CRS STUDY ANALYZES TAX REFORM'S IMPACT ON STATE AND LOCAL TAXATION AND SPENDING.

CRS Report for Congress No. 87-233 E

This report discusses the 1986 Tax Reform Act's potential effects on the level of State local spending, State tax structures, interstate tax competition, and State and local use of tax-exempt bonds.

                          Dennis Zimmerman

LIST OF TABLES

TABLE 1. An Index of Pressure on State Officials to Change State Tax Structures Due to the Linkage between Federal and State Income Taxes: CRS Calculations Based on ACIR Estimates of the Tax Reform Act of 1986

TABLE 2. Public Attitudes on the Size of the Public Sector and the Choice of State Taxes to be Increased

TABLE 3. The Effect of the Tax Reform Act of 1986 on the After- Federal-Tax Price of the Sales Tax Relative to Other Deductible Taxes

TABLE 4. Differential between Each State's Top Effective Marginal Income Tax Rate and the Average Top Effective Income Tax Rate for All States: Before and After the Tax Reform Act of 1986

TABLE 5. Reduction in Volume Cap for Private Activity Tax-Exempt Bonds Due to the Deficit Reduction Act of 1984 and Tax Reform Act of 1986

TAX REFORM: ITS POTENTIAL EFFECT ON THE STATE AND LOCAL SECTOR

The Tax Reform Act of 1986 had two major themes. The first theme was to swap rate reduction for broadened (more comprehensive) individual and corporate tax bases. The second major theme was simplification, which evolved into the removal of low-income taxpayers from the individual income tax system and a substantial reduction in the percentage of remaining taxpayers who find it financially worthwhile to itemize.

Both of these themes have potential consequences for the State and local sector in a number of important areas. Some have expressed concern that the level of State and local spending will decline; others have suggested that spending will increase. A careful examination of the Tax Reform Act turns up changes which are consistent with both interpretations. It is also possible that provisions of the Tax Reform Act could cause State and local governments to restructure their tax systems to rely less heavily on sales tax revenues and more heavily on other tax sources. Some changes in the Federal tax law can also be expected to cause businesses and individuals to reexamine interstate differences in tax structures with an eye toward making tax-motivated locational decisions. Finally, the extensive revisions in the tax treatment of tax-exempt bonds may affect State and local governmental use of these bonds.

This report discusses the potential effects of the Tax Reform Act's changes in the individual income tax on the level of State and local spending, State tax structures, interstate tax competition, and State and local use of tax-exempt bonds. ¹ The purpose of the report is to explain how these changes may affect the State and local sector and to provide some information which can be used to understand how important the changes may be.

THE LEVEL OF STATE AND LOCAL SPENDING

Several aspects of the Federal individual income tax system influence the willingness of State and local taxpayers to pay State and local taxes and support State and local spending. Several changes made by the Tax Reform Act make State and local taxpayers less willing to maintain the same level of spending; other changes may result in a higher level of spending. This section describes the relevant parts of the Federal Law and evaluates the possible effect on the level of State and local spending.

Decisions about the level of State and local government spending depend partially upon economic factors. Two of the most important of these economic factors are the after-Federal-tax cost to a jurisdiction's taxpayers of a dollar of State and local tax and the linkage between a State's tax base and the Federal tax base.

AFTER-FEDERAL-TAX COST OF A STATE OR LOCAL TAX DOLLAR

The discussion begins with the after-Federal-tax cost of a State or local tax dollar. The Tax Reform Act made three changes which will increase this tax cost: (1) statutory tax rates were lowered; (2) the percentage of taxpayers who itemize was reduced; and (3) the deductibility of the sales tax was eliminated. This cost increase can be expected to make taxpayers desire a lower level of public spending. However, the information currently available suggests the magnitude of the desired spending reduction is likely to be small in most States.

For a taxpayer who itemizes deductions, the after-Federal-tax cost of a deductible State and local tax dollar equals one minus his Federal marginal tax rate. Prior to 1987, a taxpayer with the top Federal marginal tax rate of 50 percent had a cost of $.50 for his State and local tax dollar because his Federal tax bill was reduced by $.50. Since a lower cost or price is usually accompanied by a desire to purchase more of the relatively less expensive good, deductibility is thought to increase the level of State and local spending. When the Tax Reform Act's 28 percent top tax rate is fully phased in, the same taxpayer will have an after-Federal-tax cost of $.72 for his State and local tax dollar. Thus, the reduction of Federal statutory tax rates has the effect of raising the cost to the state and local taxpayer of financing public services.

In any political jurisdiction, decisions about spending levels are made collectively with varying degrees of citizen input. Only those taxpayers who itemize on their Federal tax returns experience a cost reduction from State and local tax deductibility, and only those taxpayers will experience the cost increase just described. Thus, the average tax price for a jurisdiction's citizens is dependent on the percentage of its taxpayers who itemize on their Federal tax returns. The Tax Reform Act has the effect of reducing the percentage of taxpayers who itemize, which effectively raises their State and local tax cost to one dollar. (The top-rate taxpayer referred to above, were he to become a nonitemizer, would have his tax cost raised from $.50 to $1.00 instead of from $.50 to $.72). As the percentage of itemizers declines, the average tax price for the community as a whole increases, and the desire for a lower level of public spending increases.

Finally, the Tax Reform Act eliminated the deductibility of sales taxes and raised the sales tax cost to $1.00 for all State and local taxpayers, whether or not they are itemizers. This change also has the effect of causing State and local taxpayers to decrease the level of public spending in those States that levy sales taxes.

Rough estimates of the effect of these three tax reform changes on the level of State and local spending by State have been made. ² The reduction in tax cost from deductibility is estimated to have raised State and local spending an average of three percent in 1982 above what it would otherwise have been. This increase above what spending would otherwise be is expected to decline to about one percent in 1987. This suggests a small reduction in State and local spending from the Tax Reform Act of about two percent. In only two States (Utah and Colorado) is the decline estimated to be as high as three percent.

LINKAGE BETWEEN FEDERAL AND STATE INCOME TAX BASES

The second economic factor directly affecting the level of public spending which is influenced by the Tax Reform Act is the linkage between State and Federal income tax bases. A major theme of tax reform was the broadening of the Federal income tax base. Those States with income tax bases linked to the Federal base definition may experience windfall revenue gains. Those states experiencing a windfall gain will automatically impose a tax increase and a larger public sector on their citizens if the State income tax structure is not adjusted. Those few States experiencing a windfall loss will automatically impose a tax decrease and a smaller public sector on their citizens if the State income tax structure is not adjusted. The information presented in this section suggests the potential increase in state spending from the linkage of income tax bases is relatively small, exceeding two percent for only 15 states, even if all the windfall gain were used to increase spending.

The Advisory Commission on Intergovernmental Relations has made preliminary estimates of the percentage increase or decrease in each State's individual income tax revenues due to its coupling with the Federal income tax system. ³ These estimates are presented in table 1, column 1. The importance of these changes in income tax revenue for State spending (in contrast to the importance for any individual's tax liabilities) depends upon how important income tax revenue is as a State revenue source. Accordingly, each State's individual income tax revenue as a percentage of general revenue is presented in column 2. Column 3 gives the expected percentage change in general revenue from the linkage of the two income tax systems (column 1 times column 2). Put in this context, the change in income tax revenue is not very substantial. The change exceeds 2 percent of general revenue in only 15 States. Thus, even if a State decided to spend the additional income tax revenue, the size of the public sector would not grow very much.

These data overstate the likely increase in public spending from this linkage. Public attitudes on the size of the public sector suggest these additional revenues are not likely to be spent, but rather returned to taxpayers. The Advisory Commission on Intergovernmental Relations commissions surveys of public attitudes on government finances. ⁴ These surveys report the responses of citizens in 1982, 1983 and 1986 to a series of questions on spending and taxing levels. The results of the relevant questions are summarized under Response in the top portion of table 2.

When citizens were asked to consider their public services and the taxes they pay, and then to choose which of four statements comes closest to their view, 42 percent of respondents in 1982 and 51 percent in 1986 chose "Keep taxes and services about where they are." In contrast, 36 percent and 31 percent of respondents chose "Decrease services and taxes." Finally, 8 percent and 9 percent of respondents chose "Increase services and taxes."

The pressure for changing the level of public spending implied by these attitudes is summarized under Pressure for change in table 2. These figures suggest that officials in jurisdictions experiencing windfall gains from tax reform will be subject to substantial pressure to return these tax revenues to citizens. Fully 82 percent of respondents in 1986 want either no change in the size of the public sector (51 percent) or want it to be smaller (31 percent). The pressure on officials of jurisdictions experiencing windfall losses to raise tax revenues will be less overwhelming but still quite substantial. In 1986, 60 percent of respondents want the public sector to either remain the same size (51 percent) or get larger (9 percent).

TABLE 1. An Index of Pressure on State Officials to Change State Tax Structures Due to the Linkage between Federal and State Income Taxes:

CRS Calculations Based on ACIR Estimates of the Tax Reform Act of 1986

                     (1)             (2)           (3)        (4)

Sources:

Column 1 -- Advisory Commission on Intergovernmental Relations. Preliminary Estimates of the Effect of the 1986 Federal Tax Reform Act on State Personal Income Tax Liabilities. Staff Information Report. December 8, 1986. Table 1.

Column 2 -- Advisory Commission on Intergovernmental Relations. Significant Features of Fiscal Federalism, 1985-86 Edition. Report M-146. Table 34.

Column 3 -- CRS calculation, column 2 times column 3.

Column 4 -- CRS calculation. The absolute value in column 3 divided by the average of the absolute values of column 3, the result multiplied by 100 times either .82 (for states experencing a revenue increase) or .60 (for states experiencing a revenue decrease).

TABLE 2. Public Attitudes on the Size of the Public Sector and the Choice of State Taxes to be Increased

                                      % of Respondents

/a/ Sum of Decrease and No change

/b/ Sum of Increase and No change

Source: Response and Which State Tax Should Be Raised? -- Advisory Commission on Intergovernmental Relations, "Changing Public Attitudes on Government and Taxes, 1986: A Commission Survey." Report S-15. 1986. Tables 10 and 23; Pressure for Change -- CRS calculations.

STATE TAX STRUCTURES

The linkage of State and Federal income tax bases and the change in the State and local taxpayer's after-Federal-tax cost of a State or local tax dollar also create incentives for altering tax structures. The effect of linkage on State tax structures is discussed first.

LINKAGE OF INCOME TAX BASES

The pressure to change State tax structures depends upon the importance of the income tax revenue change and the desire of citizens to change the level of spending. These two factors cause the pressure for a change in the tax structure to vary widely among the States. For those States experiencing a windfall gain, any decrease in tax revenues is most likely to be made by adjusting State income tax bases or tax rates in order to return the windfall to those taxpayers experiencing the increased State income tax liability. This means State tax structures would not change in terms of relative reliance on different tax bases. For those States experiencing a windfall loss that may need to raise revenues, survey responses indicate some preference for raising additional revenues from sales taxes. This means State tax structures are more likely to change in these States.

The estimates presented in table 1, column 4 attempt to gauge the degree of pressure that linkage of State and Federal income tax bases may impose upon the States. These CRS estimates combine the expected percentage change in general revenue with citizen views on public sector size to produce an Index of Tax Structure Pressure. An index of 100 would occur in a State experiencing the average linkage- induced percentage change in general tax revenues in which 100 percent of the citizens desire to maintain the same size or larger (smaller) public sector. As the index rises above 100, the pressure to alter the tax structure increases; as the index falls below 100, the pressure to alter the tax structure decreases. The actual calculation of this index is explained in the footnotes to the table.

The results in column 4 of table 1 show that the pressure to alter State tax structures is likely to vary considerably among the States. Nineteen States will experience no appreciable pressure from income tax linkage (index below 50) either because they do not have an income tax (note the 0 percent for Texas in column 1), or the linkage between their income tax and the Federal tax is very weak (note the 1.0 percent change in income tax revenues for Massachusetts in column 1), or income tax revenues constitute a very small percentage of their general revenues (note the 2.2 percent share of general revenue for New Hampshire in column 2). In contrast, three States whose income tax systems are closely linked to the Federal system and who rely heavily on income tax revenues have a pressure index exceeding 200 (Oregon, Colorado, and Minnesota). Another fifteen States have a pressure index exceeding 100. All of the States with an index above 100 can be expected to experience pressure to DECREASE taxes due to windfall gains.

The ACIR survey of public attitudes is also useful in gaining some insight into which of the two major State taxes, income or sales, is likely to be altered in response to linkage-induced tax pressure. In 1983, respondents were asked the question, "Suppose your State government must raise taxes substantially, which would be a better way to do it?" The results, summarized in Table 2, indicate that 57 percent chose the sales tax, 23 percent chose the income tax, and 20 percent had no opinion.

These results suggest the nine States experiencing a windfall loss from the income tax might turn to more intensive use of general sales taxes. The survey provides less guidance on the likely choice for those more numerous States experiencing a windfall gain from the income tax and desirous of cutting taxes. One cannot assume the respondents' choices among types of taxes would be identical if they had been asked about cutting taxes. If a State's tax structure prior to the 1986 Tax Act represented the desired combination of tax sources and distribution of tax liabilities among its citizens, it would be reasonable for the State to attempt to maintain that combination and distribution. This suggests that those States experiencing substantial pressure to reduce taxes may have an incentive to return the tax revenues to those citizens who would otherwise experience an increase in State tax payments. These tax decreases can be targeted by reducing either the tax base or tax rates of those groups experiencing the increase in State tax payments.

AFTER-FEDERAL-TAX COST OF STATE AND LOCAL TAX DOLLARS

State and local decisions concerning their tax structures may also be influenced by the after-Federal-tax cost of potential State and local tax sources. The elimination of sales tax deductibility raises its after-Federal-tax cost to one dollar. But the cost of the major alternative tax sources was also increased substantially by the reduced statutory Federal tax rates and the decrease in the number of itemizers. The result is that the cost of the sales tax compared to other major tax sources did not rise very much. When this small change in relative price is combined with some evidence suggesting that State use of sales taxes may not be very sensitive to price changes, this suggests that the change in the tax structure is likely to be small in most States.

Table 3 calculates the price of the sales tax and other deductible State and local taxes for the average itemizer before and after the tax reform. The price of a dollar of sales tax increases from 0.884 before tax reform to 1.00 after tax reform due to its move to nondeductibility status. This represents an increase in price of 13.12 percent. The price of other deductible taxes increases from 0.884 before tax reform to 0.921 after tax reform, an increase of 4.19 percent. The increase is due to both the reduction in marginal tax rates and the increase in the percentage of taxpayers who are nonitemizers.

The important measure for assessing the likely effect on tax structure is presented in the last column of the table. This presents the ratio of the sales tax price to the price of other deductible taxes before and after tax reform. This RELATIVE sales tax price increases by 8.6 percent, almost four points lower than the percentage increase in the sales tax considered alone. Thus, in spite of the elimination of the sales tax deduction, the increase in the relative price of sales taxes is relatively modest (less than 9 percent) because the reduced marginal tax rates and decreased numbers of itemizers act to increase the price of other deductible tax sources as well.

Given the relative price change, the effect on tax structure depends upon how important the relative tax price is to determination of tax structure. ⁵ Current research indicates that use of the income tax does seem to be sensitive to tax price, but that use of the sales tax may be insensitive to tax price. Thus, the modest change in relative price of the sales tax combined with its possible insensitivity to the price change suggests these factors may not cause a substantial change in the State and local sector's use of general sales taxes.

INTERSTATE TAX COMPETITION

Deductibility of State and local taxes has the effect of reducing effective State and local tax rate differentials, and reducing the influence of State and local tax structure on the locational decisions of individuals and businesses. The reduction in Federal statutory tax rates increases these State and local effective tax rate differentials, and may increase tax-motivated locational decisions. State and local officials may respond to these changes by bringing their tax rate structures into closer conformity with their neighboring States.

The importance of tax differentials to the locational decisions of individuals and businesses is a much-debated topic. The effect of these differentials depends upon a host of factors, including the geographic proximity of jurisdictions with different tax rates and the magnitude of the differences in tax costs compared to other non- tax cost differences. Numerous studies have been done which suggest that in some instances these tax differentials do matter. ⁶

TABLE 3. The Effect of the Tax Reform Act of 1986 on the After- Federal-Tax Price of the Sales Tax Relative to Other Deductible Taxes

                                    After-Federal-Tax Price

Deductibility of State and local taxes has the effect of reducing the difference between high and low statutory tax rates, such that effective tax rate differentials (net of Federal tax consequences) are narrowed. This narrowing of the effective State and local rate differentials makes State and local tax structures less important incentives for businesses and individuals to alter their locational decisions.

The reduction of Federal statutory tax rates has the effect of increasing the effective tax rates for deductible State and local taxes. In addition, the interjurisdictional differential between these effective tax rates is widened. Given the responsiveness of businesses and individuals to tax rate differentials, a widening of the differential may have the effect of increasing tax-motivated locational decisions. This would cause State and local officials to be more sensitive to the relationship between their tax structure and those of neighboring jurisdictions.

The effect of tax reform on interstate State individual income tax rate differentials is summarized in table 4. The first column lists the top State individual income tax rate. The second column calculates the State effective tax rate based on a pre-1987 top Federal statutory tax rate of 50 percent. The third column calculates this rate based on a top Federal statutory tax rate of 28 percent. Although the effective rate rises in each State (compare columns 2 and 3), the important issue for interstate tax competition is the effect on the interstate effective tax rate differentials. The difference between each State's effective tax rate and the average effective tax rate for all States is presented in column 4 for the old law and in column 5 for the new law. This difference has increased for all States (compare columns 4 and 5).

Although these data illustrate the point, they may understate its importance. The most important tax rate difference for any State is not with the average for all States, but with neighboring States that are likely to be competing for the same individuals and businesses. This point can be illustrated with reference to two obvious competitors like New York and New Jersey. Their rate differential under old law (see column 2) was 4.75 (6.50 for New York and 1.75 for New Jersey). Under new law, the rate differential (see column 3) rises to 6.84 (9.36 for New York and 2.52 for New Jersey). New York's rate differential with New Jersey has risen by 2.09 points (6.84 minus 4.75). If one relied only on the State average data in columns 4 and

TABLE 4. Differential between Each State's Top Effective Marginal Income Tax Rate and the Average Top Effective Income Tax Rate for All States: Before and After the Tax Reform Act of 1986

                Top statutory    Effective         Difference between

/a/ Uses the rate which is expected to prevail in 1987.

/b/ Assumes 50 percent Federal rate for old law, 28 percent Federal rate for new law.

na -- Not applicable; State does not have an income tax system.

Source: Statutory rates in column 1 from: Advisory Commission on Intergovernmental Relations. Significant Features of Fiscal Federalism, 1985-1986. Report M-146. February 1986. Table 56, p. 80- 85. Columns 2 through 5: CRS calculations.

5, New York's rate differential would appear to increase only by 0.91 points (column 5 minus-column 4).

In the short run, these increased effective rate differentials would tend to increase tax-motivated locational decisions. One would expect State and local governments to react by altering their tax structures to maintain the original tax rate differentials.

STATE AND LOCAL USE OF TAX-EXEMPT BONDS

The Tax Reform Act of 1986 made many changes in the treatment of tax-exempt bonds. The range of activities for which State and local governments can issue unrestricted amounts of tax-exempt bonds (now known as governmental bonds) is affected by new definitions of what constitutes restricted private-activity bonds, and the volume of private-activity bonds which can be issued for many activities is constrained by new volume restrictions. The discussion in this report is confined to these changes. ⁷

The potential impact of these changes on the volume of tax- exempt bonds is substantial. Although the ability of State and local governments to issue unrestricted amounts of tax-exempt bonds has been eliminated for many purposes, this does not mean that State and local governments cannot issue bonds to finance capital spending for these activities. They have two options for financing. First, they could issue the bonds as general obligation bonds (which pledge tax revenues for payment of principal and interest) rather than as revenue bonds (which pledge revenues generated by the project being built for payment of principal and interest). The bonds would not be classified as private-activity bonds, and no Federal restrictions would apply to their issuance. Taxpayers would, of course, bear more financial responsibility for the bonds. If the facilities being constructed were of sufficient value to the community, citizens might find this type of financing to be acceptable. Second, the jurisdiction could issue taxable bonds to finance the capital spending.

GENERAL ELIGIBILITY CRITERIA FOR TAX-EXEMPT STATUS

Current law defines as tax exempt any State and local bonds whose proceeds are to be used to finance government operations. The difficulty facing the Congress over the years has been determining what constitutes a government operation, or in more familiar terminology, what constitutes a public purpose.

Congress has dealt with the issue by constructing a two-part test for identifying private use of State and local bond proceeds. Interest on bonds which satisfy both a private trade or business use test (hereafter referred to as the "use" test) AND a security interest test (hereafter referred to as the "security" test) is not tax exempt. Prior to 1987, the private use test was satisfied (that is, the bonds were potentially taxable) if MORE than 25 percent of the proceeds was used in a trade or business of a person other than a State or local government or a 501(c)(3) (non-profit) organization. The limit was 5 percent for loans to private persons (private loan bonds). The security interest test was satisfied (that is, the bonds were potentially taxable) if more than 25 percent of the principal or interest was secured by, or to be derived from property to be used in, such a trade or business. If both tests were satisfied, the bonds were considered to be industrial development bonds (IDBs) and were taxable.

The Tax Reform Act imposes more restrictive use and security tests. the new use test is satisfied (that is the bonds are potentially taxable) if 10 percent or more of the proceeds is to be used in a trade or business. For construction, rehabilitation, or operation of output facilities (essentially publicly owned water, gas, and electric facilities), the use test is satisfied if the lesser of 10 percent or $15 million of the proceeds is to be used in a trade or business. For private loan bonds, the new use test is the lesser of 5 percent or $5 million. the security interest test is satisfied if more than 10 percent of the proceeds are secured by property used in a trade or business.

EXCEPTIONS TO THE GENERAL ELIGIBILITY CRITERIA

Because many activities that Congress deems to serve a substantial public purpose would be taxable under this two-part test, exceptions to the tests have been provided for specific activities. These exceptions fall under four main categories: tax-exempt IDBs, mortgage-subsidy bonds (qualified mortgage bonds and qualified veterans' mortgage bonds), student loan bonds, and section 501(c)(3) bonds for non-profit organizations.

Prior to the Tax Reform Act of 1986, exempt-activity IDBs were defined as bonds whose proceeds were used to finance specified activities. These activities were multifamily rental housing, sports facilities, convention or trade show facilities, airports, docks and wharves, mass commuting facilities, parking facilities, sewage disposal facilities, solid waste disposal facilities, certain electric energy and gas furnishing facilities, certain hydroelectric generating facilities, local district heating or cooling facilities, air or water pollution control facilities, and small-issue IDBs.

The Tax Reform Act repeals the exception for sports facilities, convention and trade show facilities, parking facilities, and private pollution control facilities. The special exception for the other activities continues, although many of these activities such as airports and multifamily housing will be subjected to additional targeting and regulation. The only activity added to the list of special exceptions is hazardous waste treatment facilities.

Prior to the Tax Reform Act, exemption was allowed for the interest on small-issue IDBs (proceeds not exceeding $1 million, or $10 million if certain capital expenditures are taken into account). Small-issue bonds were to become taxable after December 31, 1986, except for bonds to finance manufacturing facilities which would have sunset on December 31, 1988. The Tax Reform Act allows small-issue IDBs for nonmanufacturing facilities to become taxable on the scheduled sunset date, and adds bonds for first-time farmers to bonds for manufacturing facilities for sunset a year later than originally planned, after December 31, 1989.

Bonds issued for student loans retain their tax-exempt status under the new law. The Tax Reform Act does broaden the types of student loans which are exempt.

Pre-1987 tax law provided that qualified mortgage bonds (issued to finance owner-occupied housing) would no longer be tax exempt after December 31, 1987. The Tax Reform Act postpones the sunset date to December 31, 1988, and imposes a variety of regulations designed to better target the proceeds to the use of lower-income families.

Bonds issued on behalf of nonprofit (section 501(c)(3)) organizations are also exempt under current and prior law. The Tax Reform Act imposes a $140 million maximum on the amount of outstanding bonds for each nonhospital organization, and requires that all property financed with these bonds be owned by a 501(c)(3) organization or governmental entity.

The Tax Reform Act provides another special exception for qualified redevelopment bonds, which generally finance certain land acquisition and redevelopment cost for ultimate use by nongovernmental persons. Prior law had no specific provision for this purpose, but applied existing IDB and private loan restrictions in order to determine eligibility for tax exemption.

VOLUME RESTRICTIONS

The restriction of State and local governments' ability to issue bonds for private activities is even more restricted than this discussion has suggested. The activities remaining eligible for tax- exempt financing have been subjected to more restrictive volume limitations than existed prior to 1987, and many more of these activities are subject to the volume restrictions.

Pre-1987 law imposed three different volume limitations on bonds which failed the general eligibility test for tax exemption but received a special exception. First, most tax-exempt IDBs and student loan bonds were subject to a State volume cap equal to the greater of $150 per resident of the State or $200 million. The per capita limitation was scheduled to decrease to $100 after 1986. Tax-exempt bonds (or what are frequently referred to as "private activity" bonds) for several types of activities were not included in this cap: nonprofit organizations; multifamily rental housing; and governmentally owned airports, docks and wharves, mass commuting facilities, convention centers, and trade show facilities.

Second, before 1987, a State's qualified mortgage bonds were subject to an annual volume restriction tied to the dollar value of mortgages for single-family owner-occupied residences located in the State or $200 million, whichever was greater. And third, qualified veterans' mortgage bonds were limited to a bond volume tied to the amount they issued from January 1, 1979, to June 22, 1984.

The Tax Reform Act provides a unified cap for each State equal to the greater of $75 per resident or $250 million. This cap applies until December 31, 1987, and then declines to the greater of $50 per capita or $150 million. Even more important, the new volume cap applies to almost all private activity bonds except for nonprofit organizations, airports, docks, wharves, governmentally owned solid waste disposal facilities, and qualified veterans' mortgage bonds (which remain subject to their present cap).

An additional restrictive change is that bond issues which exceed $150 million and meet the use and security interest criteria for tax exemption (in other words, not private activity bonds but what are generally called governmental bonds) will have the portion of the proceeds used for private purposes (up to 10 percent) included in the volume cap. Thus, not only has the portion of bond proceeds for private use been cut back from 25 to 10 percent, but in many instances this private use is further squeezed by inclusion in the private activity volume cap (even though ;t is part of a governmental issue).

The potential effect of the volume cap restrictions on each State's ability to issue private-activity tax-exempt bonds is presented in table 5. The first column contains the volume cap applied in 1984 by the Deficit Reduction Act, $150 per capita or $200 million, whichever is greater. The 1986 volume cap (based on 1985 population estimates) is in column 2, $75 per capita or a $250 million floor, whichever is greater. The 1988 cap is in column 3, $50 per capita or a $150 million floor, whichever is greater. The last two columns provide percentage changes in these caps. The potential reduction in bond volume is substantial in every State. For example, Michigan's 1986 volume cap represents a 50 percent reduction relative to 1984. Its 1988 volume cap represents a further reduction of 33 percent relative to its 1986 volume cap. Those States which are capped by the floor amount rather than the per capita option experience a short-lived increase in their volume cap, such as Alaska where the cap rose by 25 percent in 1986. The 1988 reduction in the floor amount to $150 million causes these States to experience a substantial reduction in the volume caps for 1988.

TABLE 5. Reduction in Volume Cap for Private Activity Tax-Exempt Bonds Due to the Deficit Reduction Act of 1984 and Tax Reform Act of 1986 (dollar amounts in thousands)

                     Private Activity              Percentage Change

Source: Population data used to calculate volume caps and columns 1 and 2 from Federal Funds Information for States. Issue Brief 86-17. October 2, 1986. Volume cap in column 3 and percentage changes in columns 4 and 5 are CRS calculations.

IMPLICATIONS FOR TAX-EXEMPT BOND VOLUME

What does all this mean for State and local use of tax-exempt bonds? In one sense, the substantial reduction in the volume cap indicated by these data understates the potential reduction in private-activity bond volume. The 1984 cap did not apply to many of the private-activity bonds which are included in the 1986 and 1988 volume caps. In 1984, only some IDBs and student loan bonds were subject to the cap. In 1986 and 1988, almost all bonds which do not qualify as governmental bonds must receive an allocation from the volume cap in order to be tax exempt. Thus, not only is the volume cap lower, but a greater percentage of all State and local bond volume is constrained by the cap.

In another sense, these data may overstate the impact on State and local use of tax-exempt bonds. It is clear that the Tax Reform Act has limited the ability of State and local governments to use the same financing techniques to issue unrestricted amounts of tax-exempt bonds for many purposes. This does not, however, mean that State and local governments cannot issue tax-exempt bonds to finance capital spending for these activities. Bonds for these projects could be issued as general obligation bonds, which pledge tax revenues for payment of principal and interest. The bonds would not be classified as private-activity bonds (because less than 10 percent of the bonds' principal and interest are secured by property used in a trade or business), and no Federal restrictions would apply to their issuance. Taxpayers would, of course, bear more financial responsibility for the bonds. If the facilities being constructed were of sufficient value to the community, citizens might find this type of financing to be acceptable. It is precisely this type of reevaluation that the bond provisions of the tax reform acts of the 1980s have been designed to encourage. ⁸

CONCLUSIONS

The Tax Reform Act of 1986 has the potential to cause State and local governments to adjust their spending levels, their tax structures, and their use of tax-exempt bonds. For most States, these effects may well be minor except for their use of tax-exempt bonds.

First, the increased cost of a State or local tax dollar will not decrease spending levels very much in most States. Second, the linkage of the State and Federal income tax bases could change income tax revenues substantially in some States. However, when this change is considered in the context of total State revenues and combined with citizen preferences concerning public sector size, the linkage- induced change in spending is expected to be small in almost all States.

Third, the incentives created for tax structure adjustment are not that great. Even though deductibility of the sales tax has been eliminated, the reductions in Federal statutory tax rates and in the number of itemizers causes the after-Federal-tax cost of other deductible taxes to increase as well. This moderates the increase in the cost of the sales tax relative to alternative tax sources. When combined with some evidence suggesting sales tax use is not particularly sensitive to its cost, this suggests minimal adjustment in State and local tax structures. In addition, those States that return most of the linkage-induced increase in income tax revenues to citizens may adjust their income tax structure rather than alter the relative contributions of tax sources by reducing other types of taxes.

Fourth, the importance of interstate tax differentials as locational incentives has been increased by tax reform. For some States the increase in tax rate differentials is fairly large. The actual effect on locational choices depends on a variety of factors. Some incentive is provided for States to adjust their tax structures to return to the previous level of tax rate differentials.

Finally, the greatest potential effect on the State and local sector is its use of tax-exempt bonds to finance capital construction. Most States will be forced either to substantially reduce the volume of bonds they issue or to change the degree of financial responsibility they bear for these bonds.

² Daphne A. Kenyon. Implicit Aid to state and Local Governments through Federal Tax Deductibility. In: Michael Bell, ed. Intergovernmental Fiscal Relations in an Era of New Federalism. JAI Press. Forthcoming.

³ Advisory Commission on Intergovernmental Relations. Preliminary Estimates of the Effect of the 1986 Federal Tax Reform Act on state Personal Income Tax Liabilities. December 1986. The estimates presented here are based on assumption 2 in the report, that States linked to Federal law as of a specified date update their references to Federal law by maintaining the same conformity structure to the new Federal provisions.

⁴ Advisory Commission on Intergovenmental Relations, "Changing Public Attitudes on Governments and Taxes, 1986: A Commission Survey," Report S-15, Washington, D.C. 1986.

⁵ For a more detailed discussion of this evidence, see Dennis Zimmerman. Federal Tax Reform and State Use of the Sales Tax. Proceedings of the National Tax Association-Tax Institute of America. 1987. Forthcoming.

⁶ Two recent analyses are illustrative of research in this area. Henry W. Herzog, Jr. and Alan M. Schlottmann. State and Local Tax Deductibility and Metropolitan Migration. National Tax Journal. June 1986. pp. 189-200; and William F. Fox. Tax Structure and the Location of Economic Activity Along State Borders. National Tax Journal. December 1986. pp. 387-402.

⁷ The desire of State and local governments to issue bonds is also affected by many other provisions in the Tax Reform Act which affect borrowing costs. A discussion of these other major changes in the treatment of tax-exempt bonds is available in U.S. Library of Congress. Congressional Research Service. Tax-Exempt Bonds as Restructured by the Conference Agreement on H.R. 3838, the Tax Reform Act of 1986. [by] Dennis Zimmerman. September 2, 1986. 7 p.

⁸ For a more complete discussion of the economics 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. 37 p.; and Dennis Zimmerman. Separating Public and Private-Purpose Tax- Exempt Bonds. Tax Notes. Vol. 31, No. 5. May 5, 1986. p. 509-513.