How federal policymakers account for the concerns of state and local governments in the formulation of federal tax policy.

These concerns all seemed to stem from fears over state fiscal collapse, not from the overlap of state and federal government tax authorities. In fact, prior to the civil war there was no federal income tax, making the question of tax-exempt bonds a moot point. Although many advocates of exemption status may note, and use, a first instance of the concept of intergovernmental tax immunity with Justice Marshall's 1819 decision and statement "the power to tax involves the power to destroy," this famous claim actually referred to the states ability to tax an instrument of the federal government.

While there were repeated attempts after ratification of the 16th amendment in 1913 to remove tax-exempt bonds in their entirety, it was not until after World War II that there was ever a discussion of limiting the particular use of tax exempt bonds. Nineteen hundred and sixty-eight marked the first attempt to restrict state uses of tax exempt bonds. The 1968 Congress began by limiting industrial development bonds (IDBs) and arbitrage bonds in response to a growth of bonds issued for private purposes. In fact, the limits on IDBs began the first qualified private activity bonds. Congress set the future trend not by defining public purpose but rather by defining what was not. The 1968 restrictions outlined the still-current two-part use and security test of a private activity bond, although at the time the use and security tests required 25 percent or more of the use or securities to be private. This test is a test for "bad" bonds, that is, if the share is greater than 25 percent the bond passes the test for a taxable bond. This and later restrictions were met with an onslaught from the states to exempt specific activities. For example, transition rules were added, in part to acquiesce to congressional pressures on behalf of their states, which included "exceptions to tax-exempt-bond-limits for a new stadium for the Miami Dolphins football team, a convention center in Miami Beach, a midtown Miami redevelopment project, and two new heating and cooling systems for the Florida Region" (Birnbaum and Murray, 1987, p. 147).

The states' pleas that were met as private activities qualifying for tax exempt status continued to include residential property; sports facilities; facilities for convention or trade show; airports; docks, wharves, parking facilities, and mass commuting facilities; and other waste, pollution, and utility facilities were allowed to qualify for tax exempt status.

The Tax Reform Act of 1986 made substantial changes to the exempted facilities and narrowed the use and security tests to ten percent (i.e., ten percent or more of the use or the securities were private). Gold (1990) points out the dramatic fall in state and local bond financing in response to changes in TRA 1986. Municipal financing fell from $204.3 billion in 1985 and $151.0 billion in 1986 to $105.5 billion in 1987 and $117.0 billion in 1989.

Despite the federal government's historical relaxation and subsequent constriction of tax exempt municipal bonds, states and local governments have a wide variety of activities that can be financed with tax exempt bonds, particularly government obligation bonds that have few limits. For example, according to the Government Accountability Office (2006), 15 percent of golf courses were owned by state and local governments. Of these, four percent were associated with resort or real estate facilities. In addition, 39 hotels associated with convention centers, airports or golf courses were identified by finance experts as being financed with tax--exempt bonds. The report also mentions over 300 government-owned convention centers and cites instances of state and local government support of gaming facilities.

Table 2 shows the distribution of bond issuance across broad categories of activities that can be considered private in nature. Of states' bond issues, at least half are for these activities. (Total bond issuances exclude general purpose since there is no reliable way to allocate those bonds to private or public purpose. Bonds issued for general purpose account for roughly a quarter of total bond issuances.) This table also includes tax-exempt, taxable, and qualified private activity bond issues, which account, respectively, for 85.1 percent, 7.4 percent, and 7.5 percent of total (including general purpose) issuances over the six-year period.

According to Table 1, above, explicitly private activity bonds account for 23 percent of the tax expenditure for bonds. This number is larger because of the existing stock. As with the property tax deduction, the tax expenditure list classifies these bonds in functional categories outside state and local activities. Nevertheless, the states and localities play an important role in allocating these resources. While some of the uses in Table 2 could be argued to be traditional functions of state and local governments, convention centers, stadiums and arenas, and other private-entertainment-related activities are questionable.

ECONOMIC EFFECTS OF OTHER FEDERAL TAX POLICIES

State and local governments are also affected indirectly by other tax policies of the federal government. The most obvious are the marginal tax rates themselves. As important, in terms of incentives, as proposals to disallow state and local tax deductions was the fall in the top marginal tax rate from 70 percent in 1980 to 28 percent in 1986. Although part of this rate reduction was reversed in 1993, with rates then reduced again in 2001, there has been little attention to this effect. Of course, states were hardly in a position to protest the lower rates because these rates benefited their taxpayers. Moreover, there may have been little in incentive effects for state and local taxes. These changes affect the benefits of interest exclusion for state and local bonds because the value of the exclusion is higher for higher marginal tax rates.

There are several other important tax policy decisions affecting tax burdens on capital income that affect tax exempt borrowing, including the tax rates on corporate source income (the corporate tax rate, capital gains tax rates, and tax rates on dividends), business subsidies, and tax preferred savings provisions. These effects depend on which assets are closer substitutes for municipal bonds.

Consider the corporate tax rate. If interest-bearing assets are much closer substitutes for state and local bonds than equities, the corporate income tax, which might normally be expected to burden competing business investment, could make state and local bond finance more costly by driving up the interest rate. Interest is deductible at the corporate level, leading corporations to favor debt finance, and their increased demand drives up the interest rate. In fact, debt is actually subsidized at the corporate level because the inflation premium is also deducted, along with the real interest rate. At the personal tax level, however, equity is favored relative to debt, because of lower capital gains tax rates (due both to deferral and to lower rates during most of the history of the income tax), leading to a shifting of the supply of capital to the corporate sector from debt to equity. High marginal rates at the corporate as well as the Individual levels should be associated with higher interest rates, other things equal. In 1986, the lowering of corporate marginal tax rates and the increase in capital gain rates were changes favorable to lower interest rates and, in this scenario, offset somewhat the unfavorable effects of the lower marginal rates on state and local borrowing costs. The higher capital gain rates would also shift supply directly from corporate equities into interest-bearing assets.

Similarly, reduced taxes on capital gains and dividends would also push up interest rates on state and local bond rates by attracting supply from interest bearing assets, along with directly shifting assets from municipal bonds to equities. Such changes have occurred recently: capital gains tax rates were reduced in 1997 and both rates were reduced in 2003.

Subsidies for business investment also attract capital away from state and local bonds for both debt and equity finance. Lowering the tax burden on corporate investment in this fashion, unlike lowering corporate tax rates, unambiguously induces a rise in interest rates and a higher return to equity investment, which should cause capital to be shifted away from municipal bonds. These rules have shifted over time. Investment credits were enacted in the 1960s and a particularly generous set of investment subsidies was enacted in 1981 when dramatically accelerated depreciation was adopted, leading to negative effective tax rates even on equity financed business investments. These benefits were scaled back somewhat in 1982 and 1984, and contracted significantly in 1986 when the investment credit was repealed and depreciation for structures slowed considerably, and the corporate marginal tax rate lowered.