Not Quite, NYT, But Getting Warmer

Posted by Bob Lord

The mainstream media has a hard time with taxes. It's hard to tell whether they're intentionally dumbing it down, or just don't quite get it. 

Tuesday's NY Times article, Qualified Private Activity Bonds Come Under New Scrutiny, is a classic example. The supposed abuse the article highlights is the use by private enterprise of cheaper borrowing designed for states and localities:

At a time when Washington is rent by the politics of taxes and deficits, select companies are enjoying a tax break normally reserved for public works. This style of financing, called “qualified private activity bonds,” saves businesses money, because they can borrow at relatively low interest rates. But those savings come at the expense of American taxpayers, because the interest paid to bondholders is exempt from taxes.

The writer is correct, but completely misses the greater and far more pernicious abuse. Yes, municipal bonds provide for somewhat lower borrowing rates, rates that really shouldn't be passed on to private enterprise. But I've emphasized "somewhat," because the rates at which state and local governments borrow by issuing municipal bonds aren't all that much lower than the rates on taxable bonds. The real abuse is that Congress enacted a tax preference for holders of municipal bonds in order to reduce borrowing costs for state and local governments, but the lion's share of the benefit is going to the bondholders, not the issuers. So, the abuse isn't so much that private enterprise is getting an undeserved subsidy, but that bondholders are getting a tax windfall. And they get that subsidy regardless of who receives the proceeds from the bond issue.

Here's how it works: The concept upon which the exemption for municipal bond interest is based is straightforward. If taxable bonds are paying interest at, say, 5 percent, bondholders would net around 3% after tax, depending on their state tax rate. Thus, they should be willing to accept a 3% or so rate on municipal bonds, since their after tax return will be the same. Of course, the desired result could be achieved more directly (and more efficiently) if no exemption for municipal bond interest were allowed and, instead, the federal income tax proceeds from municipal bond interest were distributed to the bond issuers. 

The problem with the current system is that bond interest rates represent the price of borrowed money. As such, they are driven by the law of supply and demand and most of the supply of lendable money doesn't care whether the bond interest is taxable. Pension plans, 401(k)s, IRAs, insurance companies, and banks all have little or no tax exposure on their bond portfolios. Yes, a bank must pay tax on its profits, but most of its interest income goes to pay expenses, which offset the income. The effect of having a large portion of bond buyers unconcerned about the taxabiltiy of bond interest is to compress the difference between the market rates on taxable bonds and municipal bonds. Think of there being two markets: One giant market where taxable bond issuers are chasing the trillions of dollars from lenders who are not tax sensitive (and, if the rates are high enough, those who are) and a second, much smaller market, where states and municipalities chase a much smaller pool of tax-sensitive lenders. In theory, the difference between the tax-exempt rate of interest and the taxable rate of interest should be a function of the income tax rate. In the real world, however, the difference in the interest rate between taxable bonds and municipal bonds is nowhere near the income tax savings to the bondholder. 

The end result: holders of municipal bonds take a very slight haircut on the rate they could achieve on taxable bonds, then avoid a 40% or so tax on the interest they receive. 

With that as background, here's how the Times describes the problem:

In all, more than $65 billion of these bonds have been issued by state and local governments on behalf of corporations since 2003, according to an analysis of Bloomberg bond data by The New York Times. During that period, the single biggest beneficiary of such securities was the Chevron Corporation, which issued bonds with a total face value of $2.6 billion, the analysis showed. Last year it reported a profit of $26 billion.

So, let's say Chevron saves one percentage point on its interest rate on those $2.6 billion in bonds. That's $26 million per year, or about one one-thousandth of Chevron's profits. Who's the real winner here, Chevron or the bondholders?

The real fix to municipal bond abuse is to end the tax-exemption on all municipal bonds, not just private activity bonds, and let states and municipalities borrow on the open market. Will it increase their costs? Absolutely. But it also will drive more federal tax revenue. Treasury could use some of that additional revenue to help make up the increased borrowing costs to the states and still have a tidy sum left over.