinterest. What has changed is the definition of pubiic purpose.Essentiaiiy, the concept no ionger inciudes commerciai or residential


projects. Stiii eiigitjie for unrestricted tax-exempt financing aretraditionai public projects (roads, schoois, etc.), quasi-pubiic infra-structure (airports, docks and wharves, etc.), and bonds for non-profit organizations. PABs are stiii avaiiabie in iimited amounts formanufacturing projects and inner city rehabiiitation. if state and iocaigovernments are unhappy with their now limited ability to use taxexempt finance for commerciai projects, to a iarge extent they haveoniy themseives to blame: by pursuing their iocai agendas they kiiiedthe goose that iaid the golden tax exempt eggs.

REFERENCES

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Congressionai Budget Office. 1981. Small Issue Industrial DevelopmentBonds (Washington DC: Government Printing Office).

Demaagd, Geraid R., and James K. White. 1985. "Financing PrivateCapital with iDBs." Management Accounting 66:48-52.

Gwartney, James D., and Ricfiard E. Wagner, eds. 1988. Public Choiceand Constitutionai Economics (Greenwich, CT: JAi Press).

Kopke, Richard, and Richard Syron. 1978. 'Tax Incentives: Theirimpact on Investment Decisions and Their Cost to the Treasury."New England Economic Review (Jan./Feb.):30-37.

Mariin, Matthew. 1984. "industriai Deveiopment Bonds: Reviewing theEvidence in the Norfdk-Virginia Beach SMSA." Review ofRegional Studies 14:49-56.

Patton, Cari. 1988. "Jobs and Commerciai Office Deveiopment." Eco-nomic Development Quarterly 2:316-325.

Rasmussen David, Marc Bendick, and Larry Ledebur. 1982. "EvaiuatingState Deveiopment incentives From a Firm's Perspective."Business Economics 17:25-30.

Reams, Bernard D. (ed.). 1985. A Legislative History of the Tax ReformAct of 1984: The Law, Reports, Hearings, Debates and RelatedDocuments (Buffaio: Wiiiiam S. Hein & Company).

Sonsteiie, J.C., and P.R. Portney. 1978. "Profit Maximizing Communitiesand the Theory of Locai Pubiic Fiance." Journal of UrbanEconomics 5:263-277.