"What?" and "Why?" for Tax Exempt Bonds

Temperature Rises on Tax-Exempt Bond Issue, Again

By Bradley L. Jacobs

Tax-exempt bonds have been a heated subject at state and county government, in Congress, at the U.S. Department of the Treasury, and in financial markets. And, while some of the positions are emotional, good reasons of finance, fact, and policy encourage continued existence of so-called tax-exempt bonds. I say "so-called" because it is the interest earnings paid to holders of the bonds which are tax-exempt.

First, what about policy? I think the policy should be as follows:

(A) Support the right of counties to issue debt instruments whose purchasers shall be wholly exempt from all federal taxes on all interest paid to them as holders of that debt. And, that debt shall be issued only to provide money to design and build physical assets whose services will underlie indivisible public goods and/or public services which will satisfy a public purpose objective.

(B) Furthermore, if the public purpose objective is served, then the proportional share, the nature, and the economic sector of usual operation of suppliers of (or to) those physical assets shall not be material to the tax-exempt status of any interest paid to the holders of any bonds as described above.

The emphasis in (B), above, is critical: The proceeds of bonds whose interest is tax-exempt to the receiver only must be used to design and to construct physical assets whose (a) function and (b) enabled services will meet a defined public purpose objective. Physical assets exist only to provide services. But, it is not the services that are being funded by the proceeds of these bonds. It is the physical assets. Is that nitpicking? Or is it truly important?

I think the distinction truly is important. Why? We can learn from the general revenue sharing situation and county actions which stimulated its demise.

General revenue sharing money was sent to counties in periodic packages. Those periodic packages of money were intended originally (and understood) to be targeted on adding to the stock of physical assets owned by counties. Examples include jails, water or sewer facilities and courthouses. The physical asset requirement didn't make the trip to final written requirements but the intent was known widely.

What actually occurred? Increasing percentages of the money were diverted to meet the cash flow needs of government.

Physical asset accumulation all but disappeared toward the end of General Revenue Sharing. Thus, we have yet another example of eating the seed corn, instead of planting it.

What are the lessons? (1) Use money packages which may "not come again" for a purpose which also may "not come again" at least for some time. And, (2) use money for its intended and appropriate purpose.

Specifically, bonds are repaid over a long time. Therefore, use bond money to buy something that will continue to provide function for at least as long a time as required to repay the bond money. Perhaps even reinvest some of the bond proceeds (cash management) to generate income to pay at least part of equilibrium life cycle maintenance costs. But we are getting ahead of the story.

Differentiating capital formation in the public sector from capital formation in the private sector is important for two reasons.

First, the mission of public capital is different from the mission of private capital. Public capital provides indivisible goods that cannot be provided by the private sector with the same level of effectiveness.

Second, the amplification of money spent in the private sector is greater than the amplification of money spent in the public sector. For that reason the efficiency of allocation as well as the effectiveness of utilization demand that public capital and public capital goods be limited to serving indivisible needs only.

What is an indivisible need? The sheriff's department, the countywide fire department, the welfare agency, the assessor department, the treasurer-tax collector, the auditor-controller, and the board of supervisors provide services meeting the indivisibility test. Why? Because an individual citizen cannot decide not to purchase sheriff services if he or she lives in an unincorporated area of the county. The citizen cannot do this anymore than he or she can choose not to purchase the services of the United States Air Force. Those services are also indivisible.

Indivisibility is the most fundamental criterion for deciding whether goods or services should be provided in the public or in the private sector. Then, evaluating relative effectiveness in using resources may further limit the choice. Examining life cycle costs and total consumption of resources helps to assure that effectiveness really is attended to.

Back to so-called tax-exempt bonds. These bonds must pay for investments made for the future, not for the past. Preparing for the future already is extremely difficult for government. And, the viewpoints and ways of thinking by some people in government make the task well-nigh impossible.

Governmental entities should be able to issue bonds when the people agree to issue them. And, the people should be notified and fully informed about the costs of servicing this debt.

Why is being informed so important? Future costs of paying off both principal and interest on new debt could in the future virtually assure increasing tax burdens. Increasing taxes would be called for even if other expenditures remain constant.

All debt must be serviced. Your or my home mortgage, credit card, store charge account, gasoline, whatever it might be, is debt that must be repaid. And, debt must be repaid with added interest and perhaps other charges attached. (Note the Third World Debt Swamp where borrowings pay past due interest on prior borrowings. There, the mire is strangling everyone.)

Therefore, we must be very careful in deciding what to fund with government bonds. And those bonds that provide an incentive for purchase through the tax-exempt status of the interest earnings paid to purchasers must receive special care in targeting their uses.

Only voters should make the value judgments about what should be funded with bonds. And, hopefully, more and more people will become interested in what is funded with government bonds because they will be paying the costs to service and redeem those bonds in the future.

But, information is the most important factor. Informed citizens (1) making decisions which to them make sense, (2) looking to the future, and (3) thinking through their guesses about the future, will help shape the future. And, those thoughts and guesses will help to make our future a good one.

Expectations condition behavior. And behavior and expectations are a chicken-and-egg situation. If we expect things to be bad then our behavior will help to make them bad. If things are bad then we will continue to expect them to be bad.

Conversely, if things are good then we expect them to remain good. And, our behavior based on that expectation will, in turn, assist circumstances to remain good. Self-fulfilling prophecies are well-known in the world of economics. So, also, with tax-exempt bonds. So, too with taxes. And, even with the U.S. economy. Let us assist the citizenry to be informed. Let us encourage the citizenry to vote. And, let us also encourage people to be deeply and continuously concerned with the decisions we make.

We operate government for the people. They hired us to operate their government for their benefit while consuming the fewest resources possible.

Tax-exempt bonds, properly applied, are one tool we have to manage resource uses. Bonds provide a "degree of freedom" which local government finance otherwise doesn't have: time. Let us look ahead and use human energy, time, and money effectively in our operation of the peoples' business: their government. They own it!