Overview

The federal tax code classifies state and local government bonds as either governmental bonds or private activity bonds. However, the federal tax code allows state and local governments to use tax-exempt bonds to finance certain projects that would otherwise be classified as private activities. The private activities that can be financed with tax-exempt bonds are called "qualified private activities." Generally, Congress limits the amount of tax-exempt debt that can be used for private activities and restricts the type of private activities that can be financed with tax-exempt bonds. Congress can, and does, encourage selected private activities by exempting the activity from the volume cap or by allowing tax-exempt financing for the private activity. For more on tax-exempt bonds generally, see CRS Report RL30638, Tax-Exempt Bonds: A Description of State and Local Government Debt , by [author name scrubbed]. What Is a Private Activity Bond? A private activity bond is one that primarily benefits or is used by a private entity. Bonds are private activity bonds and not tax-exempt if both of the following conditions are met:
(1) [use test] more than 10% of the proceeds of the issue are to be used for any private business use ,... [and]
(2) [security test] if the payment on the principal of, or the interest on, more than 10% of the proceeds of such issue is (under the terms of such issue or any underlying arrangement) directly or indirectly—
(A) secured by any interest in 
(i) property used or to be used for a private business use, or 
(ii) payments in respect to such property, or 
(B) Or [if the payment is] to be derived from payments (whether or not to the issuer) in respect of property, or borrowed money, used or to be used for a private business use. What Are the Qualified Private Activities? A number of qualified private activities are granted special status in the tax code (see Table 2 ). The list of qualified private activities has gradually expanded to 27 activities from the 12 that were originally defined by the Revenue and Expenditure Control Act of 1968. The national limit is $15 billion and the bonds are not subject to state volume caps for private activity bonds. Many economic development projects would not qualify absent this ARRA provision. The annual cap was increased from the greater of $50 per capita or $150 million in 2000, to the greater of $105 per capita or $311.38 million in 2018 (and is adjusted annually for inflation). Figure 1 provides a comparative measure of the state-by-state volume capacity based on 2016 state personal income.
The federal tax code classifies state and local bonds as either governmental bonds or private activity bonds. Governmental bonds are intended for governmental projects, and private activity bonds are for projects that primarily benefit private entities. Typically, the interest earned by holders of governmental bonds is exempt from federal income taxes.
The federal tax code allows state and local governments to use tax-exempt bonds to finance certain projects that would be considered private activities. The private activities that can be financed with tax-exempt bonds are called "qualified private activities." Congress uses an annual state volume cap to limit the amount of tax-exempt bond financing generally and restricts the types of qualified private activities that would qualify for tax-exempt financing to selected projects defined in the tax code.
The economic rationale for the federal limitation on tax-exempt bonds for private activities stems from the inefficiency of the mechanism to subsidize private activity and the lack of congressional control of the subsidy absent a limitation. This report explains the rules governing qualified private activity bonds, describes the federal limitations on private activity bonds, lists the qualified private activities, and reports each state's private activity bond volume cap.
Since private activity bonds were defined in 1968, the number of eligible private activities has been gradually increased from 12 activities to 27. The state volume capacity limit has increased from $150 million and $50 per capita in 1986 to the greater of $311.38 million or $105 per capita in 2018. Because of the $311.38 million floor, many smaller states are allowed to issue relatively more private activity bonds (based on the level of state personal income) than larger states. Also, more recent additions to the list of qualified activities have been exempt from a state-by-state cap and subject to a national aggregate cap.
For more on tax-exempt bonds generally, see CRS Report RL30638, Tax-Exempt Bonds: A Description of State and Local Government Debt, by [author name scrubbed]. This report will be updated as legislative events warrant.