The Beastie Boys are considered rap pioneers in part for their extensive use of “sampling,” or cutting and splicing the music of other groups into works of their own. In particular, their 1989 album, Paul’s Boutique, was an early leading example of the possibilities of the technique. (There are plenty of interesting copyright questions raised by the practice of sampling, but those questions are the province of our colleagues over at the Global Business IP and Technology Blog, which we invite you to visit. The Beastie Boys were in fact sued by jazz flautist James Newton for their use of a sample of his music. We know you’re sick of our constant references to jazz flautist James Newton on this blog, and we apologize.)
In their 1992 track “Jimmy James,” the Beastie Boys used a number of samples of the music of Jimi Hendrix, who famously closed out the Woodstock music festival back in 1969. But who knew that, also in 1969, the 91st Congress considered a technique for state and local finance that would, like a great sample, later be appreciated as a fresh new idea. That technique? Direct pay bonds.
The House Version of the Tax Reform Act of 1969 Allowed Issuers to Elect to Receive a Direct Payment Instead of Providing Bondholders with Tax-Exempt Interest
While researching the meaning of the term “reserve or replacement fund,” which is a great hazing exercise for new associates rather similar to snipe-hunting, we stumbled across the following passages from the legislation that became the Tax Reform Act of 1969. The legislative history of the 1969 Act notes that the House bill (H.R. 13270) contained a provision that would allow issuers to “voluntarily relinquish the privilege of tax exemption with respect to given debt-security issues and in these cases the Secretary of the Treasury would pay a fixed percentage of the interest yield on each such issue.” 1969-3 C.B. 457; 1969 IRB LEXIS 2456 at *140. In other words, an issuer could elect to receive a direct payment from the federal government instead of providing tax-exempt interest to the bondholder.
Under the 1969 House proposal, the federal government would choose from a subsidy of anywhere between 25 and 40 percent of the interest payments on the bonds, depending on prevailing interest rates at the time that a bond issue was issued. The subsidy rate would be set for the life of the bonds on the issue date of the bonds. For about 5 years after enactment, the proposal would have guaranteed at least a 30 percent subsidy. (Maybe I’m cynical, but I doubt that the federal government would ever have set the subsidy at anything other than the minimum permitted amount.)
The House Report for the bill, H.R. Rep. No. 91-413 (big pdf), 1969-3 C.B. 200, 1969 IRB LEXIS 2455, notes that “adjustment for any premium or any discount at which the obligations are issued may be made between the issuer and the United States at the time of issuance or such later time or times as may be appropriate,” a fairly hilarious idea, given the current sequestration controversy. 1969 IRB LEXIS 2455 at *168.
The rationale for the proposal in 1969 was similar to the rationale that we often hear today – the idea that the implicit subsidy inherent in tax-exempt bonds is less efficient than a direct subsidy from the federal government. The Conference Report notes that”tax savings for individuals and corporations from the purchase of tax-exempt bonds generally is greater than the differential between the interest yields on tax-exempts and taxable bonds.” 1969 IRB LEXIS 2456 at *139.
Despite this perceived inefficiency, the Conference Committee for the 1969 Act ultimately removed the provision, leaving us with the following somewhat-unsatisfactory explanation, 1969 IRB LEXIS 2456 at *139-40:
While there may be a problem here, the committee, because of its concern that any action with respect to State and municipal bonds could have a deleterious effect on the market for these bonds, and because of the high interest costs which are now being paid on new issues of such bonds, concluded that any action possibly having an impact on State and local government bond prices would be particularly unfortunate.
The House Report, 1969 IRB LEXIS 2455 at *163-166. tells us even more about the thinking behind this proposal. It is interesting to read the House’s rationale in full:
General reasons for change.-Capital outlays of State and local governments for such projects as schools and other public buildings, highways, water and sewage systems, and ntipollution facilities have doubled during the past decade. In order to market an increasing volume of securities to finance these public projects in competition with a growing volume of private borrowings, State and local governments have been offering higher yields, and the differential between tax-exempt and taxable securities of comparable quality has been narrowing. Historically, the ratio of yields on tax-exempt issues to taxable issues has been as low as 60 percent, but in recent years it has been close to 75 percent.
The ratio of yields has varied in response to the general availability of credit, the demand for credit and the proportionate demand by State and local governments to the total market demand for credit. As a result, high income individuals and institutions otherwise subject to high tax rates who constitute a major portion of the market for tax-exempt State and local securities have been receiving significantly larger tax benefits than needed to bring them into the market. Recent estimates place the annual saving in interest charges to State and local governments at $1.3 billion, but the annual revenue loss to the Federal Government has been estimated at $1.8 billion.
Several procedures have been recommended in the past several years which would make taxable the debt instruments that finance State and local government capital outlays, but which also would maintain the reduced interest costs to these governments through some form of subsidy. Generally, recommendations have been unattractive to State and local governments because some authority would review the need for the project that gives rise to the debt issue and the ability of the issuer to meet the obligation, and because the proposals provided for annual appropriations from Congress to make up the difference between taxable and nontaxable yields.
Direct Payment Provisions Today
Without any special fanfare, Congress gave issuers of Build America Bonds the ability to elect to receive a direct payment instead of providing a tax credit to bondholders as part of the American Recovery and Reinvestment Act of 2009, P.L. 111-5, known colloquially as the Stimulus Act. Build America Bonds expired at the end of 2010, of course, but the direct payment provision still applies to some of the qualified tax credit bonds from the Stimulus Act, such as qualified energy conservation bonds because Congress extended the direct pay provisions to all qualified tax credit bonds in the HIRE Act in 2010, P.L. 111–147. In addition, there have been numerous proposals to revive direct pay bonds to varying degrees. We have seen it most frequently in the President’s annual budget, where for several years he has proposed reviving direct pay bonds with a 28% subsidy rate in the form of America Fast Forward bonds. (See here, at page 123, for example.)
It quickly became apparent that BABs were sold to a different kind of investor than traditional tax-exempt bonds. Most eligible projects in 2009 and 2010 were thus financed with a combination of both BABs and tax-exempt bonds. Issuers were thus able to take advantage of the maximum efficiencies of each market segment to create the optimal mix of debt obligations. The argument about the efficiency of different types of subsidies was too simplistic and based on static economic models. The real world, dynamic results of BABs showed us that both forms of subsidy were efficient in their own optimal market segments and that is why borrowers chose a combination of tools.
The direct pay provisions in the Stimulus Act struck most of us as a brand new idea. Congress did not publicize any historical precedent for them, and there was no discussion of the prior iterations of this proposal in the precursor legislation to the 1969 Act. Congress probably did not use the House version of the 1969 Act as a starting point, and there are several notable differences between that proposal and what ultimately became Section 6431 of the Code, albeit probably unintentional differences. Other contemporary proposals are similar to the Stimulus Act version of this concept.
Unlike the House version of the 1969 Act, none of the contemporary provisions give the federal government the ability to change the subsidy within a Congressionally-defined band to reflect market conditions. While it may seem hopelessly naive to think that the federal government would choose anything other than the minimum permitted amount, it would be nice to include a feature such as this in contemporary proposals, if the point of direct pay provisions is to make the federal subsidy more efficient. This would be consistent with the approach currently taken with qualified tax credit bonds, where the federal government has the ability to adjust the amount of the subsidy by adjusting the “qualified tax credit bond rate.”
In addition, most current proposals to revive direct pay bonds provide for new programs for specific project purposes, many times with an accompanying volume cap limitation on the total amount of bonds that can be issued. In contrast, the 1969 proposal would have simply allowed issuers to elect to receive a subsidy for the different types of tax-exempt bonds that were already permitted instead of providing bondholders with tax-exempt interest. That proposal would not have required new types of bonds and new rules, which have limited the market’s openness to some of the new qualified tax credit bond programs for which Congress allows a direct payment election. It also would have presented the choice between tax-exempt interest and direct payments to issuers in the cleanest way, allowing them to readily find the most efficient mix of financing vehicles to achieve the lowest cost to not only those issuers but also to the federal government.
Whether knowingly or not, Congress and administration officials have sampled the ideas from the House version of the 1969 Act in writing the direct pay provisions in the Stimulus Act and the HIRE Act, and in writing other contemporary proposals. As with all samples, it is up to the listener to decide whether the artist has achieved the goal of turning the sample into something new and artistically worthwhile in its own right, or whether the sample was better off in its original context. That is, you must decide whether you side with the jazz flautists of the world, or the Beastie Boys instead.