	Background

Tax-exempt bonds are valid debt obligations of state and local  governments. This means that the interest paid to bondholders is generally  not included in their gross income for federal income tax purposes. While both governmental and qualified private activity bonds reached  historically high levels recently, the amount of governmental bonds issued  annually has fluctuated to a greater extent. Tax-exempt bond issuers tend to issue more debt when interest rates  decline. The Estimated Revenue Loss from Outstanding Tax-Exempt Bonds Is One of the Largest Federal Tax Expenditures

Because the interest earned by investors who purchase tax-exempt bonds  is generally excluded from federal income taxes, the federal government  incurs a revenue loss each year. Tax-Exempt Bonds Are Used to Finance a Wide Range of Facilities and Activities

Tax-exempt governmental and private activity bonds are used to finance a  wide range of facilities and activities, primarily in support of the entity  responsible for paying the bond debt service. Although Study Results Varied, Most Studies Generally Found That Competitive Bond Sales Have Lower Interest Costs after Controlling for Other Factors

Researchers have attempted to determine whether the method of sale (i.e.,  competition between underwriters or negotiation with underwriters) has  an effect on the interest costs that bond issuers pay investors. Some Qualified Private Activity Bond Issuers Reported Issuance Costs Exceeding Legal Limits, and Issuance Costs Vary Depending on Bond Characteristics

IRS requires qualified private activity bond issuers to report issuance costs  paid from bond proceeds on the Form 8038, and for most types of private  activity bonds, issuance costs that can be paid from bond proceeds are  limited to 2 percent of bond proceeds. Median issuance costs as a  percentage of bond proceeds for governmental bonds issued for amounts  greater than $100 million were about 0.6 percent from 2002 to 2005. Appendix I: Objectives, Scope, and Methodology

The objectives of this report were to (1) describe recent trends in the  dollar volume of tax-exempt bonds; (2) provide information on the types  of facilities and activities that are financed with tax-exempt bonds, in  particular, information on hotels and municipal golf courses that were  recently financed with tax-exempt bonds; and (3) provide information on  borrowing costs that bond issuers pay when issuing bonds by summarizing  relevant research on whether bond interest costs vary by the method of  sale, considering characteristics of the bond and bond issuer and provide  information on how bond issuance costs vary between governmental and  private activity bonds, including the extent to which private activity bond  issuers exceed the statutory limit for issuance costs as a percentage of  bond proceeds. We used SOI data from 1991 through 2005, the most recently available  data, to provide information on the overall volume of tax-exempt bonds  issued, the volume of governmental and private activity bonds issued, and  the volume of new money versus refunding bonds issued. IRS publishes descriptive statistics from these forms.
Why GAO Did This Study

The outstanding amount of state and local government tax-exempt bonds has increased over the years. Congress is interested in whether the bonds are used for appropriate purposes since the federal government forgoes billions in tax revenues annually by excluding the bonds' interest from investors' federal gross income. Questions also exist over the bonds' borrowing costs as they can divert funds from the funded projects. This report (1) describes recent trends in tax exempt bonds, (2) provides information on the types of facilities financed with tax-exempt bonds, and (3) discusses borrowing costs considering the methods of selling bonds and compares issuance costs paid from bond proceeds for governmental and qualified private activity bonds. In addition to interviewing relevant officials, we analyzed IRS's Statistics of Income (SOI) data and data from Thomson Financial to address these objectives.

What GAO Found

In recent years, the volume of tax-exempt bonds issued annually for both governmental and private activity bonds has reached historically high levels. Generally, the volume of new money bond issues has been greater than bonds issued for refunding purposes. The volume of tax-exempt bonds issued, particularly bonds issued for refunding, tends to be highest when interest rates decline. Because the interest earned by investors who purchase tax bonds is generally excluded from federal income taxes, the federal revenue losses amount to billions of dollars annually. Tax-exempt governmental and private activity bonds are used to finance a wide range of projects and activities, with bonds issued for "educational purposes" generally being the largest category of governmental bonds annually. Nonprofit organizations are the largest issuers of qualified private activity bonds. Previous legislation prohibited using qualified private activity bonds for certain facilities, including professional sports stadiums, hotels, and private golf courses. However, many of these types of facilities are still being financed with tax-exempt governmental bonds. Congress has held hearings on this issue primarily focusing on sports stadiums. Although the evidence is not definitive, studies have generally shown that interest costs are lower for bonds sold when competition between underwriters exists compared to when bond sales are negotiated with underwriters after controlling for other factors. About half of all issuers of qualified private activity bonds reported paying issuance costs from bond proceeds from 2002 to 2005. IRS's guidance does not indicate what to report when no issuance costs are paid from bond proceeds. Of those reporting issuance costs, some private activity bond issuers reported paying issuance costs from bond proceeds that exceed statutory limits.