Be Kind to Your Foreign Investor Friends
PATRICK MANCHESTER*
TABLE OF CONTENTS
INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1824
I. THE NAME’S BOND. MUNICIPAL BOND. . . . . . . . . . . . . . . . . . . . . .
1828
A.
HISTORY OF THE FEDERAL TAX EXEMPTION FOR MUNICIPAL BOND
INTEREST
B.
.......................................
1829
THE ECONOMICS OF MUNICIPAL BONDS AND ARGUMENTS AGAINST
.....................................
1830
.........
1833
II. A BRIEF INTRODUCTION TO FEDERAL TAXATION OF INBOUND
TRANSACTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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EXEMPTION
C.
A.
BUILD AMERICA BONDS AND PROPOSALS FOR REFORM
TAXATION OF FOREIGN TAXPAYERS UNDER THE INTERNAL
REVENUE CODE
B.
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TAXATION OF FOREIGN TAXPAYERS UNDER BILATERAL TAX
TREATIES
C.
...................................
.......................................
1839
TAXATION OF FOREIGN GOVERNMENT ACTIVITIES IN THE UNITED
........................................
1842
III. THE FIVE FOREIGNERS: A MODEL OF MUNICIPAL BOND TAXATION . .
1842
IV. ANALYSIS: MUNICIPAL BOND TAX STRUCTURES AND THEIR EFFECTS
ON INBOUND FOREIGN INVESTMENT . . . . . . . . . . . . . . . . . . . . . . . .
1844
STATES
A.
FOREIGN INVESTORS 1 AND 2: FOREIGNERS WITH UNITED STATES BUSINESS
ACTIVITIES
B.
1844
FOREIGN INVESTORS 3 AND 4: PASSIVE FOREIGN INVESTORS IN THE UNITED
STATES
C.
.......................................
.........................................
1845
FOREIGN INVESTOR 5: FOREIGN GOVERNMENT INVESTORS IN THE UNITED
STATES
.........................................
1849
* Georgetown Law, J.D. 2010; Duquesne University, B.S. 2007. © 2010, Patrick Manchester. I wish
to thank Professor Charles Gustafson for his help in developing the premise of this Note, and Professor
Joshua Teitelbaum for his insightful comments on earlier drafts of the Note. I also wish to thank the
staff members of the Georgetown Law Journal (particularly Bill Murray and Tim Mastrogiacomo) for
their hard work and dedication. I dedicate this Note to my mother Cheryl and my father John, for whom
I hope it will serve as a small token of my infinite gratitude for their love and support.
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V. RESULTS: ARE BUILD AMERICA BONDS THE WAY TO ENCOURAGE
FOREIGN INVESTMENT IN MUNICIPAL BONDS? . . . . . . . . . . . . . . . . .
1850
VI. SOME CAVEATS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1851
A.
DIFFERENCES BETWEEN MUNICIPAL AND TREASURY BONDS
......
1851
B.
POLITICAL BARRIERS TO MUNICIPAL BOND REFORM
...........
1853
CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1856
INTRODUCTION
State and local governments are certainly feeling the heat from the 2009
recession.1 Specifically, “[w]hen joblessness is high—it reached 10.2% nationally in October [2009]—residents pay lower income taxes and cut their spending, which reduces sales tax revenues.”2 As a result, “[t]o fill [budget] shortfalls,
many states are considering raising taxes, laying off state workers and cutting
services—all moves that threaten to slow the national economic recovery.”3 In
such dark times, one potential avenue of reprieve for beleaguered state and local
governments is to issue municipal bonds. Through municipal bonds, state and
local governments can borrow money from bond purchasers in exchange for
making periodic interest payments to the purchasers over a period of time.4
Municipal bonds are an attractive alternative because they allow state and local
governments to finance infrastructure projects—such as highways, bridges, or
schools—without having to rely on increases in state or local taxes.5
To help state and local governments finance their activities through municipal
bond issues, Internal Revenue Code (“Code”) § 103 exempts municipal bond
interest income from federal tax.6 Section 103 allows municipal bond purchasers to receive interest payments from the state or local government that issued
such bonds without including the amount of the interest payments in their gross
income for tax purposes.7 Because municipal bond purchasers do not pay taxes
1. See Amy Merrick, States Draw Up Plans for Year of Even Bigger Budget Cuts, WALL ST. J., Nov.
12, 2009, at A7, available at http://online.wsj.com/article/SB125798665633544377.html; see also
posting of John Wagner to Maryland Politics, Local Governments: We’re Not “Fat and Happy,”
http://voices.washingtonpost.com/annapolis/2009/10/local_governments_were_not_fat.html (noting budget shortfalls and other fiscal crises among local governments in Maryland).
2. Merrick, supra note 1.
3. Id.
4. See FREDERIC S. MISHKIN, THE ECONOMICS OF MONEY, BANKING, AND FINANCIAL MARKETS 3–4 (7th
ed. 2004) (“A bond is a debt security that promises to make payments periodically for a specified period
of time. The bond market is especially important to economic activity because it enables corporations
or governments to borrow to finance their activities . . . . ”).
5. See Kevin M. Yamamoto, A Proposal for the Elimination of the Exclusion for State Bond Interest,
50 FLA. L. REV. 145, 148 (1998); see also Brian H. Jenn, The Case for Tax Credits, 61 TAX LAW. 549,
592 (2008).
6. I.R.C. § 103(a) (2006).
7. See id.
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BE KIND TO YOUR FOREIGN INVESTOR FRIENDS
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on interest income they receive from such bonds, they are willing to accept
lower interest rates on municipal bonds than they would otherwise receive from
taxable bonds.8
For example, suppose an investor with a 30% tax rate can choose between
investing $1000 in either taxable bonds or tax-exempt municipal bonds. If the
prevailing annual interest rate on taxable bonds were 10%, the investor would
be willing to accept a 7% interest rate on tax-exempt municipal bonds because
such an interest rate would make the taxpayer’s after-tax interest income from
taxable bonds equal to his untaxed interest income from tax-exempt municipal
bonds ($70 in both cases). If municipal bond interest rates deviated from 7% in
either direction, municipal bonds would offer either higher or lower returns than
taxable bonds. All else being equal, investors would react to such higher or
lower municipal bond returns by buying or selling the bonds until the interest
rate reached 7%.9
As a result of this dynamic, the § 103 exemption indirectly provides state and
local governments with a federal subsidy that allows them to issue bonds at a
lower interest rate than they would otherwise obtain if interest from such bonds
they subject to federal taxes.10 Going back to the example above, the § 103 tax
exemption for municipal bond interest allows state and local governments to
issue municipal bonds at a 7% interest rate rather than the 10% interest rate
applicable to taxable bonds. Providing state and local governments with a
subsidy that reduces their borrowing costs allows the governments both to
obtain funding for projects that might not otherwise be possible and to provide
public goods.11
Despite the benefits that arise from the § 103 exemption, commentators have
long argued that the federal tax exemption for municipal bond interest income is
both inefficient and inequitable.12 These commentators suggest that the inefficiency with respect to § 103 arises from two consequences of exempting
municipal bond interest from federal income taxation. First, studies have shown
that the revenue losses to the federal government that result from the § 103
exemption far exceed the accompanying reduction in borrowing costs to state
and local governments.13 Additionally, some commentators conclude that the
inequality between federal revenue loss and state borrowing benefits has re-
8. See MISHKIN, supra note 4, at 125–26; Yamamoto, supra note 5, at 148–49.
9. See MISHKIN, supra note 4, at 125–26.
10. Yamamoto, supra note 5, at 153 (“[T]he interest exemption allows the sellers of the [municipal]
bonds to offer a lower interest rate and yet be competitive in the marketplace with taxable bonds.”).
11. Id. at 181–83.
12. See CONGRESSIONAL BUDGET OFFICE, TAX-CREDIT BONDS AND THE FEDERAL COST OF FINANCING
PUBLIC EXPENDITURES 4–6 (2004) [hereinafter CBO REPORT]; Boris I. Bittker, Equity, Efficiency, and
Income Tax Theory: Do Misallocations Drive Out Inequities?, 16 SAN DIEGO L. REV. 735, 739–44
(1979); Jenn, supra note 5, at 593–94; Calvin H. Johnson, Repeal Tax Exemption for Municipal Bonds,
117 TAX NOTES 1259, 1260–63 (2007); Yamamoto, supra note 5, at 173–81.
13. CBO REPORT, supra note 12, at 4–5; Bittker, supra note 12, at 743; Jenn, supra note 5, at 593;
Johnson, supra note 12, at 1261; Yamamoto, supra note 5, at 173.
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sulted in a situation in which the § 103 exemption disproportionately favors
higher-income taxpayers with high marginal tax rates over lower-income taxpayers with lower marginal tax rates.14
Critics of the § 103 exemption also claim that exempting municipal bond
interest income from tax violates principles of both horizontal and vertical
equity. Horizontal equity exists when taxpayers who earn the same amount of
income incur an equal amount of income taxes.15 Commentators have argued
that the § 103 exemption is horizontally inequitable because it creates a
situation in which two taxpayers with identical incomes would incur different
federal income tax liabilities if one of them invested in taxable bonds while the
other invested in tax-exempt municipal bonds.16 Vertical equity exists when the
tax system appropriately differentiates between taxpayers who earn different
levels of income.17 Commentators have argued that the § 103 exemption creates
vertical inequity in the tax system because studies have shown that higherincome taxpayers disproportionately benefit from the exemption to a greater
extent than lower-income taxpayers.18
The inefficiencies and inequities inherent in § 103 have led commentators to
argue in favor of two alternative proposals. Under one proposal, the federal
government would tax municipal bond interest income and then provide taxpayers with a tax credit equal to a specific percentage of the municipal bond interest
payments they receive in a given tax year.19 Commentators have argued that
such a tax credit would be more efficient than the present § 103 exemption
because the federal revenue losses resulting from the tax credit would be equal
to the accompanying reductions in borrowing costs on the state and local
level.20 Moreover, the proposed tax credit would be more vertically equitable
than the § 103 exemption because it would provide equal benefits to taxpayers
regardless of their marginal tax rates. Nevertheless, the credit proposal would
not necessarily introduce horizontal equity into the taxation of municipal bond
interest income because investors in creditable municipal bonds would receive
less of a tax benefit than their counterparts who invest in taxable bonds.
A second proposal suggests that the federal government should tax municipal
bond interest income and then redistribute the tax revenues back to the state and
local governments in the form of a direct subsidy.21 Commentators have argued
that this proposal is more efficient than the § 103 exemption because a direct
subsidy from the federal government to the state and local governments would
14. Bittker, supra note 12, at 743; Jenn, supra note 5, at 593; Yamamoto, supra note 5, at 173–78;
see also CBO REPORT, supra note 12, at 4–5 (discussing differing cost to the federal government for
taxpayers with differing marginal tax rates); discussion infra section I.B.
15. See Yamamoto, supra note 5, at 178–79.
16. Bittker, supra note 12, at 742; Yamamoto, supra note 5, at 179.
17. See Yamamoto, supra note 5, at 179.
18. Bittker, supra note 12, at 742; Yamamoto, supra note 5, at 179–80; see also infra section I.B.
19. See CBO REPORT, supra note 12, at 6; Jenn, supra note 5, at 593–94.
20. CBO REPORT, supra note 12, at 6; Jenn, supra note 5, at 593.
21. See CBO REPORT, supra note 12, at 5–6; Yamamoto, supra note 5, at 187–88.
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BE KIND TO YOUR FOREIGN INVESTOR FRIENDS
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ensure that the revenue loss to the federal government would be equal to the
benefits state and local governments would receive as a result of the subsidy.22
The subsidy proposal would thereby also provide for greater vertical equity than
the § 103 exemption because it would not provide greater benefits to any
particular income class of taxpayers. Additionally, the subsidy proposal would
provide for greater horizontal equity than both the § 103 exemption and the
credit proposal because it would equalize the tax treatment of both tax-exempt
municipal bonds and other types of taxable bonds.
As part of the American Recovery and Reinvestment Act of 2009 (also
known as the “economic stimulus”), Congress added a new provision to the
Code that provides for two types of Build America Bonds that would each be
subject to federal taxation in line with the tax credit and direct subsidy proposals.23 The first type of Build America Bond provides a tax credit to individuals
and entities that invest in such bonds.24 The second type of Build America Bond
provides direct subsidies to state and local governments that issue such bonds.25
In addition to making the federal government’s municipal bond interest
income taxation more efficient and equitable, Build America Bonds might also
have other, more implicit benefits. For example, Build America Bonds might
benefit state and local governments if they increase the volume of investors in
municipal bonds. Increasing the number of municipal bond buyers would
“stabilize the market for [municipal] bonds and . . . help to lessen or eliminate
the volatility in the bond market.”26 Moreover, increasing the number of
investors in the municipal bond market would help state and local governments
raise more money and subject them to less financial risk. As one commentator
has stated, “[j]ust as individuals are less exposed to financial risk when their
assets are diversified, a marketplace operates more smoothly when it has a
diversified base of demand. . . . [A] narrowed base of demand [in the municipal
bond market] makes the market one of increased costs and restricted options.”27
Thus, besides creating more equity and efficiency in the tax system, Build
America Bonds might also benefit state and local governments more than the
§ 103 tax exemption if they encourage more investment in U.S. municipal
bonds.
Accordingly, in this Note I will examine the § 103 tax exemption and the two
types of Build America Bonds in order to determine which of the three
municipal bond tax structures would most encourage foreign investors to enter
22. CBO REPORT, supra note 12, at 5–6; Yamamoto, supra note 5, at 189.
23. See I.R.C. § 54AA (West Supp. 2009); see also Mark Szakonyi, Stimulus Gives Municipal Bonds
a Shot in the Arm, JACKSONVILLE BUS. J., April 10, 2009, http://jacksonville.bizjournals.com/jacksonville/
stories/2009/04/13/story9.html.
24. See I.R.C. § 54AA(a)–(b) (West Supp. 2009).
25. See id. § 54AA(g).
26. Yamamoto, supra note 5, at 188.
27. Impact, Effectiveness and Fairness of the Tax Reform Act of 1986: Hearings Before the H.
Comm. on Ways and Means, 101st Cong. 561 (1990) (statement of David M. Thompson, Vice
Chairman, Municipal Securities Division, Public Securities Association).
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the U.S. municipal bond market, and thus increase the total number of investors
in municipal bonds. Specifically, I will use principles of economics and tax law
to determine whether the marginal foreign investor in U.S. municipal bonds
would prefer investment in either tax-exempt municipal bonds or one of the two
types of Build America Bonds. I base my analyses on the hypothesis that
foreign investors will be most likely to invest in U.S. municipal bonds at the
point where, all else being equal, such investors’ after-tax yields on taxable
bonds would be equal to their after-tax yields on municipal bonds.28
In Part I, I will discuss the history of federal taxation of municipal bond
interest, the economic principles that apply to municipal bonds, and the municipal bond tax reform proposals reflected in Build America Bonds. In Part II, I
will describe the manner in which the United States government taxes foreign
investors’ income from sources within the United States. In Part III, I will
discuss a model based on five types of potential foreign investors in U.S.
municipal bonds, which I will use to analyze the likelihood of foreign investment in either tax-exempt bonds or Build America Bonds. In Part IV, I will use
principles of economics and tax law to examine how each of the five types of
foreign investors would consider investments in either tax-exempt or Build
America Bonds. In Part V, I will discuss the implications of my analyses, and in
Part VI I will address some caveats. I conclude that in order to encourage more
foreign investment in U.S. municipal bonds, the federal government should tax
such bonds along the same lines as the direct-subsidy Build America Bond.
I. THE NAME’S BOND. MUNICIPAL BOND.
The Code defines a municipal bond29 as “an obligation of a State or a
political subdivision thereof.”30 Municipal bonds allow municipal governments31 to borrow money from bond purchasers in exchange for a future stream
of interest payments.32 Municipal governments can use municipal bonds to
finance activities such as the construction of highways, bridges, schools, stadiums, sewer systems, and other public facilities.33 Financing local activities
28. As long as foreign investors’ after-tax yields on taxable bonds remain higher than their after-tax
yields on municipal bonds, they are unlikely to enter the municipal bond market. As such, my analysis
will focus on determining which type of municipal bond tax structure would put foreign investors in a
position where investment in municipal bonds would be at least equally attractive as investment in
taxable bonds like Treasury bonds. Note that my analysis narrowly focuses on which type of bond
structure might create the best conditions for encouraging foreign investment specifically in municipal
bonds. For a discussion of how such structures might affect demand for other types of bonds like
Treasury bonds, see discussion infra section VI.B.
29. For the sake of brevity, throughout this Note I will use the term “municipal bonds” to refer to
what the Internal Revenue Code refers to as “state and local bonds.” See I.R.C. § 103(c)(1) (2006).
30. Id.
31. As in the case of municipal bonds, I will use the term “municipal governments” to refer to both
state and local governments.
32. See MISHKIN, supra note 4, at 3–4.
33. Jenn, supra note 5, at 592; Yamamoto, supra note 5, at 148.
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through municipal bonds is an attractive option for municipal government
officials because it allows such governments to carry on infrastructure projects
without having to increase state and local taxes.34
In this Part, I briefly describe the background of both the tax law and
economic principles behind the market for municipal bonds. In section I.A, I
will discuss the history of the exemption from U.S. federal taxation for municipal bond interest income. In section I.B, I will examine the economic principles
underlying the market for municipal bonds. In section I.C, I will discuss how
various commentators have used economic principles to advocate reforms in the
tax treatment of municipal bonds. I will also analyze how Build America Bonds,
which Congress created with the passage of the American Recovery and
Reinvestment Act of 2009, reflect some commentators’ proposals for reforms
with respect to municipal bond interest taxation.
A. HISTORY OF THE FEDERAL TAX EXEMPTION FOR MUNICIPAL BOND INTEREST
Prior to the passage of the Sixteenth Amendment in 1913, two primary cases
implicated the ability of the federal government to levy taxes on municipal bond
interest. In the 1870 case of Collector v. Day, the Supreme Court invalidated a
federal tax on the salary of a state judicial officer on the grounds that both the
state and federal governments should not be taxed by each other.35 Nevertheless, in 1894, Congress imposed an income tax that subjected municipal bond
interest to federal taxation.36 In Pollock v. Farmers’ Loan & Trust Co., the
Supreme Court declared the entire federal income tax regime unconstitutional,
and the Court additionally invalidated the specific tax on municipal securities as
a violation of intergovernmental immunities.37 With the adoption of the Sixteenth Amendment, Congress was once again in a position to levy a federal
income tax.38 However, both Day and Pollock led Congress to believe that the
power to levy an income tax under the Sixteenth Amendment did not extend to
the taxation of municipal bond interest.39 Thus, Congress for the first time
enacted a provision that exempted municipal bond interest income from federal
taxation.40
In keeping with historical tradition, § 103 of the Code currently provides for
an exemption from federal taxation for municipal bond interest income.41 The
exemption applies to most municipal bonds, with a few exceptions. Specifically,
the exemption in § 103 applies to general purpose, specific purpose, revenue,
34. Yamamoto, supra note 5, at 148.
35. 78 U.S. (11 Wall.) 113, 126–27 (1870).
36. Yamamoto, supra note 5, at 162.
37. 157 U.S. 429, 586 (1895).
38. See U.S. CONST. amend. XVI (“The Congress shall have power to lay and collect taxes on
incomes, from whatever source derived, without apportionment among the several States, and without
regard to any census or enumeration.”).
39. Yamamoto, supra note 5, at 165.
40. Id. at 166.
41. I.R.C. § 103(a)(1) (2006).
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and general obligation bonds.42 Municipal governments may issue general
purpose bonds for any lawful reason and may issue specific purpose bonds for
specific types of municipal projects.43 Meanwhile, general obligation bonds are
bonds that municipal governments finance through general municipal tax revenues, while revenue bonds are bonds that municipal governments finance
through the revenues that they receive from specific projects.44 The tax exemption for municipal bond interest income in § 103 applies to all municipal bonds
regardless of whether they are general purpose, specific purpose, general obligation, or revenue bonds.45 However, the § 103 exemption does not apply to
non-qualified private activity bonds, arbitrage bonds, or unregistered bonds.46
B. THE ECONOMICS OF MUNICIPAL BONDS AND ARGUMENTS AGAINST EXEMPTION
Since 1913, many reformers have argued in favor of either a replacement for,
or complete elimination of, an exemption from federal taxation for municipal
bond interest.47 Moreover, in South Carolina v. Baker, the Supreme Court
suggested that a removal of the exemption would not violate the Sixteenth
Amendment when the Court held that a proposed revision to the Code that
would remove the federal tax exemption for unregistered municipal bonds did
not violate the doctrine of intergovernmental immunity.48 Baker opened the
door to removing the federal tax exemption for municipal bond interest, and
reformers have used economic principles to argue in favor of alternative federal
tax treatments of municipal bond interest.
All else being equal, economic theory suggests that the marginal investor in
tax-exempt municipal bonds will be indifferent between purchasing either
municipal bonds or taxable bonds (such as U.S. Treasury bonds) at the point
where the after-tax yield on taxable bonds is equal to the untaxed yield on
tax-exempt bonds.49 Mathematically, where Ym equals the yield on a tax-exempt
municipal bond, Yt equals the yield on a taxable U.S. Treasury bond, and ␶i
equals the ith investor’s marginal tax rate, then, all else being equal, the ith
investor in bonds will invest in municipal bonds at the point where:
1. Y m ⫽Y t (1⫺ ␶ i )
Thus, all else being equal, the market for municipal bonds will converge
upon an equilibrium where the tax-exempt yield Ym is equal to the after-tax
yield Yt. To use a numerical example, suppose that a group of investors has a
42.
43.
44.
45.
46.
47.
48.
49.
Yamamoto, supra note 5, at 155–56.
Id. at 155.
Id.
See I.R.C. § 103(a) (2006).
Id. § 103(b).
Yamamoto, supra note 5, at 167–69.
485 U.S. 505, 527 (1988).
See, e.g., Yamamoto, supra note 5, at 148–49.
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marginal tax rate of 30% and is choosing between investing in either municipal
or Treasury bonds. If the interest rate on Treasury bonds is equal to 10%, then
investors will buy and sell municipal bonds to the point where the interest rate
on municipal bonds is equal to 7%. If the municipal yield increases to 8%, then
investors will increase their demand for municipal bonds until the yield on such
bonds drops to 7%. In contrast, if the municipal yield decreases to 6%, then
investors will decrease their demand for municipal bonds until the yield increases to 7%.
Some commentators argue that the present system of federal tax exemption
for municipal bond interest is undesirable from the standpoint of both efficiency
and equity.50 From the perspective of efficiency, these commentators argue that
the federal tax exemption for municipal bond interest is inefficient because the
amount of revenue the federal government loses from the exemption exceeds
the benefits municipal governments accrue from being able to borrow money at
a lower interest rate.51 Specifically, these commentators argue that the tax
exemption creates a situation in which one part of the lost federal revenue goes
to municipal governments, while the other part of the lost federal revenue goes
to high-bracket taxpayers.52
Consider a numerical example in which one group of investors in bonds
(group A) has a marginal tax rate of 35%, while another group of investors in
bonds (group B) has a marginal tax rate of 30%.53 If the interest rate on taxable
U.S. Treasury bonds is 10%, then investors from group A will drive the
municipal bond interest rate down to 6.5% in accordance with equation (1). If
investors from group A were the only investors in the municipal bond market,
then municipal governments would enjoy the full benefits of the federal revenue
loss from the tax exemption. If the price of Treasury bonds were $1000, then
any given investor in group A holding such bonds would earn $100 in interest
from the bond in Year 1 and would be responsible for paying $35 in taxes to the
IRS. In contrast, any member of group A holding a municipal bond would
receive a tax-free $65 yield on a $1000 municipal bond in Year 1. As a result, in
Year 1, the federal government would lose $35 in revenues from the group A
municipal bond investor, while the municipal government issuing the bond
would receive a $35 benefit in the form of reduced borrowing costs.
In spite of all this, empirical evidence suggests that investors from the highest
tax brackets, such as those in group A, do not purchase municipal bonds in
sufficient quantities to clear the municipal bond market.54 As such, investors
50. See CBO REPORT, supra note 12, at 4–5; Bittker, supra note 12, at 739–44; Jenn, supra note 5, at
593; Johnson, supra note 12, at 1260–63; Yamamoto, supra note 5, at 172–73.
51. CBO REPORT, supra note 12, at 4–5; Jenn, supra note 5, at 593; Yamamoto, supra note 5, at
173–78.
52. See supra note 51.
53. For similar numerical examples of the inefficiency argument, see CBO REPORT, supra note 12, at
4–5, and Yamamoto, supra note 5, at 173–78.
54. See, e.g., Yamamoto, supra note 5, at 175.
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from group B would enter the municipal bond market and drive up the yields on
municipal bonds to a point closer to 7% because issuers of municipal bonds
cannot differentiate interest rates to cater to different classes of taxpayers.55 The
upshot of this is that the revenue losses to the federal government resulting from
the tax exemption on municipal bond interest would exceed the benefits to
municipal governments resulting from the exemption. As a result of the new 7%
interest rate on municipal bonds, group A investors in $1000 municipal bonds
would receive $70 in tax-free interest payments in Year 1, while group A
investors in $1000 Treasury bonds would receive only $65 in after-tax yields as
a result of paying a $35 federal tax on the $100 interest payment from the
Treasury bonds. Thus, because the group B investors would have entered the
municipal bond market, the federal government would have lost potential
revenue of $35 from the group A investors, while the municipal governments
would have only obtained $30 in reduced borrowing costs. Thus, the $35
revenue loss to the federal government resulting from the municipal bond
interest exemption would be split between the municipal governments, which
would receive $30 in reduced borrowing costs, and the group A taxpayers, who
would receive $5 in interest payments on which they would otherwise have paid
taxes. In the aggregate, this effect is large—in 2008, the tax exemption for
municipal bond interest income cost the federal government $25.4 billion, while
it benefitted municipal governments by only $1.6 billion to $7.3 billion.56
In addition to arguments that the federal tax exemption for municipal bond
interest is inefficient, some commentators have argued that the exemption
violates principles of horizontal and vertical equity.57 Horizontal equity exists
when “the taxation on income is applied equally to those with equal incomes.”58
Some commentators argue that the tax exemption for municipal bond interest
violates principles of horizontal equity because if two taxpayers pay the same
marginal tax rate, one of them will have to pay taxes on interest income from
taxable Treasury bonds while the other will pay no taxes on an equal amount of
interest income from tax-exempt municipal bonds.59 Moreover, vertical equity
exists when “persons in unequal situations are differentiated in an appropriate
manner.”60 Commentators have argued that the tax exemption for municipal
bond interest violates principles of vertical equity because, as a result of the
inefficiency argument above, high-bracket taxpayers disproportionately benefit
from the exemption relative to low-bracket taxpayers.61 Thus, commentators
argue that Congress should consider eliminating the tax exemption for municipal bond interest income because it is both inefficient and inequitable on
55.
56.
57.
58.
59.
60.
61.
See id. at 175–76.
Johnson, supra note 12, at 1261.
See Bittker, supra note 12, at 742; Yamamoto, supra note 5, at 178–79.
Yamamoto, supra note 5, at 178–79.
Bittker, supra note 12, at 742; Yamamoto, supra note 5, at 179.
Yamamoto, supra note 5, at 179.
See Bittker, supra note 12, at 742; Yamamoto, supra note 5, at 179–80.
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multiple levels.
C. BUILD AMERICA BONDS AND PROPOSALS FOR REFORM
The foregoing inefficiency and inequity arguments have led some commentators to call for reform in the way federal law taxes municipal bond interest
income. This section will address two types of reforms these commentators
have proposed.
Under the first flavor of proposed reform, taxpayers would include municipal
bond interest income in their taxable income each tax year but would also claim
a tax credit equal to a specific percentage of such municipal bond interest
income (hereafter, I will refer to this as the “credit proposal”).62 The equilibrium for the credit proposal would be identical to the tax-exempt equilibrium in
equation (1) because the tax credit would be equal to the product of Ym and ␶i.63
Commentators have argued that the credit proposal is more efficient than a tax
exemption because it would not provide a subsidy to high-bracket taxpayers.64
Rather, if Congress decided to credit taxpayers for 35% of their annual municipal bond interest income, then all taxpayers, regardless of their marginal tax
rates, would receive a $35 tax break for every $100 in municipal bond interest
payments they receive in any given year. As a result, municipal governments
would benefit from decreased borrowing costs in an amount equal to foregone
federal revenues resulting from the credit proposal.65 Moreover, the credit
proposal would result in increased vertical equity because, as a result of the
efficiency gain, high-bracket taxpayers would not disproportionately benefit
from the credit proposal relative to low-bracket taxpayers. Nevertheless, the
credit proposal would not necessarily increase horizontal equity because investors in taxable bonds would ultimately receive less of every dollar of bond
interest income than similarly situated investors in creditable bonds.
Under the second flavor of proposed reform, the federal government would
collect taxes on municipal bond interest income and then redistribute those
revenues back to the municipal governments in the form of a direct subsidy
(hereafter, I will refer to this as the “subsidy proposal”).66 The equilibrium for
the subsidy proposal would occur at the point where the municipal bond yield
equals the Treasury bond yield.67 The subsidy proposal would be more efficient
62. CBO REPORT, supra note 12, at 6; Jenn, supra note 5, at 594.
63. In the case of the credit proposal, equation (1) would be rewritten as follows:
Y m (1⫺ ␶ i )⫹Y m ( ␶ i )⫽Y t (1⫺ ␶ i ).
Simplifying this expression, we get the same result as in equation (1):
Y m ⫽Y t (1⫺ ␶ i ).
64.
65.
66.
67.
CBO REPORT, supra note 12, at 6; Jenn, supra note 5, at 594.
CBO REPORT, supra note 12, at 6; Jenn, supra note 5, at 593–94.
CBO REPORT, supra note 12, at 5; Yamamoto, supra note 5, at 185–90.
In the case of the subsidy proposal, equation (1) would be rewritten as:
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than the present tax exemption on municipal bond interest because it would
remove the exemption’s benefits to high-bracket taxpayers by subjecting such
taxpayers to higher taxes on their municipal bond interest income.68 Federal
revenue loss would be equal to reduced-borrowing-cost benefits to municipal
governments because the federal government would collect taxes on municipal
bond interest income and then reduce municipalities’ borrowing costs by redistributing the proceeds back to the states.69 Thus, as in the case of the credit
proposal, the subsidy proposal would increase vertical equity because it would
remove windfalls to high-bracket taxpayers that occur under the tax exemption
regime. Moreover, the subsidy proposal would achieve more horizontal equity
than either the exemption or the credit proposal because it would equalize the
tax treatment of equal-income holders of Treasury and municipal bonds. If two
taxpayers were subject to a 35% tax, then both of them would pay $35 on every
$100 of interest income from either Treasury or municipal bonds.
With the passage of the American Recovery and Reinvestment Act of 2009,
both the sponsors of the credit proposal and the sponsors of the subsidy
proposal have finally realized their wildest dreams.70 Specifically, the economic
stimulus bill added a new provision to the Code that allows states to issue two
types of Build America Bonds very similar to the credit and subsidy proposals.71 The Code provides that interest income from both types of Build America
Bonds is includable in gross income, in contrast to other types of municipal
bonds.72 Akin to the credit proposal, the first type of Build America Bond
(which I will refer to as the “Credit BAB”) provides that, if the issuer makes an
irrevocable election to designate its bond issues as Build America Bonds,73 the
holders of such bonds are entitled to a tax credit equal to 35% of the amount of
interest payable by the issuer on a given date.74 The taxpayer is not entitled to
such a credit if the taxpayer’s total tax credits exceed her tax liability in a given
year,75 but the taxpayer may carry over unused credits to succeeding tax years.76
The second type of Build America Bond (which I will refer to as the “Subsidy
Y m (1⫺ ␶ i )⫽Y t (1⫺ ␶ i ).
Simplifying this expression, we get:
Y m ⫽Y t .
68. CBO REPORT, supra note 12, at 5–6; Yamamoto, supra note 5, at 189.
69. See supra note 68.
70. See Press Release, Internal Revenue Service, IRS Issues Guidance on New Build America Bonds
(Apr. 3, 2009), available at http://www.irs.gov/newsroom/article/0,,id⫽206037,00.html.
71. See I.R.C. § 54AA (West Supp. 2009).
72. Id. § 54AA(f)(1).
73. Id. § 54AA(d)(1)(C).
74. Id. § 54AA(a)–(b).
75. Id. § 54AA(c)(1).
76. Id. § 54AA(c)(2).
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BAB”) entitles issuers—who make an irrevocable election to issue certain
qualified bonds77—to receive tax credits equal to 35% of the interest payable on
such bonds on a given date.78 The issuer of a Subsidy BAB may only issue such
a bond in lieu of issuing a Credit BAB.79 Moreover, the elections to issue Credit
BABs or Subsidy BABs are only available for bond issues before January 1,
2011.80 During the third quarter of 2009 alone, state governments issued
approximately $20.1 billion worth of Build America Bonds.81
In the analyses that follow, I will compare Credit BABs, Subsidy BABs, and
§ 103 tax-exempt municipal bonds to determine, based on principles from both
economics and tax law, which type of bond would constitute the most attractive
investment option for foreign investors.
II. A BRIEF INTRODUCTION TO FEDERAL TAXATION OF INBOUND TRANSACTIONS
In contrast to the tax systems in many other countries, the U.S. tax system
exhibits a fairly “aggressive assertion of jurisdictional power.”82 The U.S.
government derives such power from both the Internal Revenue Code and
various bilateral tax treaties that the United States has negotiated with foreign
governments. In this Part, I will address each of these two bases of tax law.
First, I will discuss the manner in which the United States uses the Code to tax
foreign taxpayers in countries with which the United States does not maintain a
bilateral tax treaty. Second, I will examine the manner in which the United
States taxes foreign taxpayers from countries with which the United States
maintains a bilateral tax treaty. Finally, I will discuss the manner in which the
United States taxes the activities of foreign governments within the United
States.
A. TAXATION OF FOREIGN TAXPAYERS UNDER THE INTERNAL REVENUE CODE
The statutory method for U.S. taxation of foreign taxpayers generally applies
to all taxpayers who are citizens of countries with which the United States has
not negotiated bilateral tax treaties.83 The Code mandates different types of tax
treatment depending on the characteristics of a given taxpayer and the type of
income he earns. With respect to taxpayer characteristics, the Code distin-
77. Id. § 54AA(g)(2)(B).
78. Id. §§ 54AA(g)(1), 6431(a)–(b).
79. Id. § 54AA(g)(1).
80. Id. § 54AA(d)(1)(B), (g).
81. See PAUL RAINY, SEC. INDUS. & FIN. MKTS. ASSOC., MUNICIPAL BOND CREDIT REPORT 3 (2009),
http://www.sifma.org/research/pdf/RRVol4-12.pdf. In particular, four states—New York, Illinois, Texas,
and California—each issued over $1 billion worth of Build America Bonds during the third quarter of
2009. Id.
82. GUSTAFSON ET AL., TAXATION OF INTERNATIONAL TRANSACTIONS ¶ 1070 (3d ed. 2006).
83. See I.R.C. § 894(a)(1) (2006) (“The provisions of this title shall be applied to any taxpayer with
due regard to any treaty obligation of the United States which applies to such taxpayer.”).
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guishes between two types of taxpayers: domestic and foreign.84 The Code
defines a domestic taxpayer as, among others, a citizen or resident alien of the
United States, or a domestic corporation.85 A corporation is a domestic corporation if it is “created or organized in the United States or under the law of the
United States or of any State.”86 With some exceptions,87 an individual is a
resident alien of the United States if: a) he has the legal privilege of permanent
residence in the United States in accordance with the immigration laws, b) he is
present in the United States for a specified period of time over the present year
and the two immediately preceding years, or c) he elects treatment as a resident
alien.88 In contrast, the Code defines foreign taxpayers as, among others,
non-resident aliens and foreign corporations.89 A foreign corporation is a corporation that is organized under the laws of a jurisdiction other than either the
United States or any U.S. state.90 A non-resident alien is an individual who is
neither a U.S. citizen nor a resident alien of the United States.91
Furthermore, for purposes of determining tax liability, the Code distinguishes
between two types of income: U.S. source income and foreign source income.92
The Code defines the differences between U.S. and foreign source income on
the basis of source rules that apply to particular types of income that a taxpayer
may earn.93 For example, the Code generally defines the source of interest
income based on the residence of the borrower who pays the interest.94 Thus, a
taxpayer receives U.S. source interest income if he receives interest payments
from U.S. borrowers.95 In contrast, a taxpayer receives foreign source interest
income if he receives interest payments from a borrower in any country other
than the United States.96
Pursuant to U.S. law, domestic taxpayers must pay taxes on their entire
worldwide income, regardless of whether such income is U.S. source income or
foreign source income.97 Thus, if a U.S. citizen earns income from conducting a
business in which he sells goods in Canada, he must pay taxes on such income
84. Although the Code does not specifically use the terms “domestic” and “foreign” to refer to the
two classes of taxpayers, I use those terms in this Note for purposes of brevity.
85. See I.R.C. § 7701(a)(30) (2006 & West Supp. 2009).
86. Id. § 7701(a)(4).
87. For example, the Code does not accord resident alien status to individuals who are present in the
United States as a foreign government-related individual, a teacher or trainee, a student, or a professional athlete temporarily in the United States to compete in a charitable sports event. Id. § 7701(b)(5).
88. Id. § 7701(b).
89. See generally id. § 7701(a).
90. Id. § 7701(a)(4)–(5).
91. Id. § 7701(b)(1)(B).
92. Id. §§ 861–862.
93. See id.
94. Id. §§ 861(a)(1), 862(a)(1).
95. Id. § 861(a)(1).
96. Id. § 862(a)(1).
97. GUSTAFSON, supra note 82, ¶ 1155.
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to the IRS.98 In contrast, the Code subjects foreign taxpayers to one of two
principal taxing regimes in the United States in situations in which such foreign
taxpayers receive U.S. source income.99 The first U.S. tax regime confronting
foreign taxpayers subjects non-resident aliens and foreign corporations to U.S.
tax on any income they earn which is effectively connected with the conduct of
a United States trade or business (hereafter, I will refer to this tax as the trade or
business tax).100 Generally speaking, a taxpayer engages in a trade or business
under U.S. tax law if he engages in “the process of producing or seeking to
produce income from actively engaging in business activities, as distinguished
from merely owning income-producing property.”101 More specifically, a taxpayer is likely to engage in a U.S. trade or business within the meaning of the
Code if he engages in “regular, continuous and considerable business activities
in [the United States],” as opposed to “[i]solated or sporadic transactions.”102
Based on the foregoing, a foreign taxpayer will be subject to U.S tax on all
interest income that he earns in connection with the regular, continuous, and
considerable conduct of business activities in the United States.
The second U.S. tax regime facing foreign taxpayers applies to non-resident
aliens or foreign corporations who do not conduct a trade or business activity in
the United States, but who earn fixed, determinable, annual, or periodic (FDAP)
income from U.S. sources.103 The Code subjects a non-resident alien’s or
foreign corporation’s FDAP income to a 30% flat withholding tax on gross
income to the extent that such income is not effectively connected with the
conduct of a U.S. trade or business.104 Interest income is a type of FDAP
income and thus is subject to the FDAP tax.105 However, under certain circumstances, interest income may not be subject to the FDAP tax if it is a form of
portfolio interest within the meaning of the Code.106
The 30% withholding tax (which I will hereafter refer to as the “FDAP tax”)
98. As a result of U.S. taxation of worldwide income of domestic taxpayers, some U.S. citizens may
be subject to taxation in both the United States and a foreign jurisdiction. To mitigate the effects of such
double taxation, Congress has implemented a complex series of statutes that, under certain circumstances, allow domestic taxpayers to receive a foreign tax credit equal to the foreign taxes they pay in a
given tax year. See I.R.C. §§ 901–904 (2006 & West Supp. 2009). A lengthy discussion of the foreign
tax credit is beyond the scope of this Note.
99. See id. §§ 871, 881, 882.
100. Id. §§ 871(b), 882.
101. GUSTAFSON, supra note 82, ¶ 3005.
102. See, e.g., Cont’l Trading, Inc. v. Comm’r, 265 F.2d 40, 43–46 (9th Cir. 1959); Pinchot v.
Comm’r, 113 F.2d 718, 719 (2d Cir. 1940); see also GUSTAFSON, supra note 82, ¶ 3005.
103. I.R.C. §§ 871(a), 881 (2006 & West Supp. 2009).
104. Id.
105. Id. §§ 871(a)(1)(A), 881(a)(1).
106. Id. §§ 871(h), 881(c). For example, interest may constitute portfolio interest if it is associated
with a registered obligation that has a maturity of more than one year and that is issued by anyone other
than a natural person to members of the public. Id. §§ 871(h)(2)(B), (h)(7), 881(c)(2)(B), (c)(4), 163(f).
Moreover, an interest payment constitutes portfolio interest in the form of a registered obligation if it
meets certain requirements under regulations promulgated by the Treasury Department. See Treas. Reg.
§ 1.871-14(c) (2009).
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exhibits two characteristics that are unique in the Code. First, the FDAP tax is a
tax on gross income rather than net income. In the usual course, a U.S. taxpayer
calculates her tax liability for a given year as follows. First, she calculates her
gross income,107 from which she subtracts specified deductions to determine her
adjusted gross income and her taxable income.108 Once the taxpayer has
determined her taxable income, the Code specifies certain amounts that she may
credit against such income to determine her ultimate tax liability to the IRS.109
Such a tax is a tax on net income because the taxpayer incurs a tax liability on
her gross income net of deductions and credits in the Code. In contrast, the
FDAP tax is a tax on gross income because a taxpayer must incur such a tax on
total gross income without regard to potential deductions or credits that would
otherwise apply.110 Another unique feature of the FDAP tax is that the IRS
collects it through a withholding mechanism.111 The withholding mechanism
requires “all persons . . . having the control, receipt, custody, disposal, or
payment” of any non-resident alien or foreign corporation’s items of FDAP
income to withhold 30% of the value of such items for purposes of paying the
FDAP tax.112
Two rationales justify imposing the FDAP tax on gross income and collecting
the FDAP tax through a withholding mechanism. First, the withholding mechanism allows the IRS to collect taxes from foreign taxpayers in light of a
principle of international comity known as the revenue rule.113 The revenue rule
holds that a given country’s revenue agents cannot use foreign courts to collect
delinquent taxes from foreign citizens.114 Thus, if the IRS attempted to collect
FDAP taxes from non-resident aliens and foreign corporations through an
annual filing process, it would not be able to use foreign courts as a means of
collecting lost revenue in the event that a foreign taxpayer absconded to a
foreign country after failing to pay U.S. taxes to the IRS.115 In contrast, the
withholding mechanism enables the IRS to collect foreign taxpayers’ FDAP
taxes through domestic entities over which it can assert jurisdiction in domestic
courts.116 Second, the rationale for imposing the FDAP withholding tax on
gross income is to allow withholding individuals or entities to more easily
calculate foreign taxpayers’ FDAP tax liability.117 By imposing the withholding
tax on gross (rather than net) income, Congress relieves withholding agents
from having to determine the deductions or credits that a foreign taxpayer could
107.
108.
109.
110.
111.
112.
113.
114.
115.
116.
117.
See I.R.C. § 61 (2006).
See id. §§ 62, 63.
See FREELAND ET AL., FUNDAMENTALS OF FEDERAL INCOME TAXATION 941 (15th ed. 2009).
See GUSTAFSON, supra note 82, ¶ 4000.
I.R.C. §§ 1441(a)–(b), 1442(a) (2006).
Id. §§ 1441(a), 1442(a).
See GUSTAFSON, supra note 82, ¶¶ 1080, 4005.
See id. ¶ 1080.
See id.
See id. ¶ 4005.
See id.
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otherwise claim.118 In a sense, Congress designed the 30% withholding tax on
FDAP income to approximate the tax that foreign taxpayers would otherwise
pay if they filed taxes on an annual basis and included deductions and credits in
the calculation of their tax liability to the IRS.119
In summary, a foreign taxpayer from a non-treaty country could be subject to
U.S. tax liability in one of two ways. First, if the foreign taxpayer receives
income in connection with the conduct of a U.S. trade or business, it must pay
the trade or business tax on such income at the ordinary tax rates pursuant to
Code § 1 (in the case of individuals) or § 11 (in the case of corporations).120
Second, if the foreign taxpayer receives FDAP income, such as non-portfolio
interest income, the U.S. individual or entity responsible for paying such
interest income must withhold 30% of the value of the interest payments for
purposes of paying the FDAP tax to the IRS.121 In the next section, I will
explain how these results vary when the relevant foreign taxpayer hails from a
country with which the United States has negotiated a bilateral tax treaty.
B. TAXATION OF FOREIGN TAXPAYERS UNDER BILATERAL TAX TREATIES
As of March 2010, the United States has negotiated about fifty-seven bilateral
income tax treaties with various foreign governments.122 For purposes of this
analysis, I will examine treaty provisions between the United States and the
countries and categories of countries that held the most Treasury securities in
terms of dollar value between August 2008 and August 2009.123 I limit my
analysis to treaties between the United States and countries with high levels of
118. See id.
119. See id.
120. I.R.C. §§ 871(b), 882 (2006 & West Supp. 2009).
121. Id. §§ 871(a), 881.
122. The United States has directly negotiated bilateral tax treaties with the following countries:
Australia, Austria, Bangladesh, Barbados, Belgium, Bulgaria, Canada, China, Cyprus, Czech Republic,
Denmark, Egypt, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, India, Indonesia,
Ireland, Israel, Italy, Jamaica, Japan, Kazakhstan, South Korea, Latvia, Lithuania, Luxembourg, Mexico,
Morocco, Netherlands, New Zealand, Norway, Pakistan, Philippines, Poland, Portugal, Romania,
Russia, Slovak Republic, Slovenia, South Africa, Spain, Sri Lanka, Sweden, Switzerland, Thailand,
Trinidad and Tobago, Tunisia, Turkey, Ukraine, United Kingdom, and Venezuela. Internal Revenue
Service, United States Income Tax Treaties A–Z, http://www.irs.gov/businesses/international/article/
0,,id⫽96739,00.html#T (last visited Mar. 4, 2010). Additionally, the bilateral tax treaty between the
United States and the Soviet Union remains in effect with respect to the following countries: Armenia,
Azerbaijan, Belarus, Georgia, Kyrgyzstan, Moldova, Tajikistan, Turkmenistan, and Uzbekistan. Id.; see
also GUSTAFSON, supra note 82, ¶ 1235.
123. See United States Department of the Treasury, Major Foreign Holders of Treasury Securities,
http://www.treasury.gov/tic/mfh.txt (last visited Mar. 4, 2010). The top ten holders of U.S. Treasury
securities between August 2008 and August 2009 included: China, Japan, United Kingdom, oil
exporters (which includes Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar,
Saudi Arabia, United Arab Emirates, Algeria, Gabon, Libya, and Nigeria), the Caribbean banking
centers (which includes Bahamas, Bermuda, Cayman Islands, Netherlands Antilles, Panama, and the
British Virgin Islands), Brazil, Hong Kong, Russia, Luxembourg, and Taiwan. Id. Of these countries,
the United States does not maintain tax treaties with Brazil, Taiwan, Ecuador, Bahrain, Iran, Iraq,
Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates, Algeria, Gabon, Libya, Nigeria, Bahamas,
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Treasury security investment purely for analytical convenience. By analyzing
these countries’ tax treaties with the United States, I am able to examine a
representative range of treaty provisions that might apply to foreign investors,
while specifically focusing on provisions that apply to investors presumably
most interested in U.S. municipal bond investment.
The types of U.S. taxation of foreign taxpayers from treaty countries are
closely analogous to the trade or business tax and the FDAP tax that the Code
imposes on foreign taxpayers. For example, as in the case of the trade or
business tax under the Code, tax treaties allow the IRS to collect taxes on
foreign taxpayers’ income that is attributable to a permanent establishment in
the United States.124 A permanent establishment is “a fixed place of business
through which the business of an enterprise is wholly or partly carried on.”125
Among other things, a permanent establishment includes a place of management, branch, office, factory, workshop, mine, oil or gas well, quarry, or other
place of extraction of natural resources.126 Thus, if a Chinese individual or
Cayman Islands, or Panama. See Internal Revenue Service, United States Income Tax Treaties A–Z,
http://www.irs.gov/businesses/international/article/0,,id⫽96739,00.html#T (last visited Mar. 4, 2010).
124. United States Model Income Tax Convention of November 15, 2006, art. 7 ¶ 1, http://
www.ustreas.gov/offices/tax-policy/library/model006.pdf [hereinafter Model Tax Treaty] (last visited
Mar. 4, 2010); Convention Between the Government of the United States of America and the
Government of Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with
Respect to Taxes on Income, U.S.–Japan, art. 7 ¶ 1, Nov. 6, 2003, S. TREATY DOC. NO. 108-14
[hereinafter U.S.–Japan Tax Treaty]; Convention Between the Government of the United Kingdom of
Great Britain and Northern Ireland and the Government of the United States of America for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income
and on Capital Gains, U.S.–U.K., art. 7 ¶ 1, Jul. 24, 2001, 2224 U.N.T.S. 247 [hereinafter U.S.–U.K.
Tax Treaty]; Convention Between the Government of the United States of America and the Government
of the Republic of Venezuela for the Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with Respect to Taxes on Income and Capital, U.S.–Venez., art. 7 ¶ 1, Jan. 25, 1999, T.I.A.S.
NO. 13,020 [hereinafter U.S.–Venez. Tax Treaty]; Convention Between the Government of the United
States of America and the Government of the Republic of Indonesia for the Avoidance of Double
Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, U.S.–Indon., art. 8 ¶ 1,
Jul. 24, 1996, S. TREATY DOC. NO. 104-32 (modifying a July 11, 1988 agreement) [hereinafter
U.S.–Indon. Tax Treaty]; Convention Between the Government of the United States of America and the
Government of the Grand Duchy of Luxembourg for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital, U.S.–Lux., art. 7 ¶ 1, Apr.
3, 1996, 2148 U.N.T.S. 81 [hereinafter U.S.–Lux. Tax Treaty]; Convention Between the United States
of America and the Russian Federation for the Avoidance of Double Taxation and the Prevention of
Fiscal Evasion with Respect to Taxes on Income and Capital, U.S.–Russ., art. 6 ¶ 1, Jun. 17, 1992, S.
TREATY DOC. NO. 102-39 [hereinafter U.S.–Russ. Tax Treaty]; Agreement Between the Government of
the United States of America and the Government of the People’s Republic of China for the Avoidance
of Double Taxation and the Prevention of Tax Evasion with Respect to Taxes on Income, U.S.–P.R.C.,
art. 7 ¶ 1, Apr. 30, 1984, T.I.A.S. NO. 12,065 [hereinafter U.S.–P.R.C. Tax Treaty].
125. Model Tax Treaty, art. 5 ¶ 1; see U.S.–Japan Tax Treaty, supra note 124, art. 5 ¶ 1; U.S.–U.K.
Tax Treaty, supra note 124, art. 5 ¶ 1; U.S.–Venez. Tax Treaty, supra note 124, art. 5 ¶ 1; U.S.–Indon.
Tax Treaty, supra note 124, art. 5 ¶ 1; U.S.–Lux. Tax Treaty, supra note 124, art. 5 ¶ 1; U.S.–Russ. Tax
Treaty, supra note 124, art. 5 ¶ 1 (specifying that a fixed place of business may constitute a permanent
establishment whether or not it is a legal entity); U.S.–P.R.C. Tax Treaty, supra note 124, art. 5 ¶ 1.
126. See Model Tax Treaty, supra note 124, art. 5 ¶ 2; U.S.–Japan Tax Treaty, supra note 124, art. 5
¶ 2; U.S.–U.K. Tax Treaty, supra note 124, art. 5 ¶ 2; U.S.–Venez. Tax Treaty, supra note 124, art. 5 ¶
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entity operates a factory in the United States in which it produces umbrellas, the
IRS may tax the Chinese individual or entity on all income attributable to the
operation of the factory in the United States.127
Furthermore, as in the case of the FDAP tax under the Code, tax treaties
contain provisions relating to the taxation of FDAP-like income. However,
unlike the FDAP tax, tax treaties between the United States and foreign
governments typically relieve or reduce the U.S. taxes that foreign taxpayers
must pay on FDAP-like income. For example, tax treaties usually either eliminate or substantially reduce U.S. taxes that foreign taxpayers must pay on
interest income not attributable to a permanent establishment in the United
States.128 Under the terms of such treaties, the term “interest” includes “income
from government securities.”129 Thus, under the terms of the applicable treaty, a
British investor who receives interest income from investment in U.S. government securities need not pay U.S. taxes on such income.130 Similarly, under the
terms of the applicable treaty, a Japanese investor who receives interest income
from investment in U.S. government securities may be subject to as much as a
10% U.S. tax.131
In summary, a foreign taxpayer from a treaty country may be subject to U.S.
tax liability in one of two ways. First, as in the case of the trade or business tax
under the Code, tax treaties require foreign taxpayers to pay U.S. taxes on
income attributable to the operation of a permanent establishment in the United
States.132 Alternatively, a foreign taxpayer may be subject to no U.S. tax
liability or reduced U.S. tax liability on any FDAP-like income that the foreign
taxpayer earns from sources within the United States to the extent that such
2; U.S.–Indon. Tax Treaty, supra note 124, art. 5 ¶ 2; U.S.–Lux. Tax Treaty, supra note 124, art. 5 ¶ 2;
U.S.–Russ. Tax Treaty, supra note 124, art. 5 ¶ 2; U.S.–P.R.C. Tax Treaty, supra note 124, art. 5 ¶ 2.
127. U.S.–P.R.C. Tax Treaty, supra note 124, arts. 7 ¶ 1, 5 ¶¶ 1–2.
128. Model Tax Treaty, supra note 124, art. 11 ¶¶ 1, 4 (eliminating U.S. tax on foreign taxpayers’
U.S. source interest income); U.S.–Japan Tax Treaty, supra note 124, art. 11 ¶¶ 1, 2, 6 (restricting U.S.
tax on foreign taxpayers’ U.S source interest income to 10% of such income); U.S.–U.K. Tax Treaty,
supra note 124, art. 11 ¶¶ 1, 3 (eliminating U.S. tax on foreign taxpayers’ U.S. source interest income);
U.S.–Venez. Tax Treaty, supra note 124, art. 11 ¶¶ 1, 2, 6 (restricting U.S. tax on foreign taxpayers’ U.S
source interest income to 4.95% of such income in the case of interest beneficially owned by financial
institutions, and 10% of such income in all other cases); U.S.–Indon. Tax Treaty, supra note 124, art. 12
¶¶ 1, 2, 4 (restricting U.S. tax on foreign taxpayers’ U.S source interest income to 15% of such income);
U.S.–Lux. Tax Treaty, supra note 124, art. 12 ¶¶ 1, 3 (eliminating U.S. tax on foreign taxpayers’ U.S.
source interest income); U.S.–Russ. Tax Treaty, supra note 124, art. 11 ¶¶ 1, 3 (eliminating U.S. tax on
foreign taxpayers’ U.S. source interest income); U.S.–P.R.C. Tax Treaty, supra note 124, art. 10 ¶¶ 1, 2,
5 (restricting U.S. tax on foreign taxpayers’ U.S source interest income to 10% of such income).
129. Model Tax Treaty, supra note 124, art. 11 ¶ 3; U.S.–Japan Tax Treaty, supra note 124, art. 11 ¶
5; U.S.–U.K. Tax Treaty, supra note 124, art. 11 ¶ 2; U.S.–Venez. Tax Treaty, supra note 124, art. 11 ¶
5; U.S.–Indon. Tax Treaty, supra note 124, art. 12 ¶ 6; U.S.–Lux. Tax Treaty, supra note 124, art. 12 ¶
2; U.S.–Russ. Tax Treaty, supra note 124, art. 11 ¶ 2; U.S.–P.R.C. Tax Treaty, supra note 124, art. 10 ¶
4.
130. U.S.–U.K. Tax Treaty, supra note 124, art. 11 ¶¶ 1–3.
131. U.S.–Japan Tax Treaty, supra note 124, art. 11 ¶¶ 1, 2, 5, 6.
132. See, e.g., Model Tax Treaty, supra note 124, art. 7 ¶ 1.
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income is not attributable to a U.S. permanent establishment.133
C. TAXATION OF FOREIGN GOVERNMENT ACTIVITIES IN THE UNITED STATES
The United States does not impose tax liability on income that foreign
governments earn from certain passive investment activities in the United
States.134 Thus foreign governments are not subject to taxation by the IRS if
they receive income from, among other things, U.S. stocks or bonds, U.S.
financial instruments held for the purpose of executing government fiscal or
monetary policy, or interest from U.S. bank deposits.135 However, foreign
governments may be subject to U.S. taxation when they derive any income from
the conduct of a commercial activity, receipts by or from a controlled commercial entity, or the disposition of any interest in a controlled commercial entity.136
Moreover, a foreign government’s income from the conduct of a commercial
activity may be subject to U.S. taxation regardless of whether the foreign
government conducts the commercial activity within the United States.137 In
short, foreign governments are essentially only subject to U.S. taxation—that is,
the trade or business tax, the FDAP tax, or any tax treaty obligations—in
situations in which they earn U.S. source income through the conduct of
commercial activities anywhere in the world.138
III. THE FIVE FOREIGNERS: A MODEL OF MUNICIPAL BOND TAXATION
Based on the way the U.S. government taxes foreign taxpayers’ income,139 I
will use principles of economics and tax law to determine which out of the
§ 103 tax-exempt bonds, the Credit BAB, or the Subsidy BAB is most likely to
attract the marginal foreign investor in U.S. municipal bonds. In order to
undertake this analysis, I will divide foreign taxpayers into five categories based
on U.S. tax law principles:
133. See, e.g., id., art. 11 ¶¶ 1, 4.
134. I.R.C. § 892(a)(1) (2006). The same rule also applies to income from passive U.S. investments
by international organizations. Id. § 892(b).
135. Id. § 892(a)(1).
136. Id. § 892(a)(2). A “controlled commercial entity” refers to
any entity engaged in commercial activities (whether within or outside the United States) if
the government . . . . holds (directly or indirectly) any interest in such entity which (by value
or voting interest) is 50% or more of the total of such interests in such entity, or . . . holds
(directly or indirectly) any other interest in such entity which provides the foreign government
with effective control of such entity.
Id. § 892(a)(2)(B). Moreover, “a central bank of issue shall be treated as a controlled commercial entity
only if engaged in commercial activities within the United States.” Id.
137. Id. § 892(a)(2)(A)(i).
138. Pursuant to the Code, foreign governments are treated as foreign corporations for purposes of
imposing U.S. taxes. Id. § 892(a)(3).
139. See discussion supra Part II.
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Foreign Investor 1: Includes foreign investors from non-treaty countries
who earn municipal bond interest income in connection with a U.S.
trade or business.
Foreign Investor 2: Includes foreign investors from treaty countries who
receive municipal bond interest income attributable to a U.S. permanent
establishment.
Foreign Investor 3: Includes foreign investors from non-treaty countries
who receive municipal bond interest income from passive U.S. investments—that is, municipal bond interest income as FDAP income.
Foreign Investor 4: Includes foreign investors from treaty countries who
receive municipal bond interest income from passive U.S. investments.
Foreign Investor 5: Includes foreign governments who receive municipal bond interest income from tax-exempt U.S. investments.
I will premise my analysis on the condition that, where Ytd represents the
after-tax Treasury yield for domestic investors, Ytf represents the after-tax
Treasury yield for foreign investors, Ymd represents the after-tax municipal yield
for domestic investors, and Ymf represents the after-tax municipal yield for
foreign investors, foreign investors will be most likely to invest in U.S. municipal bonds in the situation when:
2. Y td ⫽ Y tf ⫽ Y md ⫽ Y mf
By examining how the tax results that apply to each of the five types of foreign
investors might change the condition in equation (2), I will be able to determine
which of the three types of municipal bond structures would most likely attract
foreign investment in U.S. municipal bonds.
The condition in equation (2) assumes that, all else being equal, individual
foreign and domestic investors will only be indifferent between purchasing like
Treasury and municipal bonds in situations where the after-tax yields on such
bonds are equal. Moreover, from a supply-side perspective, equation (2) assumes that state and local governments will be indifferent between soliciting
investment from foreign and domestic investors in situations where the after-tax
yields on municipal bonds in the hands of domestic investors are the same as
the after-tax yields on municipal bonds in the hands of foreign investors. If the
effective interest rates facing foreign and domestic investors were unequal due
to the differing tax treatment of such bonds in the hands of different investors,
then states would be more likely to solicit investment from borrowers that
would offer them the lower borrowing cost. Thus, if domestic investors paid a
lower after-tax yield on municipal bonds than their foreign counterparts, municipal governments would more likely solicit domestic investors because interest
payments to them would be lower.
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IV. ANALYSIS: MUNICIPAL BOND TAX STRUCTURES AND THEIR EFFECTS ON
INBOUND FOREIGN INVESTMENT
In this Part, I analyze the tax consequences that would result for each of the
five types of foreign investors if the U.S. government taxed municipal bond
interest income according to the § 103 exemption, the Credit BAB scheme, or
the Subsidy BAB scheme. In section IV.A, I will examine the economic and tax
consequences that would obtain if Foreign Investor 1 (a foreign investor from a
non-treaty country who receives municipal bond interest income in connection
with a U.S. trade or business) or Foreign Investor 2 (a foreign investor from a
treaty country who receives municipal bond interest income attributable to a
U.S. permanent establishment) had a choice between investing in tax-exempt
bonds, Credit BABs, or Subsidy BABs. In section IV.B, I will analyze the
economic and tax consequences that would obtain if Foreign Investor 3 (a
foreign investor from a non-treaty country who receives municipal bond interest
income from passive U.S. investment) or Foreign Investor 4 (a foreign investor
from a treaty country who receives municipal bond interest income from
passive U.S. investment) had a choice between investing in any of the three
types of bonds. Finally, in section IV.C, I will discuss the economic and tax
consequences that would obtain if Foreign Investor 5 (a foreign government
engaging in tax-exempt investment in the United States) had a choice between
investing in any of the three types of bonds.
A. FOREIGN INVESTORS 1 AND 2: FOREIGNERS WITH UNITED STATES BUSINESS
ACTIVITIES
When it comes to municipal bond interest income, Foreign Investor 1 sits in
the same shoes as a domestic investor in municipal bonds because he140 must
pay the U.S. trade or business tax at the ordinary marginal tax rates.141
Likewise, Foreign Investor 2 sits in the same position as domestic investors
when it comes to municipal bond interest income because, under the terms of
the applicable treaty, she would be subject to U.S. tax on her municipal bond
interest income attributable to a U.S. permanent establishment at the ordinary
marginal tax rates.142
Thus, with respect to tax-exempt municipal bonds, Foreign Investors 1 and
2—like similarly situated domestic investors—would be indifferent between
purchasing Treasury and municipal bonds because, due to the equilibrium in
equation (1), their after-tax Treasury yields would be equal to their untaxed
municipal yields. Similarly, Foreign Investors 1 and 2 would be indifferent
between purchasing Treasury bonds and Credit BABs because, based on equa-
140. In order to clarify my analyses in this Part, I will use the male pronoun in reference to Foreign
Investors 1 and 3, and the female pronoun in reference to Foreign Investors 2 and 4.
141. See I.R.C. §§ 871(b), 882 (2006 & West Supp. 2009); see also id. §§ 1, 11.
142. See, e.g., Model Tax Treaty, supra note 124, art. 7 ¶ 1; see also I.R.C. §§ 1, 11, 871(b), 882
(2006 & West Supp. 2009).
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tion (1), their after-tax yields on Treasury bonds would be equal to their
post-tax-credit municipal bond yields. Finally, Foreign Investors 1 and 2 would
be indifferent between purchasing Treasury bonds and Subsidy BABs because
they would be subject to the same tax rate on both types of bonds. Based on the
equilibrium in equation (1), Subsidy BAB interest rates would roughly equal
Treasury bond interest rates because, all else being equal, the federal tax on
Subsidy BABs would put upward pressure on their yields. As a result, for
Foreign Investors 1 and 2, their after-tax (and before-tax) yields on investment
in Subsidy BABs would be equal to their after-tax (and before-tax) yields on
investment in Treasury bonds. In short, the equilibrium in equation (2) is
satisfied with respect to Foreign Investors 1 and 2 regardless of whether
municipal governments issue tax-exempt bonds, Credit BABs, or Subsidy
BABs. Therefore, Foreign Investors 1 and 2 are equally likely to invest in
municipal bonds regardless of the tax form they take.
B. FOREIGN INVESTORS 3 AND 4: PASSIVE FOREIGN INVESTORS IN THE UNITED STATES
In contrast to Foreign Investors 1 and 2, Foreign Investor 3 would likely have
very different preferences with respect to investment in § 103 tax-exempt
municipal bonds because he is subject to a 30% withholding tax on all U.S.
source FDAP income.143 From a tax perspective, Foreign Investor 3 would not
likely have to pay any U.S. taxes144 on interest income from Treasury bonds
because, as a type of registered obligation, Treasury bond interest would likely
fall within the portfolio interest exemption to the FDAP tax.145 Furthermore,
Foreign Investor 3 would not likely be subject to U.S. taxes on his interest
income from tax-exempt municipal bonds because § 103 exempts municipal
143. I.R.C. §§ 871(a), 881 (2006 & West Supp. 2009).
144. It is also worth noting at this point in the analysis that foreign taxpayers are likely subject to
little or no foreign tax on the income they earn from investment in U.S. Treasury or municipal bonds
because many foreign jurisdictions exempt their taxpayers from paying taxes on income from U.S.
sources. See GUSTAFSON, supra note 82, ¶¶ 1070, 1095. Even if Foreign Investors 3 and 4 were subject
to foreign taxes on their interest income from investment in U.S. Treasury or municipal bonds, the tax
might be lower than the tax rate applicable to similarly situated domestic taxpayers. For instance, as of
2008, Japan is the only country in the Organization for Economic Cooperation and Development
(OECD) to charge a higher combined corporate income tax rate than the United States. Tax Policy
Center, OECD Taxation of Corporate Income 2000–2008, available at http://www.taxpolicycenter.org/
taxfacts/displayafact.cfm?Docid⫽479&Topic2id⫽95 (last visited Nov. 14, 2009). Even still, for purposes of this analysis, the effect of any applicable foreign taxes is negated by the fact that such taxes
would presumably apply equally to both U.S. Treasury and municipal bond interest income. To
illustrate this numerically, suppose that Foreign Investor 3 must pay a 30% foreign tax on all income
from U.S. sources. Moreover, suppose that as a result of the equilibrium in equation (1), the interest rate
on Treasury bonds is 10%, while the interest rate on municipal bonds is 7%. In such a scenario, Foreign
Investor 3 will prefer to invest in Treasury bonds because, after applying foreign taxes, his yield on
Treasury bonds would be 7%, while his yield on municipal bonds would be 4.9%.
145. See I.R.C. §§ 871(h)(2)(B), 881(c)(2)(B) (2006 & West Supp. 2009); see also GUSTAFSON, supra
note 82, ¶ 4040 (“As a result of the [portfolio interest] exclusion, most interest payments to foreign
persons on publicly traded debt securities that are either registered obligations or are bearer obligations . . . will not be subject to the [FDAP] withholding tax. Such debt securities include bonds and
other debt issued by the U.S. government.”).
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bond interest from gross income, which includes gross income for purposes of
calculating the FDAP tax.146 Likewise, Foreign Investor 4’s preferences with
respect to investment in U.S. bonds are closely analogous to Foreign Investor
3’s preferences for simpler reasons. Because Foreign Investor 4 hails from a
treaty country, the provisions of the treaty would apply in determining her total
U.S. income tax liability.147 As a result, Foreign Investor 4 would either pay no
U.S. tax or a reduced U.S. tax on interest income from Treasury bonds or
tax-exempt municipal bonds.148
From an economic perspective, if Foreign Investors 3 and 4 would not have
U.S. tax liability with respect to their interest income from investments in either
Treasury bonds or tax-exempt municipal bonds, then the presence of domestic
investors in the municipal bond market would drive them to prefer investment
in Treasury bonds over municipal bonds. As the equilibrium in equation (1)
suggests, the tax exemption on municipal bonds in § 103 drives domestic
taxpayers to increase their demand for municipal bonds to the point where the
domestic after-tax yields on Treasury bonds equals the untaxed yields on
municipal bonds. As a result, the before-tax yield on municipal bonds is always
less than the before-tax yield on Treasury bonds. Thus, from the perspective of
Foreign Investors 3 and 4, who would not have to pay taxes on investment in
either type of bond, an investment in Treasury bonds would always be more
attractive than an investment in municipal bonds because it would always
provide a higher yield. As a result, Foreign Investors 3 and 4 would likely prefer
investment in Treasury bonds if, all else being equal, U.S. law exempts municipal bond interest income from federal taxation.
As in the case of tax-exempt municipal bonds, Foreign Investors 3 and 4
would also likely prefer investment in Treasury bonds to investment in Credit
BABs, albeit for different reasons. On the one hand, Foreign Investor 3 would
not have to pay any U.S. taxes on interest income from U.S. Treasury bonds
because such bonds likely fall under the portfolio interest exemption to the
FDAP tax.149 However, in contrast to the tax-exempt municipal bond scenario,
Foreign Investor 3 might have to pay a 30% U.S. withholding tax on his interest
income from Credit BABs because such income constitutes FDAP interest
income.150 In such a case, Foreign Investor 3 would not be entitled to the tax
credit for Credit BABs because the FDAP tax is a tax on gross income, which
does not include credits or deductions.151 Note that such a result may not obtain
146. See I.R.C. §§ 103, 871(a), 881 (2006 & West Supp. 2009).
147. See id. § 894(a).
148. See, e.g., Model Tax Treaty, supra note 124, art. 11 ¶ 1 (providing for no U.S. tax on interest
income earned by foreign taxpayers); U.S.–Japan Tax Treaty, supra note 124, art. 11 ¶¶ 1–2 (allowing
up to a 10% U.S. tax on interest income earned by foreign taxpayers).
149. See I.R.C. §§ 871(h)(2)(B), 881(c)(2)(B) (2006 & West Supp. 2009); see also GUSTAFSON, supra
note 82, ¶ 4040.
150. See I.R.C. §§ 871(a), 881 (2006 & West Supp. 2009).
151. See GUSTAFSON, supra note 82, ¶¶ 4000, 4005.
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if interest income from Credit BABs fits within the portfolio exemption to the
FDAP tax.152 If interest from Credit BABs constitutes portfolio interest, then
Foreign Investor 3 would have no U.S. tax liability from his Credit BAB
interest income. Alternatively, under the applicable treaty, Foreign Investor 4
would incur similar tax consequences from investment in either Credit BABs or
tax-exempt municipal bonds. Either the Credit BAB tax credit would be irrelevant to Foreign Investor 4 because she would pay no U.S. taxes on municipal
bond interest, or the Credit BAB would provide her with a small tax credit if
she paid reduced U.S. taxes.
Given these tax consequences, economic theory suggests that Foreign Investors 3 and 4 would prefer investment in Treasury bonds to investment in Credit
BABs. As a result of the tax credit on Credit BABs, domestic investors would
increase their investment in such bonds to the point where the equilibrium in
equation (1) would result. Hence, as in the case of tax-exempt municipal bonds,
the before-tax yields on Treasury bonds would always be greater than the
before-tax yields on Credit BABs. Thus, Foreign Investors 3 and 4 would prefer
investment in Treasury bonds to investment in Credit BABs because they would
likely not have to pay any U.S. taxes on Treasury bonds or Credit BABs as a
result of either the portfolio interest or treaty interest exemptions. If Foreign
Investor 3 or 4 had to uniquely pay U.S. taxes on their Credit BAB interest
income as a result of either the FDAP tax or a reduced tax on interest income
under the applicable treaty, they would prefer investment in Treasury bonds
even more so because the FDAP tax or reduced treaty tax would further
decrease their ultimate yields from Credit BABs. Thus, Foreign Investors 3 and
4 would likely prefer investment in U.S. Treasury bonds to investment in Credit
BABs.
However, in contrast to both tax-exempt municipal bonds and Credit BABs,
Foreign Investors 3 and 4 would likely be indifferent between investment in
Treasury bonds and Subsidy BABs. Moreover, given the right circumstances,
Foreign Investors 3 and 4 may even prefer investment in Subsidy BABs to
investment in Treasury bonds. From a tax perspective, Foreign Investor 3 would
probably not have to pay U.S. taxes on interest income from Treasury bonds
because such income likely falls within the portfolio interest exemption to the
FDAP tax.153 Just as in the case of Credit BABs, Foreign Investor 3 would
either have to pay the FDAP tax on his Subsidy BAB interest income or pay no
U.S. tax on his Subsidy BAB interest income, depending on whether the
portfolio interest exemption would apply to such income.154 Alternatively, due
to the terms of the applicable treaty, Foreign Investor 4 would likely pay no
U.S. taxes or reduced U.S. taxes on interest income from either Treasury bonds
152. See I.R.C. §§ 871(h), 881(c) (2006 & West Supp. 2009). For example, interest income from
Credit BABs could fit into the portfolio interest exemption to the FDAP tax if municipal governments
issue Credit BABs as registered obligations. See id. §§ 871(h)(2)(B), 881(c)(2)(B).
153. See id. §§ 871(h), 881(c).
154. See id. §§ 871(a), (h), 881(a), (c).
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or Subsidy BABs.
The economic consequences resulting from the issuance of Subsidy BABs
would be markedly different than in the case of Credit BABs or tax-exempt
municipal bonds. All else being equal, domestic investors would not likely
increase their demand for Subsidy BABs, relative to Treasury bonds, because
Subsidy BABs do not offer investors the tax advantages that accrue from Credit
BABs and tax-exempt municipal bonds. Thus, the equilibrium in equation (1)
would change so that the before-tax and after-tax yield on Subsidy BABs would
be equal to the before-tax and after-tax yield on Treasury bonds. Given these
economic consequences, if Foreign Investor 3 had to pay U.S. taxes on Subsidy
BAB interest income as a result of the FDAP tax, then he would likely prefer
investment in Treasury bonds to investment in Subsidy BABs because his
untaxed yields on Treasury bonds would exceed his after-tax yields on Subsidy
BABs. In the more likely scenario that Subsidy BABs constitute a registered
obligation within the meaning of the portfolio interest exemption, Foreign
Investor 3 would be indifferent between investing in Treasury bonds and
Subsidy BABs because the after-tax (and before-tax) yields on both instruments
would be identical. In contrast, Foreign Investor 4 would likely be indifferent
between purchasing Treasury bonds and Subsidy BABs despite any reduced tax
on interest income under the treaty because such a reduced tax would apply to
interest income from both types of bonds.
Under certain circumstances, Foreign Investors 3 and 4 might even prefer
investment in Subsidy BABs to investment in Treasury bonds. For instance, if
the federal subsidy in § 54AA(g) of the Code exceeded the borrowing benefits
that municipalities currently incur from the § 103 tax-exemption for municipal
bond interest, municipal governments might increase the supply of Subsidy
BABs as a result of the high federal subsidy. As a result, the yields on Subsidy
BABs would increase relative to the yields on Treasury bonds to the point
where Subsidy BAB interest rates might actually exceed Treasury bond interest
rates.155 If Foreign Investors 3 and 4 did not have any U.S. tax obligations with
respect to either their Treasury bond or Subsidy BAB interest income, then they
would likely prefer Subsidy BABs to Treasury bonds because, all else being
equal, their untaxed yields on Subsidy BABs would exceed their untaxed yields
on Treasury bonds. Thus, Foreign Investors 3 and 4 would at least be indifferent
between investment in Treasury bonds and investment in Subsidy BABs, or
might even prefer investment in Subsidy BABs to investment in Treasury
bonds.
In summary, principles from both tax law and economic theory suggest that
155. The same result might obtain if particularly cranky domestic taxpayers decided to take out their
anger over lost tax-exemptions or tax credits on municipal bonds by decreasing their demand for
Subsidy BABs. As a result of such a decrease in demand, the yields on Subsidy BABs would increase
relative to Treasury bond yields to the point where Foreign Investors 3 and 4 (if they pay no U.S. taxes
on either Subsidy BABs or Treasury bonds) might prefer investment in Subsidy BABs to investment in
Treasury bonds.
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municipal governments would most encourage municipal bond investment by
Foreign Investors 3 and 4 if they issued Subsidy BABs rather than Credit BABs
or tax-exempt municipal bonds. Foreign Investors 3 and 4 would likely prefer
investment in Treasury bonds to investment in either tax-exempt municipal
bonds or Credit BABs because the presence of domestic investors in tax-exempt
municipal bond and Credit BAB markets would drive down the before-tax
yields on municipal bonds to a point where they would be less than the
before-tax yields on like Treasury bonds. In contrast, because Subsidy BABs do
not provide tax benefits like a credit or exemption, the issuance of such bonds
would lead to an equilibrium friendlier to foreign investors, where the beforetax and after-tax yields on Subsidy BABs would be equal to the before-tax and
after-tax yields on like Treasury bonds. Moreover, municipal governments
might increase the supply of Subsidy BABs if the subsidies they received from
the federal government exceeded the reduced borrowing costs they otherwise
would have incurred through the § 103 tax-exemption. As such, Foreign Investors 3 and 4 would at least be indifferent between purchasing Treasury bonds
and Subsidy BABs, and may even prefer investment in Subsidy BABs.
C. FOREIGN INVESTOR
5: FOREIGN GOVERNMENT INVESTORS IN THE UNITED STATES
Foreign Investor 5 incorporates only a foreign government investor who
partakes in U.S. municipal bond investments that are tax-exempt within the
meaning of the Code.156 If a foreign government partakes in any kind of
commercial activity, it may be subject to U.S. taxation depending on whether it
receives income from the conduct of a U.S. trade or business,157 income
attributable to a permanent establishment in the United States,158 or income
from passive investment in U.S. source FDAP income.159 If the foreign government were subject to U.S. taxation by reason of conducting some sort of
commercial activity, then the economic and tax consequences of investing in
one of the three types of municipal bonds would be analogous to other similarly
situated foreign investors—one of Foreign Investors 1 through 4.160
Foreign Investor 5 would not have any U.S. tax liability with respect to any
interest income deriving from Treasury bonds, tax-exempt municipal bonds,
Credit BABs or Subsidy BABs.161 As a result, Foreign Investor 5’s U.S. bond
investment preferences would be similar to those of Foreign Investors 3 and 4.
156. See I.R.C. § 892(a) (2006).
157. If the foreign government sits in a non-treaty country, it might have to pay the U.S. trade or
business tax. See discussion supra sections II.A, II.C, IV.A.
158. If the foreign government sits in a treaty country, it might have to pay U.S. tax on its business
profits. See discussion supra sections II.B, II.C, IV.A.
159. In such a case, the foreign government might have to pay the U.S. FDAP tax if it sits in a
non-treaty country. See discussion supra sections II.A, II.C, IV.B. However, if the foreign government
sits in a treaty country, it might be subject to no tax or a reduced tax on FDAP income depending on the
terms of the applicable treaty. See discussion supra sections II.B, II.C, IV.B.
160. See discussion supra sections II.C, IV.A–B.
161. See I.R.C. § 892(a)(1) (2006).
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Foreign Investor 5 would prefer investment in Treasury bonds to investment in
either tax-exempt municipal bonds or Credit BABs because increased domestic
demand for tax-advantaged tax-exempt municipal bonds and/or Credit BABs
would drive Foreign Investor 5’s untaxed municipal bond yields to a level
below its untaxed Treasury bond yields. In contrast, because domestic investors
would not increase their relative demand for Subsidy BABs that offer them no
tax advantages, Foreign Investor 5’s untaxed Subsidy BAB interest income
would be equal to its untaxed Treasury bond interest income. Moreover, as in
the cases of Foreign Investors 3 and 4, if municipal governments increased the
supply of Subsidy BABs relative to Treasury bonds, then Foreign Investor 5’s
untaxed interest income from Subsidy BABs would exceed its untaxed income
from Treasury bonds. Thus, Foreign Investor 5 would either be indifferent
between purchasing Treasury bonds and Subsidy BABs, or would prefer investment in Subsidy BABs over investment in Treasury bonds.
V. RESULTS: ARE BUILD AMERICA BONDS THE WAY TO ENCOURAGE FOREIGN
INVESTMENT IN MUNICIPAL BONDS?
The foregoing analyses suggest that the principles of economic theory and tax
law that bear on foreign investors’ choices between investments in Treasury and
municipal bonds lead to relatively consistent conclusions across the spectrum of
potential foreign investors in U.S. bonds. In particular, the analyses in Part IV
lead to several conclusions about the way Congress should tax municipal bonds
if it wants to attract foreign investment in such bonds. First, the results suggest
that Congress should consider revising or eliminating the tax exemption for
municipal bond interest income under § 103 because it creates a situation in
which Foreign Investors 3, 4, and 5 would prefer to invest in Treasury bonds
rather than tax-exempt municipal bonds. Likewise, the Credit BAB would not
likely facilitate foreign investment in U.S. municipal bonds for the same reason
that tax-exempt municipal bonds do not. Because domestic investors in taxexempt municipal bonds and Credit BABs would increase their demand for
such bonds as a result of their tax advantages, Foreign Investors 3, 4, and 5
would rather invest in Treasury bonds because such investors’ untaxed or
low-taxed yields on Treasury bonds would necessarily exceed their untaxed or
low-taxed yields on tax-exempt municipal bonds or Credit BABs.
In contrast, foreign investors would at least be indifferent between investments in Subsidy BABs versus investments in like Treasury bonds because their
before-tax and after-tax yields on Subsidy BABs would at the very least be
equal to their before-tax and after-tax yields on Treasury bonds. Moreover, as
the analyses above suggest, foreign investors might actually prefer investment
in Subsidy BABs to investment in Treasury bonds under certain circumstances.
If the federal government offers subsidies to municipal governments under
§ 54AA(g) that exceed the reduced borrowing cost benefits that municipalities
would otherwise receive under a tax-exempt municipal bond or Credit BAB
regime, then the yields on Subsidy BABs might exceed the yields on Treasury
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bonds. All else being equal, this result might drive foreign investors to put their
money in Subsidy BABs over Treasury bonds.
Therefore, when Congress added § 54AA to the Code in the American
Recovery and Reinvestment Act of 2009, it at least partially opened the door to
a potential increase of investors in U.S. municipal bonds. My results suggest
that if Congress wishes to encourage more foreign investment in U.S. municipal
bonds, then it should do away with § 103 tax-exempt municipal bonds and
Credit BABs. Moreover, to encourage more foreign investment in U.S. municipal bonds, Congress should extend Subsidy BABs past their current 2011
sunset162 and should consider making a tax regime similar to Subsidy BABs the
new paradigm for federal taxation of interest income from municipal bonds. Of
course, as I will discuss in Part VI, my analysis and results are not without their
limitations and caveats.
VI. SOME CAVEATS
The results of the analyses in this Note are subject to a few caveats. In section
VI.A, I will discuss how divergent characteristics of municipal bonds might
change foreign investors’ determinations of whether to invest in them despite
the manner in which the U.S. federal government taxes municipal bond interest
income. In section VI.B, I will examine potential political obstacles to changing
the federal tax structure of municipal bond interest income.
A. DIFFERENCES BETWEEN MUNICIPAL AND TREASURY BONDS
Not all municipal bonds are created equal. The analyses in this Note assume
that tax-exempt municipal bonds, Credit BABs, and Subsidy BABs are identical
to Treasury bonds in all respects other than tax treatment. In reality, municipal
bonds might differ from Treasury bonds along several dimensions that affect
their relative yields.163 For example, if municipal bonds are riskier for investors
than Treasury bonds because of a greater degree of price volatility in the market
for municipal bonds, the increased risk would put upward pressure on municipal
bond yields relative to Treasury bond yields.164 Likewise, if municipal bonds
are less liquid165 than Treasury bonds—that is, the amount of trading activity in
municipal bonds is less than the amount of trading activity in Treasury bonds—
then such a lack of relative liquidity would also put upward pressure on
municipal bond yields relative to Treasury bond yields.166 Municipal bond
162. See I.R.C. § 54AA(g) (West Supp. 2009).
163. See MISHKIN, supra note 4, at 93–97; Jess B. Yawitz et al., Taxes, Default Risk, and Yield
Spreads, 40 J. FIN. 1127, 1139–40 (1985); Junbo Wang et al., Liquidity, Default, Taxes and Yields on
Municipal Bonds, 2005 FED. RES. BOARD FIN. & ECON. DISCUSSION SERIES 35, at 35–37, available at
http://www.federalreserve.gov/pubs/feds/2005/200535/200535pap.pdf.
164. MISHKIN, supra note 4, at 96.
165. By liquidity, I mean “the relative ease and speed with which an asset can be converted into a
medium of exchange” such as cash. Id. at 47, 86.
166. MISHKIN, supra note 4, at 96; see also Junbo Wang et al., supra note 163, at 35–37.
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yields may also differ from Treasury bond yields due to differences in the
bonds’ credit ratings.167 For instance, all else being equal, municipal bonds may
have higher yields than Treasury bonds in order to compensate investors for the
increased risk that municipal governments may default on interest payments on
such bonds.168
Changes in variables such as risk, liquidity, and credit rating can have
multiple implications for foreign investors’ decisions about investment in U.S.
municipal bonds. In reality, the majority of municipal bond issues tend to have
lower liquidity, higher risk of default, and lower credit ratings than Treasury
bonds.169 As a result, most municipal bonds tend to have higher yields than
Treasury bonds in order to compensate investors for the relatively higher risk
attendant to purchasing municipal bonds.170 Such an upward pressure on municipal bond yields might, in turn, counteract the effects on municipal bond yields
that result from various tax structures for municipal bond interest income. For
instance, while tax advantages inherent in § 103 tax-exempt bonds and Credit
BABs tend to put downward pressure on such bonds’ relative yields, the relative
illiquidity and default risks of such bonds may impose a countervailing upward
pressure on their yields. Likewise, Subsidy BABs with higher illiquidity or
default risk than Treasury bonds would likely have a higher yield than equation
(1) suggests.
Nevertheless, the changes in municipal bond yields resulting from differing
liquidity, default risk, or credit ratings among such bonds may or may not have
major effects on foreign investment in municipal bonds dependent on foreign
investors’ risk preferences. Theoretically, if municipal bond yields adequately
reflect their reduced liquidity or credit rating relative to Treasury bonds, then in
the long run their average risk-adjusted returns should approximate the returns
on municipal bonds with liquidity and creditworthiness characteristics more
similar to Treasury bonds. Thus, foreign investors who are risk-neutral (and
who invest in sufficiently large quantities of U.S. municipal bonds) would likely
invest in high-risk bonds based on their risk-adjusted yields. On the other hand,
more risk-affine foreign investors might prefer investment in municipal bonds
with low liquidity and creditworthiness because of the potential for higher
returns than other municipal bonds. In contrast, risk-averse foreign investors
would not likely undertake particularly high levels of investment in U.S.
municipal bonds because the data suggest that only a small proportion of
municipal bonds have high credit ratings.171 Further investigation of foreign
investors’ risk preferences would prove fruitful in future studies of ways in
which U.S. governments could encourage more foreign investment in U.S.
municipal bonds.
167.
168.
169.
170.
171.
See Yawitz et al., supra note 163, at 1139–40; see also RAINY, supra note 81, at 2–6.
See generally RAINY, supra note 81, at 2–6.
See RAINY, supra note 81, at 2–6; Junbo Wang et al., supra note 163, at 3–5.
See RAINY, supra note 81, at 2.
Id. at 5–6.
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B. POLITICAL BARRIERS TO MUNICIPAL BOND REFORM
The analysis in this Note assumes that increased foreign investment in
municipal bonds would be a positive result because it would inject more
investment capital into U.S. municipal bond markets than exists at present.
Nevertheless, certain political barriers to municipal bond interest income tax
reform may hinder changes to the current framework. For instance, some
commentators have suggested that eliminating the tax exemption for municipal
bond interest income and enacting a Subsidy BAB-like measure in its place
might conflict with principles of federalism. Although South Carolina v. Baker
can be read to suggest that the federal government can constitutionally limit or
eliminate the present tax exemption for municipal bond interest income,172
some commentators have suggested otherwise.
For example, Miller and Glick have argued that the Court prematurely
decided the constitutionality of federal taxation of municipal bond interest in
Baker.173 Miller and Glick also argue that federal imposition of a tax on
municipal bond interest income would violate federalism principles because
“imposing increased costs on a state’s prerogative to borrow money is tantamount to telling indigents that they have a constitutional right to vote, while
demanding that they pay a poll tax to exercise their franchise. Acknowledging
the right while simultaneously impeding its exercise eviscerates the right of any
meaning.”174 Likewise, in her dissent in Baker, Justice O’Connor argued that
“[g]overnmental operations will be hindered severely if the cost of capital rises
by one-third. If Congress may tax the interest paid on state and local bonds, it
may strike at the very heart of state and local government activities.”175
Yamamoto further argues that instruments like the Subsidy BAB may conflict
with federalism principles because “[a] direct federal subsidy interest plan
would . . . . give[] the federal government more influence over state affairs,
thereby upsetting the balance of power.”176 Nevertheless, at present, there is no
general consensus that imposing a tax regime similar to the Subsidy BAB
would explicitly violate the Constitution.177
In addition to issues of federalism, municipal governments may have other
political reasons to restrict federal tax reform with respect to municipal bond
interest. Many historical efforts to tax municipal bond interest income have
172. 485 U.S. 505, 527 (1988); see also Yamamoto, supra note 5, at 171 (“The Supreme Court, in a
seven to one opinion, stated that . . . .there were no constitutional barriers to the federal taxation of state
and local bond interest.”).
173. Maxwell A. Miller & Mark A. Glick, The Resurgence of Federalism: The Case for Tax-Exempt
Bonds, 1 TEX. REV. L. & POL. 25, 50 (1997) (“Deciding whether an outright repeal of the exemption
from federal taxation on state and local bonds violates intergovernmental tax immunity should have
awaited a case which raised that issue.”).
174. Id. at 34.
175. Baker, 485 U.S. at 531–32 (1988) (O’Connor, J., dissenting).
176. Yamamoto, supra note 5, at 191.
177. Id. (“The federalism question is not whether the direct federal interest subsidy plan would be
constitutional or not; it most likely would pass constitutional scrutiny.”) (citing Baker, 485 U.S. at 515).
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failed largely due to opposition by municipal government officials (albeit not
always for uniform reasons).178 Municipal governments may oppose the idea of
receiving a direct subsidy from the federal government because, along the lines
of the federalism arguments above, they fear that such a policy would hinder
both their sovereignty and their borrowing power. Municipal governments may
also like the idea of exempting municipal bond interest from federal taxation
because doing so provides a benefit to their constituents in the form of reduced
federal taxes. For these reasons, municipal governments might engage in tactics
to discourage foreign investment in U.S. municipal bonds despite the tax
advantages that might accrue to foreign investors. For example, municipal
governments might sell municipal bonds on exchanges more populated with
domestic investors or sell municipal bonds with terms more favorable to
domestic investors.179
Municipal governments may also have more practical reasons for favoring
domestic bondholders over foreign bondholders. The downward economic trend
in 2008 and 2009 has led to increased fiscal difficulty for municipal governments across the United States.180 In particular, states have been forced to make
budget and spending cuts in response to reductions in tax revenues not offset by
federal economic stimulus measures.181 Moreover, “[d]espite an apparent turnaround in U.S. economic growth, the recovery of employment and wages—the
two most important factors for state finances—is projected to lag well into the
future.”182 The upshot of these trends is that municipal governments may find
themselves having to restructure their municipal bond debts due to budgetary
shortfalls.
In examining fiscal crises in several developing countries during the late
twentieth century, Gelpern and Setser have observed that it is in sovereign
borrowers’ best interest to be able to discriminate in favor of domestic creditors
over external or foreign creditors.183 Sovereign entities have a specific incentive
to favor domestic creditors over external creditors when it comes to debt
restructuring for several reasons. For example, if sovereign entities recover
funds from or pay funds to domestic creditors, this would only constitute a
shifting of income within the same domestic economy.184 In contrast, funds
recovered from external creditors constitute an inflow into the domestic
economy,185 while funds paid out to external creditors constitute an outflow
178. Id. at 172.
179. Future studies of Build America Bonds may consider the extent to which municipal governments might already be undertaking these kinds of activities.
180. See RAINY, supra note 81, at 2.
181. Id.
182. Id.
183. See Anna Gelpern & Brad Setser, Domestic and External Debt: The Doomed Quest for Equal
Treatment, 35 GEO. J. INT’L L. 795, 796–97 (2004); see also Anna Gelpern, Sovereign Debt Crisis:
Creditors’ Rights vs. Development, 97 AM. SOC’Y OF INT’L L. PROC. 221, 222–23 (2003).
184. See Gelpern & Setser, supra note 183, at 813.
185. See Gelpern, supra note 183, at 222.
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from the domestic economy.186 As a result, sovereign debtors have an incentive
to tailor debt restructurings so that they favor domestic debtors because doing
so keeps money inside a crisis-laden domestic economy.187 Sovereign debtors
may also have an incentive to favor domestic debtors in debt restructuring
because doing so would allow them to curry favor with powerful domestic
political constituents.188 To make matters more complicated, Waibel has suggested that external creditors face difficult procedural hurdles in litigation or
arbitration attempts to overcome discrimination against them in sovereign debt
restructurings.189
That municipal governments may have incentives to favor domestic creditors
when it comes to restructuring municipal bond debt has several implications for
the likelihood that foreign investors would want to invest in U.S. municipal
bonds. Specifically, despite changes to the federal taxation of U.S. municipal
bond interest income, foreign investors may not like the idea of investing in
municipal bonds from faltering U.S. municipal governments because such
governments might favor domestic investors if they had to restructure their
municipal bond debt. It seems especially likely during the 2009 economic
recession that foreign investors may be leery of investing in U.S. municipal
bonds because the likelihood that at least some municipal governments might
have to restructure their municipal bond debts is especially high. Nevertheless,
foreign investors may still have an incentive to invest in higher-grade U.S.
municipal bonds because of the lower likelihood that the governments issuing
such bonds would need to restructure their municipal bond debt. Future studies
of foreign investment in U.S. municipal bonds might examine the extent to
which municipal governments engage in municipal bond debt restructuring, and
how this might affect foreign investors’ incentives to put their money in U.S.
municipal bond investments.
In addition to municipal governments, both the federal government and
domestic investors may also have political incentives to bar federal tax reform
with respect to municipal bond interest. Especially in the case of general
obligation bonds, domestic investors may not like the idea of using their state
and local taxes to finance interest payments on municipal bonds held by foreign
investors, who may not have a similar obligation to pay taxes to U.S. state and
local governments.190 Moreover, the federal government may not like the idea
of removing barriers to foreign investment in U.S. municipal bonds because
doing so would generate competition for foreign investment in Treasury and
186. See Gelpern & Setser, supra note 183, at 813.
187. See id.
188. See id. at 797.
189. See Michael Waibel, Opening Pandora’s Box: Sovereign Bonds in International Arbitration,
101 AM. J. INT’L L. 711, 711–12 (2007).
190. Note, however, that such a problem may not arise if municipal governments issue revenue
bonds to foreign investors.
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municipal bonds.191 Lobbying by powerful domestic investors in municipal
bonds coupled with hesitation by Congress to facilitate increased competition
for foreign investment in Treasury bonds might be enough to forestall any
attempts to establish Subsidy BABs as a permanent component of federal tax
law.
In short, although implementing a tax regime similar to that applying to
Subsidy BABs might benefit municipal governments by introducing more
capital into the markets for their bonds, several political considerations may
temper major tax reforms in the municipal bond area. For one thing, municipal
governments may try to forestall foreign investment in municipal bonds because
they fear the encroachment of federal power or because they fear the political
consequences if they support measures to reduce tax breaks to domestic investors who invest in municipal bonds. On a related note, foreign investors may be
less likely to invest in certain types of U.S. municipal bonds because they fear
the consequences to them if municipal governments had to restructure their
municipal bond debts. Meanwhile, domestic investors may not wish to restructure the federal taxation of municipal bond interest income because doing so
might provide advantages to foreign investors who are not responsible for
paying the U.S. state and local taxes that fund municipal bond interest payments. The federal government may also look unfavorably on measures that
would increase the competition between Treasury and municipal bonds for
coveted pockets of foreign investment. Note, however, that none of these
political barriers necessarily precludes tax reform in the municipal bond area.
Given the right circumstances, policymakers may be willing to warm up to the
idea of tax reforms such as Subsidy BABs because of the efficiency and
financial benefits that such bonds provide to municipal governments. The
present success of the Build America Bond program suggests that, at least to
some extent, this may already be the case.192
CONCLUSION
This Note examined three ways in which Congress could regulate the taxation of U.S. municipal bonds in order to determine which method would
encourage the most foreign investment in such bonds. The key assumption
behind my analysis is that increased foreign investment in municipal bonds
191. In fact, foreign investors account for a significant amount of investment in U.S. Treasury
securities. Between March 2009 and March 2010, foreign investors held, on average, approximately
$2.03 trillion in U.S. Treasury bonds and notes. See United States Department of the Treasury, Major
Foreign Holders of Treasury Securities, http://www.treasury.gov/tic/mfh.txt (last visited May 15, 2010).
192. See, e.g., RAINY, supra note 81, at 2–3; see also Dan Eggen, New Bonds for Strapped States
Also Lifting Wall Street; Industry Pushes Congress To Extend Federal Subsidies, WASH. POST, June 7,
2010, at A5 (“Few would dispute that the [Build America Bonds] program has been popular. The
Treasury Department said last week that more than $106 billion in Build America Bonds have been
issued [between April 2009 and June 2010], with estimated savings of $12 billion to local governments
and other issuers. The bonds now constitute over 20 percent of the municipal bonds market, officials
said.”).
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would be good for U.S. municipal governments because it would increase
investment in such bonds and reduce the volatility and risk in the municipal
bond market. As a result, municipal governments would be able to obtain a
more stable source of bond revenues for purposes of funding various public
projects. The results of my analyses suggest that, if Congress wishes to tax
municipal bonds in a way that encourages the most foreign investment in such
bonds, it should tax municipal bonds in accordance with the Subsidy BABs
included in the American Recovery and Reinvestment Act of 2009. My analyses
also suggest that, from the perspective of encouraging foreign investment in
municipal bonds, Congress should consider limiting or eliminating the sections
of the Internal Revenue Code that provide for Credit BABs and tax-exemptions
for municipal bond interest.
Although encouraging foreign investment in municipal bonds may have the
benefits of injecting more capital into municipal bond markets, it also has some
potential drawbacks. Some commentators have suggested that both federal
taxation of municipal bonds and federal issuance of Subsidy BABs conflict with
principles of federalism.193 Moreover, domestic bond investors, municipal governments, and the federal government may have reservations against taxing
bonds in such a way that the federal government provides direct subsidies to
municipal governments.194 For example, domestic investors may not like the
idea of using their municipal tax dollars to make interest payments to foreign
investors who may not incur similar municipal taxes. Along similar lines,
municipal governments may wish to protect their constituents’ current tax
advantages for acquiring municipal bonds, and may fear that a direct subsidy
from the federal government would unnecessarily erode their sovereignty.
Foreign investors may also fear the consequences if certain municipal governments restructured their municipal bond debts in favor of domestic investors.
Finally, the federal government may oppose encouraging foreign investment in
municipal bonds because doing so would open up competition between municipal and federal governments to attract foreign investments.
Nevertheless, Subsidy BABs have several key advantages. For one, Subsidy
BABs, like Credit BABs, are more efficient than tax-exempt municipal bonds
because they eliminate subsidies to high-bracket taxpayers and equalize federal
revenue losses and municipal subsidies.195 Moreover, like Credit BABs, Subsidy BABs provide for more vertical equity than tax-exempt municipal bonds
because they remove windfalls to high-bracket taxpayers that introduce regressivity into the tax system.196 Subsidy BABs also provide for more horizontal
equity than both Credit BABs and tax-exempt municipal bonds because they
subject like investors in Treasury and municipal bonds to like tax treatment.197
193.
194.
195.
196.
197.
See discussion supra Part VI.
Id.
See discussion supra section II.C.
Id.
Id.
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Although some commentators have suggested that Subsidy BABs may conflict
with some principles of federalism, current Supreme Court precedent affirmatively suggests that federal taxation of municipal bond interest income does not
violate the Constitution.198 To date, no one has yet challenged the constitutionality of § 54AA(g) of the Code. Finally, as this Note suggests, Subsidy BABs
would not only provide municipal governments with reduced borrowing costs,
but would also encourage introduction of foreign capital into the U.S. municipal
bond market. In the final calculation, this Note suggests that increased incentive
for foreign investment provides yet another reason that Congress should seriously consider using Subsidy BABs as a model for future federal taxation of
municipal bond interest income.
198. See South Carolina v. Baker, 485 U.S. 505, 527 (1988).