Individuals and businesses lend their accumulated savings to borrowers. The federal government intervenes in the public capital market by granting the debt instruments of state and local governments a unique privilege—the exemption of interest income earned on these bonds from federal income tax. The tax exemption lowers the cost of capital for state and local governments, which should then induce an increase in state and local capital formation. Since state and local taxpayers are likely to be unwilling to provide these services to nonresidents without compensation, it is probable that state and local services will be under provided. Total Debt Outstanding

State and local governments were estimated to have $3.043 trillion in debt issuances outstanding at the end of the third quarter in 2017. Classifying State and Local Debt Instruments

State and local debt can be classified based on (1) the maturity (or term), which is the length of time before the principal is repaid; (2) the type of security , which is the financial backing for the debt; (3) the use of the proceeds for either new facilities or to refinance previously issued bonds; and (4) whether the type of activity being financed has a public or a private purpose. All tax-exempt interest income attributable to state and local governments does not appear in the form of bonds. New issues represent bonds issued to finance new capital facilities. Advance refunding bonds are issued prior to the date on which the original bonds are refunded, so that for a period of time there are two bond issues outstanding to finance the same capital facilities. The 2017 tax revision ( P.L. These selected activities can be financed with tax-exempt bonds. Table 2 provides the dollar value of new issues of tax-exempt private-activity bonds and their share of total private-activity volume capacity for 2014 and 2015. Private Activities Eligible for Tax Exemption

All tax-exempt private-activity bonds are subject to restrictions that do not apply to governmental bonds, chief among them was the now-repealed ability to issue advance refundings and the inclusion of the interest income in the alternative minimum income tax base. Bonds issued for several activities classified as private are not subject to the volume cap if the facilities are governmentally owned. Many individuals and businesses make money by engaging in arbitrage, borrowing money at one interest rate and lending that borrowed money to others at a higher interest rate. State and local governments do not pay federal income tax, and absent federal constraint, have unlimited capacity to issue debt at low interest rates and reinvest the bond proceeds in higher-yielding taxable debt instruments, thereby earning arbitrage profits. Unchecked, state and local governments could substitute arbitrage earnings for a substantial portion of their own citizens' tax effort. Congress has decided that such arbitrage should be limited, and that tax-exempt bond proceeds must be used as quickly as possible to pay contractors for the construction of the capital facilities for which the bonds were issued. Tax Credit Bonds (TCBs) are an alternative to tax-exempt bonds that offer investors a federal tax credit or the issuer a direct payment proportional to the bond's value in lieu of a federal tax exemption. The 2017 tax revision ( P.L. 115-97 ) repealed the authority to issue new TCBs after December 31, 2017. For more information on tax credit bonds, see CRS Report R40523, Tax Credit Bonds: Overview and Analysis . 1 ) that was passed in the House included provisions that would repeal authority to issue PABs and eliminate the use of tax-exempt bonds to fund professional sports stadiums. The direction of future changes to the federal tax code will likely dictate which modifications, if any, are made to the tax treatment of state and local government debt.
This report provides information about state and local government debt. State and local governments issue debt instruments in exchange for the use of individuals' and businesses' savings. This debt obligates state and local governments to make interest payments for the use of these savings and to repay, at some time in the future, the amount borrowed. State and local governments may finance capital facilities with debt rather than out of current tax revenue to more closely align benefits and tax payments. There was just over $3 trillion in state and local debt outstanding in the third quarter of 2017.
The federal government subsidizes the cost of most state and local debt by excluding the interest income from federal income taxation. This tax exemption is granted in part because it is believed that state and local capital facilities will be underprovided if state and local taxpayers have to pay the full cost. The federal government also provides a tax preference through tax credit bonds (TCBs), which either provide investors with a federal tax credit in lieu of interest payments or a direct payment to the issuer. P.L. 115-97, the 2017 tax revision, repealed the authority to issue TCBs beginning in 2018. For more on TCBs, see CRS Report R40523, Tax Credit Bonds: Overview and Analysis.
State and local debt is issued as bonds, to be repaid over a period of time greater than one year and perhaps exceeding 20 years, and as notes, to be repaid within one year. General obligation bonds are secured by the promise to repay with general tax revenue, and revenue bonds are secured with the promise to use a specific stream of tax revenue. Most debt is issued to finance new capital facilities, but some is issued to refund a prior bond issue (usually to take advantage of lower interest rates). Tax-exempt bonds issued for some activities are classified as governmental bonds and can be issued without federal constraint because most of the benefits from the capital facilities are enjoyed by the general public. Many tax-exempt revenue bonds are issued for activities Congress has classified as private because most of the benefits from the activities appear to be enjoyed by private individuals and businesses. The annual volume of a subset of these tax-exempt private-activity bonds (PABs) is capped. For more on private activity bonds, see CRS Report RL31457, Private Activity Bonds: An Introduction.
Arbitrage bonds devote a substantial share of the proceeds to the purchase of assets with higher interest rates than that being paid on the tax-exempt bonds. Such arbitrage bonds are not tax exempt because Congress does not want state and local governments to issue tax-exempt bonds and use the proceeds to earn arbitrage profits. The arbitrage profits could substitute for state and local taxes.
A number of tax reform proposals have been introduced that would modify the tax treatment of state and local government bonds. Another policy issue is whether constraints should be relaxed on the types of activities, such as infrastructure spending, for which entities can issue tax-exempt debt. The list of activities that classify tax-exempt private-activity bonds—and whether they should be included in the volume cap—is another area of potential change or reform. The 2017 tax revision repealed authority to issue TCBs and advanced refunding bonds, but did not otherwise modify tax-exempt bonds or PABs.