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Issuance of Tax-Exempt Municipal Debentures

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Issuance of Tax-Exempt Municipal Debentures Issuance of Tax-Exempt Municipal Debentures (City Council on August 1, 2, 3 and 4, 2000, adopted this Clause, without amendment.) The Policy and Finance Committee recommendations the adoption of the following report (July 4, 2000) from the Chief Financial Officer and Treasurer: Purpose: To discuss the potential advantages and disadvantages if the City is legally allowed to issue tax-free municipal bonds and to provide a strategy to proceed with this issue. Financial Implications and Impact Statement: N/A Recommendations: It is recommended that: (1) this report be received for information; and (2) a copy of this report be forwarded to Team Toronto for its consideration with other possible alternative financing strategies being explored with the provincial and federal governments. Background: At the Council meeting held on January 27, 2000, Councillor Davis moved a Notice of Motion requesting Council to establish a Working Committee on Municipal Debt composed of five members of City Council working with staff to establish a proposal for presentation to federal and provincial finance Ministers and officials concerning tax-free municipal bonds. The motion was referred to the Chief Administrative Officer for a report to the Policy and Finance Committee who requested a report from the Chief Financial Officer and Treasurer. Comments: In the United States, the federal government exempts interest payments on municipal debt from federal income taxes, thus lowering the cost of borrowing for state and local governments. Bonds purchased in one’s own jurisdiction are usually also exempt from local and state income taxes, e.g., New York residents who purchase New York City bonds. Purchasers of municipal bonds are willing to accept a lower interest rate because they receive interest payments that are tax-free. A recent U.S. study indicated that for every $225 million tax-exempt bond issued, the federal Treasury loses an average of $70 million in foregone tax collections. Municipal bond markets in the United States continue to be very active with total outstanding tax-exempt debt of $1.3 trillion as of 1997. Of the approximately $173 billion in new issues of long-term municipal bonds, 83 percent (or $144 billion) were tax-exempt with the remainder of 17 percent ($29 billion) were classified as taxable. Local governments and their authorities issued 60 percent of municipal bonds and state governments and their agencies issued the remainder. The municipal bond market began in the United States in 1812 when New York City issued its first bond. Thereafter, states and localities issued bonds to finance various projects such as roads, bridges, schools, water and sewage projects necessitated by continued population growth and urbanization. During the nineteenth century, limits on the ability of the federal government to impose taxes that interfered with the borrowing power of states was established in a series of Supreme Court decisions that found federal income tax unconstitutional when levied on the interest payments from state and local debt. The implied tax-exempt status of these bonds was contained in the 16th Amendment to the U.S. Constitution, ratified in 1913 and the National Income Tax Act of 1913 where the exemption of interest on state and local bonds was explicitly stated. In fact, the U.S. is the only country in the world that permits local governments to borrow on a tax-exempt basis. The Tax Reform Act of 1986 imposed alternative minimum taxable income to generate federal tax revenue for non tax-paying corporations and individuals that had substantially sheltered their taxable income through investment in tax-exempt bonds. With these changes to U.S. tax legislation, municipal bonds have become less attractive to corporations such as insurance companies and banks, while individual investors’ share of this market grew from 25 percent in 1980 to 70 percent currently. Previous Attempts to Issue Tax-Exempt Bonds in Ontario: In August, 1995, the Working Committee on Municipal Debt Issuance and Investment Policy, comprised of finance staff from various municipalities, the Province of Ontario and the investment banking community examined the issue of tax-free municipal bonds and concluded that the disadvantages outweighed any advantage of providing a lower cost of funds for infrastructure projects. Based upon the conclusions of this group, it was decided not to proceed with further representation to the provincial or federal governments. Advantages: The issuance of tax-exempt bonds could provide a lower cost of funds for Canadian municipalities that would be facilitated through a subsidy from the federal (and perhaps provincial) governments by foregoing tax revenue. While having a mechanism that allows these levels of government to share in the costs of financing local infrastructure projects may seem desirable from the viewpoint of the municipality, it is not considered to be an efficient method of subsidy on an economic basis. The availability of these securities could increase the potential investor base for municipal bonds by attracting investors with higher taxable incomes who would be willing to accept lower yields that are accompanied by a reduction in their income tax liability. Disadvantages: A major disadvantage to issuing tax-exempt municipal securities in Canada is the perception that the provision of this type of cost sharing is inefficient from an economic viewpoint since a substantial portion of the federal subsidy never reaches the local government. A recent U.S. study states that thirty-five cents of every dollar that is forgone from collecting taxes on municipal interest payments is diverted to investors in the highest tax brackets. Therefore, while the Federal government is providing a subsidy to the local bond issuer, it is also transferring wealth from ordinary taxpayers to high tax bracket individuals. Most economists agree that a direct subsidy to offset the costs of local infrastructure investment is more efficient than an indirect subsidy provided through the Income Tax Act. A tax exemption on income from municipal bonds in Canada does not have any historical or constitutional references as exists in the United States. Therefore, any changes would require amendments to the federal Income Tax Act and tax collections agreements with the Provinces with broad-based policy support from the federal government who could experience a negative fiscal impact of approximately $50 million per year, based upon forecasted municipal debt issuance of $1.5 billion for 2000 as provided by various Canadian investment dealers. Since these securities are tax-exempt, they do not attract tax-exempt investors such as pension funds, other levels of government and individuals who are utilizing their RRSP capacity. These groups traditionally purchase approximately 65 percent of municipal debt issued in the Canadian domestic market. If they are excluded from the tax-exempt market, there will be fewer potential investors to support smaller local issuers and interest rates may have to increase to offset lower demand for these securities, even if they offer a tax-exempt rate of return. The creation of a new class of municipal debt could devalue the existing market of non tax-exempt municipal debt, as it would create confusion, inefficiencies and disruptions in the domestic market while discouraging investment from global capital market participants. In the current environment of encouraging investment from various international sources to increase access to capital funds at competitive interest rates, the tax-exempt market would only appeal to a small number of wealthy individuals and corporations with a high tax bracket who operate in the domestic market. Based upon the projected increasing need for local infrastructure investments over the next several years, it seems improbable that this relatively small group of domestic investors will be able to supply the necessary capital to finance these requirements. Since our tax base does not contain the number of wealthy individuals and corporations as exists in the United States on a proportional basis, local governments may also have to revert to issuing bonds at higher market interest rates if the tax-exempt market does not have the capacity to provide all of their financing requirements. Based upon these disadvantages and obstacles, it is felt that the establishment by Council of a separate working committee on municipal debt to approach the federal and provincial governments at this time with a recommendation to allow municipalities to issue tax-exempt bonds would not be successful and possibly conflict with the mandate, objectives and efforts of Team Toronto. Team Toronto is currently engaged in developing a strategy to define a new relationship with these levels of government and the implementation of issuing tax-exempt bonds as well as other financing alternatives would also require a redefining of tax and fiscal relationships with the provincial and federal governments. Therefore, it would be an appropriate forum for Team Toronto to consider the impact of this issue on its policy objectives and decide whether to include it in discussions with other levels of government. Conclusion: There is strong evidence from the U.S. experience that tax-exempt bonds may not be the most effective or efficient method to stimulate or subsidize local infrastructure investment. While providing lower borrowing costs to municipalities and a subsidy to investors in a high tax bracket, these bonds are not attractive
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