Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : Small-Issue IDBs-Tax Policy in Search of a Focus, August 13, 1984

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but a study of IDB use in Michigan
found few diversification benefits.'
Little of the IDB money was used in
automobile-related
industries (the
state's dominant industry); the bulk
of the money did aid other durablegoods manufacturing
facilities,
which suffer much the same pattern
of cyclical peaks and troughs as the
automobile industry.
Currently, IDB use appears to be
most efficiently targeted toward small
businesses. The 1968 limitations
drastically reduced the average size of
IDB issues and concentrated their
use in small- and medium-sized firms.
Even here, however, targeting could
be improved. The peculiar provisions
of the 1968 targeting amendments,
which define small businesses by capital assets rather than by sales or
size of work force, allow large firms
with many small, geographically dispersed facilities to benefit from IDB
use? For example, a large discount
retailer financed 96 stores in 19 states
between 1975 and 1980 through the
use of IDBs. In 1978 and 1979, 16 percent of the dollar volume of IDB sales
aided companies on the Fortune 500
list of top nonindustrial
firms or
the Fortune 1,000 list of the largest
industrial companies.l? On the other
hand, the 1982 restrictions against

7. See CBO, Small Issue Industrial Revenue
Bonds, pp. 70-71. CBO data for these 6 years
provided 271 observations. The correlation
between per capita income and IDB use was 0.273
and was significant at the 1 percent level. The
correlation between the unemployment rate and
IDB volume was 0.022, which was not significant at even the 10 percent level. The pattern of

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IDB use by restaurants,
auto dealerships, and entertainment
facilities,
and the restrictions of many states
against funding commercial facilities
with IDBs, exclude large portions of
the small business community from
IDB financing.
Moreover, the use of a capital expenditure limit has a perverse influence
on employment in the community.
Many city officials and politicians
are interested in small businesses,
because they could generate a large
number of new jobs. Here again,
however, it might be more useful
to categorize firms by their existing
sales volume or size of work force,
rather than by their capital spending.
The size of capital investment stimulated by IDBs directly affects the
number of jobs created. By limiting
capital expenditures to $10 million,
the community gains less employment for each IDB dollar than it
might under another plan. For
example, if cities were to use IDB
financing to lure firms that plan to
build facilities costing more than
$10 million, the IDB program might
generate more jobs. In addition, by
including expenditures for three
years after the IDB issue date in the
capital expenditure limit, the current
law could prohibit a rapidly expanding firm from building new facilities
until the three-year period is over.

Conclusion: An Opportunity
for Redirection
Despite the inefficiencies in the use
of IDBs, Congress might wish to
maintain current policy. A clear consensus on these issues is difficult to
obtain, and proponents may point
out that a portion of the lost tax revenues, however small, does eventually reach the various conflicting
objectives of the program. But previous legislation affecting IDBs has
been directed at saving money and
correcting abuses, not at ensuring
that this method of funding fulfills
its purpose. The current debate on
IDB use presents an excellent opportunity, not only to curb the impact of
IDBs on federal revenues and deficits, but also to focus IDB financing
more closely on federal objectives.
The controversy surrounding IDB
financing illustrates what is true of
tax legislation more generally: an
approach aimed only at the indirect
prohibition of certain activities,
rather than the direct encouragement of public goals, does not necessarily lead to coherent or effective policy.

these results was unchanged, even when the state
of Pennsylvania (by far the largest user of IDBs
in this period) was omitted from the analysis.

9. The new law restricts this loophole somewhat
by limiting the total amount a single user of
IDBs may have outstanding at one time to
$40 million.

8. See Ann R. Thomas, "Industrial Revenue
Bonds:' in Michigan s Fiscal and Economic Structure, Harvey E. Brazer, Ed., Ann Arbor, MI: University of Michigan Press, 1982, p. 320.

10. CBO, Small Issue Industrial Revenue Bonds,
p.23.

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Small-Issue IDBsTax Policy in
Search of a Focus
by Paul Gary Wyckoff
Although no cash actually changes
hands, a significant portion of federal
government resources are being used
to subsidize the activities of households and private firms. This subsidy occurs rather indirectly, in the
form of a loss to the U. S. Treasury
when state and local governments
are allowed to issue private-purpose
tax-exempt bonds. According to the
Congressional Budget Office, this tax
loss to the federal government will
total approximately $13 billion per
year over the next five years. This
amount is more than the federal government is expected to spend annually
on highways through 1989, and more
than it will spend in total for assistance to public transit systems, wastewater treatment, water resources,
airports, air traffic control, and
municipal water-supply systems.'
The single largest segment of the
private-purpose,
tax-exempt bond
market-more
than one-fifth of the
total volume of new issues-is
made
up of small-issue industrial development bonds (see table 1). An industrial development bond (IDB) is really

Paul Gary Wyckoff, an economist with the Federal
Reserve Bank of Cleveland, studies the public sector.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

a corporate bond that, through the
intervention of state and local governments, is treated as a municipal
bond for federal income tax purposes.' The bonds are termed smallissue because they are granted tax
exemption through a provision
that limits their size to $10 million.
Typically, a local government issues
the bonds and constructs a plant
or purchases equipment with the proceeds. The local government in turn
leases the new facilities to a private
firm, using lease installments to
payoff the principal and interest on
the bonds. Since the interest earned
on IDBs is not taxable under current
law, the bond purchaser usually is
willing to lend the money at lower
rates than he would demand if the
bonds were taxable. The credit of the
issuing government is unaffected by
this transaction, because the bonds
are backed by the revenue of the leasing firm, not by the taxing power of
the local government. If the leasing
firm goes bankrupt, the issuing
government is not required to pay
off the bonds.
As a part of its recent effort to
make a "down payment" on the federal deficit, Congress has revived the
debate about federal tax incentives
for business investment. In formulating new limits for small-issue IDBs,
Congress has raised anew many longstanding questions about the appropriateness of IDBs as an instrument

1. See Alice M. Rivlin's 1983 testimony before
House Ways and Means Committee, reproduced in
Alice M. Rivlin, "CBO's Position on Tax-Exempt
Financing for Private Activities:' Municipal
Finance Journal, vol. 4, no. 4 (Fall 1983), p. 303.

August

13, 1984

Table 1 Volume of Reported PrivatePurpose Tax-Exempt Bonds in 1983
By type of activity; in millions of dollars
Type of bond

Student loan bonds"
Private exempt entity bonds"
IDBs:
Multifamily rental housing
Sports facility
Convention facility
Airports, docks, wharves, and
mass-commuting facility
Sewage or waste disposal facility
Pollution-control facility
Water-furnishing facility
Hydroelectric-generating
facility
Mass-commuting vehicle
Local district heating and
cooling facility
Electric energy and gas facility
Industrial park
Small-issues
TOTAL

Total new
Issues=

3,464
8,231
5,253
209
238
2,147
1,393
3,834
87
59
17
86
1,060
191
13,514
39,784

NOTE: Preliminary data compiled from Form 8038;
figures may not add to total due to rounding.
a. New issue volume equals the purchase price of the
bonds minus proceeds used to refund earlier issues.
b. No information on the amount of refunding was
collected for student loan bonds.
c. Private exempt entity bonds include bonds issued
for l. R. C. Section S01(cX3)organizations-principally
private nonprofit hospitals and educational facilities.
SOURCE: U.S. Department of the Treasury, Office of
Tax Analysis, Treasury Report on Private Purpose TaxExempt Bond Activity during Calendar Year 1983,
March 28, 1984, table 2.

2. At one time, a distinction was made between
industrial revenue bonds and industrial development bonds, based on whether the issuing jurisdiction used its taxing authority to secure the
bonds. Since local governments now only rarely
back the bonds in this way, the distinction
has faded and the two terms have become
synonymous.

of tax policy. This Economic Commentary discusses the history of smallissue IDBs in the United States and
analyzes the debate that surrounds
this controversial method of financing.

The History of IDBs

Industrial development bonds were
first used in the United States in
1936, when the state of Mississippi
established a Balance Agriculture
with Industry program that used the
borrowing power of state and local
governments to diversify its Depression -stricken, agricul tural- based
economy. Use of the bonds spread
slowly, however; by 1950, only Alabama, Kentucky, and Mississippi
had authorized their issuance. In the
1960s, IDB financing became popular
and spread to the East and the Midwest, where it was embraced as a
means of attracting new industries
and preventing old ones from moving
to the Sunbelt. By 1968, the volume
of IDBs issued had climbed to
$1.8 billion.
The growth in volume of the
bonds caused concern in Congress, for
three reasons. During the 1960s, the
loss to the U.S. Treasury through
the tax exemption was considerable.
Also, there was alarm that IDBs
threatened the market for more traditional public-purpose municipal
bonds (like those used for schools
and highways) by driving up interest
rates on all municipal issues. Third,
the average size of the issues had
expanded dramatically, from $366,000
in 1957 to $7.8 million a decade later.'
Even after being adjusted for inflation, these figures represented a
17-fold increase. It became clear that
large firms were reaping the tax
benefits of IDBs. Policymakers believed that such firms did not need
the subsidy, and that availability of
IDB financing was not a major factor
in where large firms chose to locate .

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3. See Susan R. Robertson, "Industrial Development Bonds: They're Not What They Used to
Be;' Business Review, Federal Reserve Bank of
Philadelphia (March 1969), p. 4.

In response to these criticisms,
Congress attempted to trim IDB
growth by establishing two criteria
for tax exemption-purpose
and size.
The Revenue Expenditure and Control Act of 1968 revoked the tax
exemption for IDBs of large size,
except for quasi-public-purpose
projects. This exemption includes airports, docks, mass transportation
and parking facilities, plant and
equipment for local utilities, residential housing, sewage and solid waste
disposal facilities, stadiums, trade
and convention centers, and wharves.
Also covered are bonds to finance the
purchase of air- and water-pollutioncontrol equipment and bonds used to
acquire and develop industrial parks.
In addition, the 1968 act allowed
all IDB issues of less than $1 million
to retain their tax-exempt status, and
these bonds became known as smallissue IDBs. Subsequent amendments to the act raised the ceiling on
small-issues to $5 million, and then
to $10 million, but stipulated that
a firm receiving the assistance of an
issue greater than $1 million must
not spend more than $10 million
on capital facilities in the issuing
jurisdiction. (Projects funded with
the assistance of Urban Development
Action Grant money may spend
$20 million.) The $lO-million limit
applies to the firm's total expenditures (not just those financed by the
bond) on plant and equipment over
six years, beginning three years
prior to the issuance of the IDB. By
amending the act in this way, Congress sought to provide greater
help to state and local governments
that were trying to develop their
economies, while also restricting IDB
assistance to small firms.

After the 1968 law was passed,
IDB sales took a nosedive and
then began to climb upward again,
partly because issuers began to recognize the breadth of activities that
could be financed under the smallissue exemption. From its traditional
use to support industrial activities,
IDB financing spread increasingly
into commercial and retail projects.
Reports of IDBs being used to finance
massage parlors, racquet clubs, and
race tracks motivated Congress to
include additional trimming measures in the Tax Equity and Fiscal
Responsibility Act of 1982. This law
restricted IDB financing for automobile dealerships, recreation and
entertainment
facilities, and restaurants, requiring for the first time that
IDB issues be reported to the Internal Revenue Service. In addition,
specific recreation and entertainment
facilities, including the three listed
above, were entirely prohibited from
IDB use. Congress also enacted a
sunset provision that would remove
the tax exemption for small-issue
IDBs, beginning in 1987.
As part of its effort to reduce
the federal deficit, Congress recently
approved further tightening provisions, one of which limits the combined volume of IDB and studentloan bonds that may be issued
in each state to $150 per person or
total of $200 million, whichever is
greater. This cap applies to all IDBs,
not just small-issues, with the exception of multifamily housing issues
and bonds to finance airports, convention centers, docks, transportation facilities, and wharves. However, these limitations are not as
restrictive as they might seem. The
two-part nature of the cap appears to
guarantee that almost all states will
be able to issue the same volume of

bonds as before, so the legislation
affects only the future rate of growth
of IDBs. Moreover, bonds that are
sold by the end of 1984 for projects
approved before June 19, 1984, are
exempt from the provision. As a final
weakening measure, Congress excluded
manufacturing
projects from the
sunset provision of 1982, prolonging
the tax-exempt status of these bonds
until 1989. .

Finding a Target: Problems
in Small-Issue IDB Use

IDBs as national policy. Suppose
for a moment that the federal government cared only about the nation's
aggregate income and employment and
not about their geographic distribution. As a national policy, it would be
difficult to justify the use of IDBs
because there are more efficient ways
to reach the various goals for which
IDBs were established. For example,
if the goal is to stimulate business
investment generally, targeting the
funds through an investment-tax
credit would produce a much greater
reduction in the cost of investment
capital without changing the revenue
loss to the U.S. Treasury. Much of
the money lost through IDBs simply
reduces the taxes of high-income
taxpayers, without affecting investment. Suppose, for example, that
tax-exempt issues are yielding 75 percent of the return on taxable bonds.
Then a taxpayer in the 25 percent
marginal tax bracket would be indifferent between taxable and tax-

exempt bonds. Anyone with a marginal tax rate higher than 25 percent
would purchase tax-exempt bonds
and would receive a tax subsidy, in
the sense that he or she would be
paid an interest rate higher than
necessary to ensure purchase of the
tax-exempt securities. Or, to put it
another way, purchasing the bonds
would enable anyone in these higher
tax brackets to lower his or her tax
rate to 25 percent (the interest foregone on the tax-exempt securities).
Since the exact income distribution of IDB investors is unknown, the
precise amount of this slippage is
impossible to calculate, but it is possibly quite large. In its analysis of the
revenue losses from IDBs, the Congressional Budget Office suggests
that the average small-issue IDB
investor has a marginal tax rate that
is close to 40 percent.' This means
that, in this example, three-eighths
of the revenue lost through IDBs
(25 percent divided by the taxpayer's
40 percent tax rate) benefits highincome taxpayers, and only the
remaining five-eighths benefits firms
in the form of lower interest costs.
In addition to revenue losses and
inefficient stimulation of investment
nationally, IDB financing detracts
from the ability of local governments
to raise funds for traditional projects
such as roads, schools, and sewers.
By drawing borrowers away from the
taxable into the tax-exempt market,
IDBs and other private-purpose bonds
increase the competition for funds in
the municipal market and drive up
municipal interest rates. This "crowding out" effect is potentially serious. In 1983, private-purpose bonds
accounted for 68 percent of the total
volume of long-term, tax-exempt
issues, with small-issue IDBs alone
making up 15 percent of this total.'

However, partly because Congress
did not require reporting of the
bonds until 1982, the magnitude of
this interest-rate effect is not knownf
Regional targeting. On the other
hand, IDBs might be considered as part
of some regional policy, intended to
favor certain firms and certain parts
of the country. In the course of the
debate over IDBs, advocates have
argued that the bonds benefit rural
communities, economically distressed
regions, areas trying to diversify
their industrial base, and small businesses. However, it is doubtful
whether these groups are favored
over others, since all 50 states have
authorized IDBs, and the federal
government has made few legislative efforts to target the funds.
For example, there is no system
among communities using IDBs
to ensure that distressed areas receive
all or even most of the aid provided
by IDBs. In fact, based on CBO estimates of IDB sales from 1975 to 1980,
there is a positive and significant
correlation between IDB sales in a
specific state and state per capita
income. In addition, no significant
correlation exists between IDB sales
and state unemployment?
Thus,
neither of these standard measures
of economic distress-income
and
employment-suggests
that IDB dollars typically find their way into
economically disadvantaged
states.
On the other hand, it could be that
IDBs are used disproportionately
by
the most distressed areas within
each state, so that these statewide
correlations are misleading. This
seems unlikely, however, since only a
few states direct their IDB funds to
economically troubled areas.
Similarly, IDBs were originally
intended to diversify local economies,

••

4. See Congressional Budget Office, Small Issue
Industrial Revenue Bonds, Washington: U.S.
Government Printing Office, September 1981,
p. 41, n. 5.

5. See U.S. Department of the Treasury, Office
of Tax Analysis, Treasury Report on Private Purpose Tax-Exempt Bond Activity during Calendar
Year 1983, March 28, 1984, p. 2.

6. To reduce transactions costs, most IDBs are
privately placed with banks and other local investors, not sold on organized exchanges. Short of
contacting each of these investors individually,
establishing the magnitude of IDB sales prior to
1982 is difficult. This lack of historical data has
hampered research into the impact of IDBs in
a variety of areas, including interest rates.