The multibillion-dollar fund-raising efforts of many cities, counties and states have been seriously disrupted by restrictions on tax-exempt bond issues that the House of Representatives approved last December in its version of tax revision.
The House bill not only would restrict the types of projects that are qualified for tax-exempt financing, it also attempts to ensure that localities actually spend the funds they raise on government projects rather than investing them in higher-yielding U.S. Treasury securities and earning interest with the subsidized funds.
Tax-exempt bonds are an important source of funds for states, cities and counties that pay relatively low interest rates on money borrowed through bond issues. Investors will accept lower rates because the income from the bonds is exempt from taxation. The tax exemption is a federal subsidy to local governments.
For many local governments, some of the proposed restrictions are expected to be difficult, if not impossible, to meet, according to bond experts. Some states, such as Georgia, would have to amend their state constitutions to permit their local governments to comply with the provisions in the House bill.
After an explosion of new tax-exempt bond issues in the last few months of 1985 (some of them hurried on to the market to beat the tax-bill restrictions), the market has virtually ground to a halt. A number of municipalities have canceled bond issues scheduled for the early weeks of 1986 because they could not comply with the restrictions contained in the House bill.
The State of Georgia canceled a scheduled $307 billion bond offering. Several Mississippi school districts withdrew bonds, which were to finance kindergarten construction, to bring the school systems into compliance with a 1983 state education law. Other localities have canceled issues because they could not comply with the House bill or felt compliance would make the cost of issuing bonds too expensive.
The House bill is not yet law. It will be months before the Senate comes up with its version of tax revision -- and the Senate may or may not adopt provisions similar to those approved by the House.
"But we have to deal with it as if it were a law," said Joseph Carrigan Jr., comptroller of the Washington Suburban Sanitary Commission, the bicounty agency that provides water and sewer services to Montgomery and Prince George's counties.
The House bill mandates that the new tax rules for tax-exempt bonds, generally called municipal bonds, take effect Jan. 1, 1986. Neither the governments that sell them nor the investors that purchase municipal bonds can take the risks inherent in assuming that the effective date will be changed or the rules loosened in the final law, according to Gordon McDanold, vice president of Continental Illinois National Bank.
If the municipality issuing the bonds violates any of the new restrictions at any point during the life of the bond, the interest investors receive may lose its tax-exempt status, retroactive to the first payment months or years earlier.
As a result, investors are demanding higher interest rates this year from localities that have sold new issues of municipal bonds. McDanold estimated that a recent State of Illinois offering that yielded 7.75 percent for investors could have been sold for 7.4 percent to 7.5 percent were it not for investor worries that the bonds at some point might fail to meet all the rigorous tests of the House bill.
The House, in an attempt to correct what it perceived to be abuses of the federal treasury by municipal bond issuers, voted to change many of the ground rules -- both those that define what types of projects can be funded by tax-exempt financing and what the states must do with the money once they raise it.
The House bill requires that states must spend 5 percent of the funds within 30 days after they are raised and must spend the entire amount within three years. The provisions are designed to ensure that localities don't raise low-cost money at Treasury expense, then put the proceeds into higher-yielding investments such as Treasury securities at further cost to the federal till -- a procedure called arbitrage.
If the localities do not spend the full amount of a bond offering in six months, they must calculate their "arbitrage" profits and refund them to the federal government.
If the localities were to fail to spend 5 percent within 30 days or the full amount within three years, the bond offering could be declared taxable. The 5 percent rule virtually precludes Georgia and several other states from issuing new bonds unless they change their constitutions. Georgia's constitution requires that a locality have the proceeds of a bond sale in hand before it can put out bids for contractors.
Many localities cannot issue tax-exempt bonds now, because "the basis of issuance is an unqualified legal opinion that the bonds are fully exempt," according to Jean J. Rousseau, senior vice president and director of municipal markets for the giant securities firm of Merrill Lynch, Pierce, Fenner & Smith.
The House bill, and its Jan. 1 effective date, make it difficult, if not impossible, for bond lawyers to issue unqualified opinions. Even when they are able to, as in the State of Illinois or in a recent sale by WSSC, the interest rate on the bonds is higher because of the uncertainty.
Those local governments that could rushed their bond issues to market in November and December to avoid the Jan. 1 restrictions in the House bill. It was the wildest local financing effort in history.
In November and December, municipalities sold about 2,300 new issues of municipal bonds, raising more than $85 billion. During the same two months of 1984, 1,064 issues were sold with a total value of less than $32 billion.
But last month, the first period covered by the House bill, only 63 municipal issues came to market -- with a total value of $2.3 billion.
Undoubtedly, some of the January slowdown occurred because many localities moved up sales to beat the Jan. 1 deadline. January also has been historically slower than the final months of the year.
But January 1986 was the lightest month for new municipal bond issues in 15 years, according to Henry Kaufman, chief economist for the securities firm Salomon Brothers Inc.
Uncertainty over what will be contained in the final tax bill -- if there is one -- is clouding a number of economic and financial decisions, from corporate takeovers to real estate deals or plant and equipment investment.
"In our area, the problem is not uncertainty. We are dealing with House Resolution 3838 the tax bill's formal title as if it were the law. The problem is that it is very difficult to comply with," according to Merrill Lynch's Rousseau.