Subsidyscope

Exclusion of Interest on State and Local Government Bonds for Private Nonprofit and Qualified Public Educational Facilities

All text from: Congressional Research Service (CRS). “Tax Expenditures: Compendium of Background Materials on Individual Provisions.” December 2008. GPO: Washington DC.

Description

Interest income on State and local bonds used to finance the construction of nonprofit educational facilities (usually university and college facilities such as classrooms and dormitories) and qualified public educational facilities is tax exempt. These nonprofit organization bonds are classified as private-activity bonds rather than governmental bonds because a substantial portion of their benefits accrues to individuals or business rather than to the general public. For more discussion of the distinction between governmental bonds and private-activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Bonds issued for nonprofit educational facilities are not subject to the State volume cap on private activity bonds. This exclusion probably reflects the belief that the nonprofit bonds have a larger component of benefit to the general public than do many of the other private activities eligible for tax exemption. The bonds are subject to a $150 million cap on the amount of bonds any nonprofit institution can have outstanding.

Bonds issued for qualified public education facilities are subject to a separate State-by-State cap: the greater of $10 per capita or $5 million annually.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low interest rates enable issuers to finance educational facilities at reduced interest rates. Some of the benefits of the tax exemption also flow to bond- holders. For a discussion of the factors that determine the shares of benefits going to bondholders and users of the nonprofit educational facilities, and estimates of the distribution of tax-exempt interest income by income class, see the “Impact” discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

An early decision of the U.S. Supreme Court predating the enactment of the first Federal income tax, Dartmouth College v. Woodward (17 U.S. 518 [1819]), confirmed the legality of government support for charitable organizations that provided services to the public. The income tax adopted in 1913, in conformance with this principle, exempted from taxation virtually the same organizations now included under Section 501(c)(3). In addition to their tax-exempt status, these institutions were permitted to receive the benefits of tax-exempt bonds under The Revenue and Expenditure Control Act of 1968. Almost all States have established public authorities to issue tax-exempt bonds for nonprofit educational facilities.

The interest exclusion for qualified public educational facilities was provided for in the Economic Growth and Tax Relief Reconciliation Act of 2001 and is intended to extend tax preferences to public school facilities which are owned by private, for-profit corporations. The school must have, however, a public-private agreement with the local education authority. The private-activity bond status of these bonds subjects them to more severe restrictions in some areas, such as arbitrage rebate and advance refunding, than would apply if they were classified as traditional governmental school bonds.

Assessment

Efforts have been made to reclassify nonprofit bonds as governmental bonds. Central to this issue is the extent to which nonprofit organizations are fulfilling their public purpose. Some argue that these entities are using their tax-exempt status to subsidize goods and services for groups that might receive more critical scrutiny if they were subsidized by direct federal expenditure.

As one of many categories of tax-exempt private-activity bonds, nonprofit educational facilities and public education bonds have increased the financing costs of bonds issued for more traditional public capital stock. In addition, this class of tax-exempt bonds has increased the supply of assets that individuals and corporations can use to shelter income from taxation.

Selected Bibliography

• Maguire, Steven. Private Activity Bonds: An Introduction. Library of Congress, Congressional Research Service Report RL31457. March 2008.
• — . Tax-Exempt Bonds: A Description of State and Local Government Debt. Library of Congress, Congressional Research Service Report RL30638. March 2008.
• Plummer, Elizabeth. “The Effects of State Funding on Property Tax Rates and School Construction,” Economics of Education Review, vol. 25, no. 5, October 2006.
• U.S. Congress, Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 107th Congress, Joint Committee Print JCS-1-03, January 24, 2003.
• Weisbrod, Burton A. The Nonprofit Economy. Cambridge, Mass.: Harvard University Press, 1988.
• Zimmerman, Dennis. “Nonprofit Organizations, Social Benefits, and Tax Policy,” National Tax Journal. September 1991, pp. 341-349.
• — . The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activities. Washington, DC: The Urban Institute Press, 1991.

All text from: Congressional Research Service (CRS). “Tax Expenditures: Compendium of Background Materials on Individual Provisions.” December 2008. GPO: Washington DC.