CRS DISCUSSES DEFICIT TARGETS, NATIONAL SAVINGS, AND SOCIAL SECURITY.

CRS REPORT FOR CONGRESS

The Omnibus Budget Reconciliation Act of 1987 restricted the authority of State and local governments to issue tax-exempt bonds to finance the purchase (takeover) of nongovernmentally-owned output facilities. Three policy issues fueled this debate: the potential Federal revenue loss from tax-exempt bonds issued to finance takeovers; whether State and local provision of utility services generates benefits for Federal taxpayers, thereby satisfying a public purpose; and whether tax-exempt financing is necessary to preserve a takeover threat that inhibits monopoly pricing by private utilities. This report describes the legislation and provides an economic analysis of the policy issues.

                               By: Dennis Zimmerman

LEGISLATION

THE FEDERAL REVENUE LOSS

THE DEBATE OVER PUBLIC PURPOSE AND PRIVATIZATION

MONOPOLY PRICING

SUMMARY

TAX-EXEMPT BOND-FINANCED TAKEOVER OF INVESTOR-OWNED UTILITIES: AN ISSUE OF PRIVATIZATION AND COMPETITION

The appropriate division of responsibilities among the public, private, and nonprofit sectors has become a subject of considerable debate. Private sector claims of unfair competition from both the public sector and tax-exempt organizations have led to calls for "privatization" of some activities (moving the provision of some public services to the private sector) and a reduction of Federal tax subsidies for others.

Local government efforts to take over the provision of electric and gas utility services from the private sector runs counter to the "privatization" effort. The Omnibus Budget Reconciliation Act of 1987 (Public Law 100-203) restricted the authority of State and local governments to issue tax-exempt bonds to finance the purchase (takeover) of nongovernmentally-owned output facilities. Although this output-facilities restriction was supported by the private utility industry, it was adamantly opposed by the public power industry and many State and local officials. The opponents have not conceded the issue, and are considering the introduction of legislation to repeal this provision. ¹

Three policy issues fueled the 1987 debate: the potential Federal revenue loss from tax-exempt bonds issued to finance takeovers; whether State and local provision of utility services generates benefits for Federal taxpayers, thereby satisfying a public purpose; and whether tax-exempt financing is necessary to preserve a takeover threat that inhibits monopoly pricing by private utilities. This report describes the 1987 legislation and provides an economic analysis of the policy issues. ²

LEGISLATION

Under the law which prevailed prior to the Omnibus Budget Reconciliation Act of 1987, State and local governments were permitted to issue tax-exempt bonds to finance the construction, acquisition, or operation of output facilities that were to be GOVERNMENTALLY OWNED. This authority encompassed the purchase of existing output facilities from nongovernmental entities. Such purchases converted private utilities into governmentally owned public utilities and made them eligible for tax-exempt financing. The only restrictions on this authority concerned limitations on the amount of the proceeds devoted to private use (referred to as nonqualified proceeds, see Internal Revenue Code section 141(b)(4)).

The 1987 Act narrows the ability of State and local governments to provide tax-exempt financing for utility customers through the purchase of output facilities owned by the private, nonprofit, or Federal sectors. The bonds issued for the purchase of such facilities (generating, transmission, distribution, and other related facilities) are now considered to be TAXABLE private activity bonds.

An exception is provided if the bonds are issued to acquire facilities for electric energy or gas. In this case, the bonds are TAX-EXEMPT provided they receive an allotment from the State private- activity bond volume cap. As of 1988, these annual volume caps are $50 per capita for each State. Given the cost of most utility takeovers, a significant portion of the volume cap would have to be allocated for a utility takeover. State and local government officials must now decide whether their taxpayers value the benefits of utility takeover more than they value the benefits from using the allotted bond volume for other activities.

Two exceptions are provided that would allow the issuance of tax-exempt bonds to acquire nongovernmental output property without recourse to the private activity bond volume cap. First, the acquisition of output property may be financed with tax-exempt bonds if the acquisition is used to satisfy increased demand WITHIN a service area that has been served by the acquiring governmental unit for at least ten years. A public utility that experienced increased demand due to sales outside its usual service area could not use this increased demand as justification for acquisition of nongovernmental output property financed with tax-exempt bonds not subject to the volume cap.

Second, tax-exempt financing outside the volume cap is permissible if the purpose is to extend utility service to areas acquired through annexation. The annexation must be for general governmental purposes, as determined by transfer of voting registration and property tax rolls, and the extension of general governmental services to the annexed area. To qualify, the annexed areas must not exceed ten percent of the prior geographic area of the governmental unit OR the increased output capacity must not exceed ten percent of prior output capacity.

THE FEDERAL REVENUE LOSS

Many State and local officials believe that the legislation passed in 1982, 1984, and 1986 that restricted tax-exempt bond volume was motivated primarily by the desire of the Federal Government to reduce Federal revenue losses and reduce the deficit. ³ To counteract such sentiment, the American Public Power Association argued during deliberations over the 1987 Act that, rather than costing the Federal Government revenues, takeovers actually would increase Federal revenues.

(. . .) reduced electric rates lead to increased discretionary income for consumers and additional capital for new investment in plants and equipment. The resulting increased payrolls (and thus, increased tax revenue) and reduced Federal welfare and unemployment costs more than compensate for the revenue loss from further issuance of tax-exempt bonds for even a large public takeover. ⁴

This type of argument is used by proponents of a wide variety of Federal subsidies. It may even be true in the limited context in which it is presented. Lower utility prices will increase the real incomes of utility consumers and may even lead to some of the effects claimed in the remainder of the quotation.

But this argument is arguably incorrect and misleading because it ignores the part of the calculation that is detrimental to the public utilities' case. When placed in the context of the entire economy a very different result emerges.

One must ask what the foregone Federal revenues (that make the price reduction possible) would have been used for if they had not subsidized a utility takeover. Would they have lain idle? Of course not. Either taxes would have been lower and after-tax disposable incomes higher, or the Federal Government would have used the money to subsidize some other activity. In either case, all the beneficial things talked about in the quotation would have occurred in some other industry or activity. These foregone benefits represent the costs from Federal subsidy of a takeover, and must be subtracted from the benefits identified in the quotation to arrive at a measure of net benefits It is very unlikely that a net benefit would result from such a calculation. ⁵

THE DEBATE OVER PUBLIC PURPOSE AND PRIVATIZATION

More fundamental issues of public policy are at work here. This section examines this output-facilities provision for consistency with the developing Federal view of what activities satisfy a public purpose and what activities might be considered for privatization.

First, it is necessary to deal with the issue of whether an economic case can be made that electricity (or gas) must be produced by the public sector. In economic terms, electric and gas utility services do not possess the characteristics that require provision by the public sector. ⁶ So, as a first approximation, one might say that electricity or gas can be produced by the private sector.

Second, are there complications that may require public provision because the private sector does not produce the correct amount at the correct price? Several possibilities come to mind. There may be some costs associated with the production of electricity (such as pollution of various sorts) that are imposed on society as a whole, and for which the decisions of private producers and consumers do not account; there may be some concerns that reliance on a sole provider for a geographic area (as a cost-minimizing strategy) may enable the provider to engage in monopoly pricing; and there may be concerns that a private producer may not find it profitable to provide the universal service that society deems to be fair at a cost that is affordable to geographically isolated consumers.

These three concerns can in principle be addressed with appropriate governmental regulation of private industry rather than government production. In other words, economic factors do not require public provision in order that the socially desirable amount of electricity be provided. Nonetheless, the determination of public provision versus public regulation is sufficiently subjective that the definition of what constitutes a public service rather than a private good cannot be precisely specified.

This decision is further complicated in the context of the federal system of government in the United States. The subjective judgment of taxpayers in a State or a local region may be that public provision of electricity is justified. This does not, however, necessarily imply that it makes sense for the Federal Government to tax its taxpayers to help pay for this State or local decision. Federal subsidy would only be justified if a portion of the benefits for society from public provision accrues to taxpayers who reside outside the State or local area providing the service. If such spillovers do not exist, then a Federal subsidy has the effect of redistributing income geographically, which is probably not the intent of the subsidy.

Given this technical background, one must note that Congress has been engaged in a twenty-year effort to restrict the tax exemption privilege to the provision of goods and services that satisfy its conception of public services. This effort has generated a substantial amount of legislation to restrict bond issuance to those public services traditionally provided by the State and local sector. ⁷

Well, one might ask, is it not true that electricity historically has been provided by both the private and public sectors, even though it is obvious that utility services are amenable to private provision? The answer, clearly, is yes. And this legislation continues to provide Federal financial support for most such activities.

First, those governments that have a tradition of public provision of utility services can continue to finance the purchase of privately-owned electric and gas output facilities with tax-exempt bonds. Allowances were made for those governments to expand their capacity as demand grows because of population growth or political annexation. Second, the legislation does not prohibit the use of tax- exempt bonds by any jurisdiction for the construction of NEW output facilities that are to be publicly owned and perhaps competitive with privately-owned facilities.

But at the same time, the Congress seems reluctant to allow Federal financial support to be extended to those parts of the country that have historically had utility services provided through the private sector. As a small step in that direction, the 1987 legislation says that if a State or local government in such an area wants to provide electricity or gas by purchasing nongovernmentally- owned output facilities (rather than constructing new facilities), the Federal Government will not provide any financial support unless State and local taxpayers agree to use part of their allowable private activity bond volume. Note that Congress did not prohibit State and local officials from deciding that electricity or gas generation is a legitimate public activity for the State and local sector; Congress simply said that the Federal taxpayer receives inadequate benefits to justify unrestricted access to a Federal subsidy.

MONOPOLY PRICING

The complaint of interested consumer groups and some in the public power industry is that the output-facilities legislation eliminates the threat of public takeover as an incentive for investor-owned utilities to avoid monopolistic pricing. This suggests that, without tax-exempt financing, the takeover by municipalities of some investor-owned output facilities would be economically infeasible. What is not clear is why the takeover of an investor- owned utility practicing monopolistic pricing depends upon the use of tax-exempt bonds. A public authority can always go to the taxable market for capital.

An examination of possible municipal behavior upon removal of the capital cost advantage provided by tax-exempt bonds can help to clarify the issue. A takeover decision financed with taxable bonds implies that the takeover remains advantageous to all local taxpayers, which implies the existence of monopoly pricing (assuming neither the public nor private sectors possess operating cost advantages) . All taxpayers would benefit from the lower prices a takeover would bring.

In contrast, a switch to a no-takeover decision implies that the investor-owned utility threatened with municipal takeover is not engaging in monopoly pricing. In such circumstances, a no-takeover decision is precisely the conclusion that the Congress is hoping will be reached.

It is, of course, possible that a local government might still decide in favor of takeover even if monopoly pricing is not present. This is, however, less likely without tax-exempt financing because it cannot be advantageous to all local taxpayers. Such a takeover would subsidize local taxpayers as a function of their utility consumption and tax local taxpayers as a function of the tax structure. Who knows which citizens would be the winners and which citizens would be the losers? In contrast, with tax-exempt financing, local officials still have a powerful incentive to go ahead with a takeover because all local taxpayers can benefit from the lower price made possible by the tax-exempt financing. Federal taxpayers are placed in the position of paying for lower utility prices for select groups of local taxpayers without the compensating social gain of monopoly price elimination.

Even if investor-owned utilities are practicing monopoliatic pricing behavior, it is not clear that public takeover financed with tax-exempt bonds is the reasonable policy response. Are not regulators supposed to keep track of utility pricing? If regulation is not working to prevent monopoly pricing, it is properly a State and local problem. Solving the problem of an artifcially high price caused by monopolistic price setting my be better handled by the regulatory process than by Federal subsidy of selected groups of local taxpayers without compensating benefits to Federal taxpayers.

SUMMARY

The Omnibus Budget Reconciliation Act of 1987 included a tax- exempt bond provision that addressed the issue of the appropriate Federal role in the provision of utility services. This report discussed three policy issues that arose in the debate over placing limitations on tax-exempt bond-financed public takeover of investor- owned output facilities.

First, it is very unlikely that utility takeovers generate more Federal revenue from increased economic activity than they cost in foregone tax revenue on the exempt interest income. Assertions of Federal revenue gain are fundamentally flawed because they ignore the alternative uses to which the Federal subsidy could be put, thereby seriously overstating the net gain to Federal revenues.

Second, the economic characteristics of electricity and gas provision are fully consistent with private provision. It is, however, possible that the private sector may not provide the correct amounts at the correct price due to pollution costs, monopoly pricing, or unwillingness to provide universal service. All of these difficulties may be more easily handled through the regulatory process, however, rather than through public provision. And a decision by local government to provide utility services does not necessarily imply there are national benefits to justify Federal subsidy.

Given these economic considerations, the output-facilities provision in the 1987 Act is consistent with congressional efforts over the last twenty years to restrict the use of tax-exempt bonds to traditional State and local public purposes. Even this provision is not very restrictive -- tax-exempt bonds can still be issued for construction of new facilities without restriction, and allowance is made for jurisdictions that already provide utility services to use tax-exempt bonds to purchase facilities to satisfy increased demand due to population growth or annexation.

The exception for new construction and the denial of tax-exempt financing for acquisitions are arguably not consistent policies. This differential treatment may cause a local government to choose tax- exempt financing for new facilities rather than the acquisition of nongovernmentally-owned facilities. If State and local provision of electricity and gas is not considered a reasonable activity for the Federal Government to support financially, tax-exempt financing for new construction of facilities would seem questionable. If public power financing comes before the Congress again, this dichotomy in treatment may become an important issue.

Third, use of tax-exempt bonds is not essential to preserve the threat of a public takeover as an incentive for investor-owned utilities to avoid monopolistic pricing. Taxable-financed takeovers are also effective and are far less likely to encourage inefficient economic decisions. If a takeover is economically infeasible without tax-exempt bonds, this suggests that monopoly pricing is not a problem. If this is true, allowing tax-exempt financing for such takeovers means that Federal taxpayers are paying for the lower utility prices of consumers in a select local ares and, presumably, receiving few, if any, benefits in return.

² The analysis in this report ignores the constitutional argument against taxation of any interest income from State and local bonds, whatever their purpose. The legal justification for exemption rests on specific statutory exclusion of such income by Congress. Some claim that, absent such an exclusion, interest income would still be exempt as a matter of comity between the Federal and State and local governments, just as interest on Federal securities is exempt from State and local income taxation. The Supreme Court has never decided the question of the constitutional right of Congress to delete the statutory exclusion and tax the interest income. See U.S. Department of Treasury. Office of State and Local Finance. Federal- State-Local Fiscal Relations, Report to the President and the Congress. September 1985, p. 284.

³ For a discussion of th;s issue, see U.S. Library of Congress. Congressional Research Service. Tax-Exempt Bonds and Twenty Years of Tax Reform: Controlling Public Subsidy of Private Activities. Report No. 87-922 E, by Dennis Zimmerman. Washington, 1987.

⁴ American Public Power Association. Talking Points on Section 10173. Undated. p. 2.

⁵ For a more complete discussion of this issue, see U.S. Library of Congress. Congressional Research Service. Limiting the Growth of Tax-Exempt Industrial Development Bonds: An Economic Evaluation. Report No. 84-37 E, by Dennis Zimmerman. Washington, 1984. Chapter II, pp. 9-12.

⁶ A good that requires public provision possesses two essential characteristics: (1) consumption cannot be denied to those unwilling to pay for the good (like national defense, which once provided can be consumed whether or not an individual pays for it); and (2) one family's consumption of a unit of the good does not prevent another family from using that unit (again like national defense).

⁷ This issue is discussed more completely in Congressional Research Service. Tax-Exempt Bonds and Twenty Years of Tax Reform . . . (see note 3).