RL30411: Electricity Restructuring and Tax-Exempt Bonds:
Economic Analysis of Legislative Proposals

Dennis Zimmerman

Analyst in Public Finance
Domestic Social Policy Division

January 20, 2000

CONTENTS

• Summary
• I. Introduction
• II. Deregulation of Generation and Retailing: Electricity Prices and Tax-Exempt Bonds
• A. Competition and Electricity Prices
• B. Electricity Prices and Tax-Exempt Bonds
• III. Tax-Exempt Bonds for Output Facilities?
• A. New Output Facilities
• B. Existing Output Facilities
• IV. Might Social Benefits Justify Post-Restructuring Tax-Exempt Bond Use for New Output Facilities?
• A. The Justification for the Tax Advantage
• B. Bond Legislation Affecting Public Power
• V. Are Transmission and Distribution Facilities a Special Case?
• VI. Analysis of Proposed Legislation
• A. Economic Treatment
• B. Discussion of S. 1048
• C. Discussion of S. 386 and H.R. 721
• D. Discussion of H.R. 1253
• VII. H.R. 1253 and Federal Taxation of Public Power Income
• Footnotes

List of Tables

Table 1. Can New Public Power Electric Output Facilities Be Financed with Tax-Exempt Bonds?: Comparison of Economic Treatment with Three Legislative Proposals
Table 2. Do Private-Activity Bond Rules Apply to Outstanding Bonds That Financed Public Power's Existing Electric Output Facilities?: Comparison of Economic Treatment with Three Legislative Proposals

Summary

Tax-exempt bonds reduce public power's interest cost on debt and enable it to lower the price of electricity. This subsidy makes taxpayers better off only if the private market fails to provide the correct amount of electricity. In general, the private market can provide the correct amount of electricity; in those cases when it can not, the tax-exempt bond subsidy is unlikely to correct the problem. Tax-exempt bond legislation has been consistent with this perspective that an interest subsidy for electricity production does not correct a market failure; its focus has been to prohibit the spread of subsidized public power beyond its traditional service areas.

For public power entities entering a restructured and competitive electricity network, the existing tax rules would eliminate tax-exempt status for bonds that fund new capital facilities and also would require issuance of taxable debt to retire outstanding tax-exempt bonds for existing facilities. As a result, several bills have been introduced to change the current tax treatment of public power's debt after restructuring occurs.

The analysis in this report suggests that general economic welfare would be enhanced by enforcing the existing tax rules that would prohibit tax-exempt bonds to finance new capital facilities used in the competitive network. In contrast, it finds that economic welfare would be worsened by enforcing the tax rules that would require bonds for existing facilities used in the competitive network to be refinanced with taxable debt. Failure to grandfather existing tax-exempt bonds could adversely affect economic gains from restructuring if the expense of taxable interest rates induced public power to avoid the expense by maintaining their monopoly (not participating in open access plans), thereby reducing the scope of competition.

Some argue that the treatment suggested above might be acceptable for generation facilities, but that a special exception should be made to allow continued tax-exempt financing of new transmission and distribution facilities because these facilities are similar to public highways. High exclusion costs make public provision of local highways more efficient than private provision. However, exclusion is not a problem for the transmission network. Continued subsidy via tax-exempt bonds would lower electricity prices and reduce federal revenue without providing many offsetting benefits for federal taxpayers. Distribution facilities might still be financed with tax-exempt bonds for practical reasons, provided the facilities are also used to provide other public services, such as street lighting.

The Administration's proposal, introduced by request as S. 1048, would institute treatment fairly close to the economic treatment described in this report: no tax-exempt bonds for new facilities, except for distribution; existing bonds for facilities used in the competitive network would retain their tax exempt status. S. 386/H.R. 721 would institute treatment that is relatively favorable to public power's continued use of tax-exempt bond financing. H.R. 1253 would institute treatment that is generally closer to economic treatment than is S. 386/H.R. 721, but more favorable for continued public power use than is S. 1048.

I. Introduction

The electricity industry has long been characterized by monopoly, that is, by firms with exclusive franchises to transmit and sell electricity to consumers in predetermined areas. Regulatory policies are being implemented at the present time to restructure the industry. These policies would replace a portion of this monopolistic structure with competition among utilities for the generation and sale of power, and would require that facilities to transmit power be made available to all generators of power at nondiscriminatory prices. The intention is to lower electricity prices, thereby enhancing economic welfare. This move to restructure the industry has heightened policy concerns about several cost-reducing tax advantages that give local governments or their duly designated power authorities ("public power") the capacity to sell electricity at a price that does not reflect its real resource cost. This price potentially is below the price charged by utilities owned by private investors (investor owned, or "IOUs"), whose price presumably more closely reflects real resource costs. Continuation of these subsidies could reduce the enhanced economic welfare that restructuring is expected to provide.

One of these cost-reducing tax advantages, the exclusion from a federal taxpayer's gross income of the interest income earned on state-local debt, reduces public power's capital cost. Although the IOUs long objected to public power's use of these "tax-exempt bonds," the subsidy was not particularly economically threatening as long as the electricity market was characterized by monopoly. From the IOUs' perspective, competition makes the cost advantage conveyed by public power's use of tax-exempt bonds a more serious threat to their market share and financial success.

The Internal Revenue Code limits public power's ability to use tax-exempt bonds to finance output property when some of the output will be used by private individuals and businesses on a basis other than the basis on which the general public uses the output. ⁽¹⁾ No more than 10% of the bond proceeds ($15 million maximum) can be used to build capacity for such private use. These private-activity bond rules would require many public power entities that choose or are forced to engage in competition to forego use of tax-exempt debt for new output property (generation, transmission, and distribution facilities) and to refinance debt for existing output property at taxable interest rates. IOUs believe these private-activity bond tax rules are appropriate.

From public power's perspective, the use of tax-exempt bonds is an historical and legal right, one that enables it to provide electric power at a price that does not reflect real resource cost for good reason. Public power believes that any violation of the existing tax-exempt bond rules that results from actions taken to comply with restructuring policies is not one it has chosen but one being forced upon it. It believes tax-exempt bond law should be adjusted to allow public power continued use of these bonds. ⁽²⁾

Section II of this report explains how competition is expected to affect electricity prices and how the use of tax-exempt bonds can affect these prices. Section III analyzes whether the economic goal of electricity restructuring is better served by continuing or eliminating public power's use of tax-exempt bonds. The analysis indicates this goal is furthered by: (1) denying use of tax-exempt bonds for new output facilities; and (2) not requiring existing output facilities to replace outstanding tax-exempt debt with taxable debt. Some argue that continued use of tax-exempt bonds for new output facilities would be beneficial because the cost reduction satisfies some federal policy goal that provides benefits to federal taxpayers other than lower electricity prices. This issue is discussed in section IV. Section V discusses the contention that new transmission facilities are a special case and that investment in such new facilities should receive special consideration for continued tax-exempt bond financing. Section VI uses these analyses to compare the potential economic effects of the major legislative proposals that would change the tax-exempt bond rules for electric output facilities: the Administration's proposed treatment of tax-exempt bonds as presented in its electricity restructuring plan of March 25, 1998, introduced by request as S. 1048 by Senator Murkowski; S. 386 and H.R. 721, introduced by Senator Gorton and Representative Hayworth; and H.R. 1253 introduced by Representative English. Section VII provides a brief discussion of another cost-reducing tax advantage the Internal Revenue Code provides to public power, exclusion of its income from federal income taxation. H.R. 1253 includes a provision that would impose the federal income tax on some public power utility income.

II. Deregulation of Generation and Retailing: Electricity Prices and Tax-Exempt Bonds

This section explains the relationship between deregulation (the introduction of competition into the generation and sale of electricity) and price; and how the use of tax-exempt bonds can affect the price charged by a utility.

A. Competition and Electricity Prices

The provision of electricity in the United States historically has been divided among investor-owned utilities (IOUs), public power, cooperatives, federal agencies ("federal power"), and independent power producers. In 1996, the 2,000+ public power utilities produced about 8.6% of the nation's utility-produced electric power. Because public power purchases electricity for resale from IOUs and federal power, it accounts for about 14% of final electricity sales.

Provision of electricity involves four distinct functions: generation -- the creation of electricity; transmission -- transportation of electricity over long distances; distribution -- transportation of electricity from distribution centers to consumers; and retailing -- the metering and billing of consumers. The industry historically has been organized into firms with exclusive franchises to sell electricity to consumers within a predetermined area. Many of these monopolies are vertically integrated, which means that they perform some combination of these four functions. Not all firms perform all functions. For example, some distribute and retail but buy generation and transmission services from other firms.

Monopolies are regulated by the government to counteract their tendency to sell too little output at higher than optimal prices. With electric utilities, this regulation tends to focus on setting prices to ensure that producers receive an "adequate" rate of return on capital. In other words, prices are set to enable each utility to recover its prudently-incurred capital costs, even if the production facilities built with the capital are inefficient and produce power that is more costly than could be obtained from alternative sources.

Some have argued that two of the four functions, generation and retailing, are not natural monopolies and can be transformed into competitive markets. In a competitive electricity market, prices would reflect the marginal cost of electricity generation (the additional cost of producing an additional unit of output). Generation plants for which this price is insufficient to pay for average costs (total costs divided by total output) would be replaced by plants whose costs were lower. Inefficient producers would be driven from the market and electricity prices would decline for many consumers. The Energy Department has estimated that consumer benefits could amount to $20 billion per year and as much as $32 billion in 2010. ⁽³⁾

The Public Utility Regulatory Policies Act of 1978 inadvertently laid the foundation for restructuring by opening the generation of electricity to non-utility entrants. ⁽⁴⁾ These new entrants along with the advent of new generating technology created a cost-effective alternative to traditional generation, leading the Federal Energy Regulatory Commission (FERC) to approve interstate wholesale sales based on market rates rather than on the seller's costs incurred to generate and transmit the power. The Energy Policy Act of 1992 introduced additional competition in the wholesale generation market.

Of course, the advantages of low-cost electricity generation can be lost if competitors with high-cost electricity who also own the transmission lines price transmission services in a noncompetitive fashion. Accordingly, FERC Orders 888 and 889, adopted in April 1996, provide for open access to the interstate transmission grid at the wholesale level for all generators of electricity, which means transmission services must be priced in a nondiscriminatory manner. FERC does not have the authority, however, to mandate open access within a state -- access that is necessary to realize the full benefits of retail competition. Many states have been implementing or studying retail competition, and are considering open access plans for transmission facilities. ⁽⁵⁾

B. Electricity Prices and Tax-Exempt Bonds

Government occasionally intervenes in the market system of prices by imposing taxes on the production of some goods and granting subsidies for the production of other goods. The subsidized producer can offer a lower price and has a competitive advantage over unsubsidized producers. Section 103 of the Internal Revenue Code (the Code) excludes from gross income and federal income taxation the interest income on bonds issued by public power. This lowers the interest rate on the bonds and reduces public power's cost of capital. Public power and its customers value the capital resources at the interest cost paid by public power. But the real value of the capital is measured by its best alternative use; this value is measured by the higher interest cost paid on taxable bonds.

In a world without competition, public power can use its lower borrowing cost to do any combination of three things. ⁽⁶⁾ First, it can pass the subsidy through to its customers in the form of lower prices. Second, it can charge a price consistent with no subsidy and use the cost savings to provide related services such as low-income energy assistance or preferential rates for rural customers. Or it can pass the subsidy through to the political jurisdiction's general fund for tax relief and/or increased public services. Third, it can operate inefficiently with high variable costs (such things as labor, fuel, and transportation), providing neither lower prices nor tax relief/higher public services.

To the extent public power chooses the first of these options and lowers price, public power's customers either are being induced by the low price to consume more electricity than they otherwise would or they could have purchased (absent monopoly) that electricity from another producer who was paying the full cost of capital but managed to produce electricity more efficiently. In either case, the system may be wasteful. With the advent of competition in electricity generation, IOUs argue this subsidy will give public power a competitive advantage over IOUs and could inhibit the market adjustments necessary to produce electricity at the least cost to society.

III. Tax-Exempt Bonds for Output Facilities?

The economic effects of continuing tax-exempt bond use after restructuring differ depending upon whether the bonds finance new or existing output facilities.

A. New Output Facilities

In a competitive market, price is set equal to marginal cost, the cost of producing an additional unit of output. A firm making a decision about investing in new plant will not make the investment if its expected price and output are not sufficient to cover all costs inclusive of fixed costs. Since the tax-exempt bond subsidy reduces public power's fixed costs, it gives public power the potential to drive the market price down to a level that would impose losses on IOUs. Thus, according to economic analysis, IOUs are correct that continued public power use of tax-exempt bonds to finance new facilities in a competitive market could provide public power with a price advantage.

B. Existing Output Facilities

Will the tax-exempt bonds that public power used to finance existing output property allow it to charge a lower price and gain an unfair advantage when competing to sell power from those facilities? Money that was borrowed to construct existing output facilities represents fixed costs. The interest cost on its debt is part of these fixed costs. Public power must pay these costs, unless it goes bankrupt, whether or not it maintains its production and customer base.

A public power utility will make pricing decisions to compete against other utilities on the basis of its variable cost, items whose use varies with production such as labor, fuel, and transportation. It will lower its price to retain or attract customers provided the marginal revenue from that decision equals or exceeds its variable cost. If its variable cost is high relative to its competitors' variable cost, those competitors will drive price down to a level where the public power authority cannot compete and it will lose market share. If its variable cost is low relative to its competitors' variable cost, it will drive price down to a level where its competitors cannot compete and it will increase market share. Note that the lower interest cost of public power relative to IOUs does not affect this pricing decision on production from existing output facilities and under competitive conditions will not provide an unfair advantage to public power. ⁽⁷⁾

If a decision to compete or a mandate to share its facilities with private entities causes public power's tax-exempt bonds to violate the private-activity bond rules, these bonds become retroactively taxable. ⁽⁸⁾ The way such a situation is likely to be handled is either for the utility to issue taxable debt and use the bond proceeds to retire the tax-exempt debt or to pay the Internal Revenue Service the lost federal tax revenue that would result if the bonds were to remain tax-exempt. Such increased costs shift up the firm's fixed costs and decrease its net income or increase its net loss, but they do not affect its variable cost or its pricing decision. In other words, forcing public power to refinance its existing tax-exempt debt as taxable debt will not change the competitive relationship between public power and IOUs nor will it improve the ability of deregulation to provide economic benefits to consumers.

Refinancing at taxable rates could, however, have some negative consequences. The federal government is responsible for regulating interstate commerce in electricity, but the regulatory task for intrastate commerce is left to the states. The federal government cannot force the states to force public power to open access to its transmission and distribution facilities for intrastate retail competition. Public power firms that see few benefits from competition may be reluctant to participate in open access plans because the decision might cause their outstanding tax-exempt bonds to become taxable and raise their interest costs. This would reduce the geographic reach of the network, the amount of competition, and the potential benefits for other consumers.

Thus, it makes economic sense to provide public power relief from post-restructuring violation of the private-activity bond rules for debt outstanding at the time restructuring occurs. Providing relief would not adversely affect IOUs' ability to compete for customers and the potential economic benefits of deregulation. A decision to enforce the private-activity bond rules for existing output facilities has two major consequences, one a clearly undesirable negative effect on economic efficiency and the other a distributional effect whose desirability depends upon subjective judgments. First, enforcing the existing rules might induce some public power authorities to refuse to participate in open access plans in order to retain their tax-exempt bond privilege, an action that would limit the scope of competition and reduce the economic gains from restructuring. Second, for those public power authorities that do choose to participate, it would shift the incidence of the cost of the subsidy from all federal taxpayers to public power's electricity consumers.

IV. Might Social Benefits Justify Post-Restructuring Tax-Exempt Bond Use for New Output Facilities?

Some argue that continued public power use of tax-exempt bonds for new output facilities is a desirable public policy because this subsidy of public power satisfies some federal policy goal that provides benefits to federal taxpayers. Public power claims that its tax advantages flow from: (1) the right of communities to operate electric utilities as a public service, the very basis of our democratic and multi-level (federal) system of government; and (2) that its lower rates relative to IOUs serve as a competitive yardstick that reflects the "true" costs of electric service. ⁽⁹⁾

A. The Justification for the Tax Advantage

The alleged right of state-local governments to make their own fiscal decisions in our democratic multi-level system of government without interference from another level of government is a legal justification. It asserts that any taxation of interest income derived from state-local bonds is unconstitutional because the exemption is protected by the Tenth Amendment and the doctrine of intergovernmental tax immunity.

As the congressional effort begun in 1968 to restrict state-local governments' use of tax-exempt bonds for what Congress believed to be private purposes intensified in the 1980s, the issue of whether the basis for tax-exempt bonds is constitutional or statutory was tested in the courts. The issue was settled by a 1988 Supreme Court decision (South Carolina v. Baker, 485 U.S. 505 [1988]) that rejected this claim of constitutional protection, leaving Congress free to impose restrictions through the legislative process (described in detail in Section IV. B.). ⁽¹⁰⁾

This Supreme Court decision leaves public power's second argument to justify its use of tax-exempt bonds for new output facilities -- that its lower electric rates serve as a competitive yardstick which reflects the true cost of electric service. Section II.B. explained the economic perspective that use of tax-exempt bonds allows public power to charge a price that understates the real resource cost of electricity. This understatement of real resource cost can only represent what public power refers to as "true" cost if the private market for electricity fails to provide the proper amount of electricity at the proper price, and the tax-exempt bond subsidy enables public power to lower its price and correct this market failure.

Markets can fail in a variety of ways. If electricity's economic characteristics rendered it unsuitable for private production, public power provision would be necessary. This is not the case. Electricity possesses the characteristics required for private sector production: consumption can be denied to those unwilling to pay for it (unlike national defense); and one family's consumption of a unit of electricity prevents another family from consuming the same unit (again, unlike national defense). Public production is not necessary in order that electricity be provided, as is obvious from the fact that more than 75% of electricity consumption is provided by IOUs.

But private markets also fail when they provide a good but the amount they provide is too large or too small. In fact, this is the economic rationale for state-local provision of many services. And it is the economic rationale (as opposed to the legal rationale discussed above) for the tax-exempt bond subsidy of public capital formation -- that state-local public capital facilities and the public services provided by those capital facilities tend to be underprovided. The sheer number of state and local jurisdictions implies that any one jurisdiction's political boundaries likely fail to encompass all individuals and businesses who benefit from its public services. Thus, some of the collective consumption benefits from public services spill over the border of a taxing jurisdiction, as in the case of some educational services or environmental projects. Collective consumption benefits from providing such goods exceed the benefits to taxpayers in the providing jurisdiction. Because taxpayers tend to be unwilling to pay for services received by nonresidents, it may be desirable for a higher level of government (which does receive payments from the nonresident beneficiaries) to subsidize residents' consumption in order to induce state-local governments to provide the proper, that is, a larger, amount of facilities.

Thus, the economic case for a federal subsidy such as tax-exempt bonds focuses on the likelihood that the state-local sector does not adequately correct the private market failure, and this state-local "under provision" is attributable to its citizens' unwillingness to pay for benefits that would be provided to taxpayers living outside the jurisdiction. Does state-local provision of electricity satisfy this criterion? Does the tax-exempt bond subsidy enable public power to account for the social benefits and social costs of electricity?

Three circumstances might cause the amount of electricity provided by public power to be nonoptimal and impose external or spillover effects on nonresident federal taxpayers. First, the electricity production process might generate environmental costs that flow down river or are carried upwind/downwind to nonresidents, and consequently are not taken into account when making decisions about output and price. To the extent these costs exist, from an economic perspective a more appropriate federal response would be to impose a tax (thereby internalizing the pollution costs) or to impose regulations, not to provide a subsidy to public power.

Second, reliance on a sole provider for a geographic area (as a cost-minimizing strategy) might impose higher electricity costs and prices on nonresidents by denying the utilities serving these nonresidents access to markets necessary to achieve an efficient scale of operation. A subsidy of public power does not correct this problem. In fact, the current efforts of the federal government and some states to adjust the industry's regulatory structure to promote competition are designed to correct this problem, and the tax-exempt bond subsidy of public power is potentially an impediment to these efforts.

Finally, the development of public power may have been necessary because private producers did not find it profitable to provide the universal service that society deems to be fair at a cost that is affordable to geographically isolated consumers. And federal taxpayers may value the redistributional aspects of such service such that they are willing to pay for it. At the end of the 20^th century, universal service is a reality. ⁽¹¹⁾ But economists argue that using tax-exempt bonds to achieve such service is inefficient and inequitable. Bond finance subsidizes consumers within public power service areas that have no universal service problem. In areas with a problem, it subsidizes all consumers rather than the relatively few who need it. In areas served by IOUs, bond finance provides no subsidy for needy consumers. And finally, the federal government's Low-Income Home Energy Assistance Program already provides such financial support in the form of grants provided to the states to be used for low-income energy consumers.

In summary, the exclusion from federal income taxation of interest income on tax-exempt bonds for public power is a subsidy that obscures rather than reveals the true cost of electricity and redistributes income to public power customers from the 75 percent of the country that purchases its electric power through the private sector. Such subsidies might be expected to serve an efficiency goal of correcting for market failure caused by spillover effects, but these do not appear to be great for electricity provision, and those that do exist can be addressed through government regulation or taxation of private industry rather than government production. To the extent the subsidy is used to finance lower-cost service to those in need, such assistance could probably be provided more efficiently (at lower federal budget cost) by an expansion of the Low-Income Home Energy Assistance Program.

Of course, the subjective judgment of taxpayers in a state or a local region still may be that public production of electricity is justified, and if they believe such provision should be subsidized they are free to provide such subsidies even in the absence of a federal subsidy. ⁽¹²⁾ In addition to the benefits such a subsidy would provide to state-local taxpayers due to a perceived correction of market failure, it would redistribute income to state-local citizens according to each person's electricity consumption and from state-local citizens according to each person's state-local tax burden.

B. Bond Legislation Affecting Public Power

The preceding discussion suggests continued use of tax-exempt bonds to finance new output facilities would tend to reduce the Nation's economic welfare. Would denying such bond use represent a break with congressional tax-exempt bond policy?

Congress has engaged in a 30-year effort to deny use of the federal subsidy provided by tax-exempt bonds for goods and services that do not satisfy its conception of public services. ⁽¹³⁾ And some of these efforts have been directed specifically at public power.

Having federal taxpayers pay part of the interest costs on state-local borrowing encourages state-local governments to invest in capital facilities to provide public services. But it also creates a problem: it encourages state-local officials to use the low-cost capital to provide services to their constituents at a reduced price, services that can be and are provided by the private sector at a higher price that reflects the private sector's higher borrowing cost (the full value of the resources used). The public sector can provide these services in two ways. First, it can directly produce the good at a lower price. Second, it can make loans to private businesses or private individuals to produce the good at a lower price. The potential for the state-local sector to expand the scope of its production activities or to assume the role of a commercial banker is obvious.

Congress first attempted in 1968 to control the commercial banker role of state-local officials. It declared state-local bonds to be taxable if: (1) 25% or more of the bond proceeds are to be used by a nongovernmental person (the "use" test); and (2) 25% or more of the debt service on the bonds is to be secured (paid) by property used directly or indirectly in a trade or business (the "security" test). These percentages were changed to 10% in the Tax Reform Act of 1986, and bonds satisfying the tests were called taxable private-activity bonds. ⁽¹⁴⁾

The focus of these rules was to prevent tax-exempt bond proceeds from being converted into loans for private investments in manufacturing and commercial physical capital. Some activities were allowed continued use of tax-exempt bonds even if they satisfied the private-activity bond rules. One of these activities is "local furnishing" of electricity. An IOU's (or independent power producer's) electricity sales must be confined to two contiguous counties or a city and a contiguous county to qualify as a local furnisher eligible to use tax-exempt private-activity bonds. However, Congress limited the use of these bonds by including them in the state private-activity bond volume cap that is equal to the greater of $50 per state resident or $150 million each year. Inclusion in the cap means that the bonds issued for local furnishers must compete with most other exempt private activities within a state for a share of the state's annual allocation of tax-exempt private-activity bonds. ⁽¹⁵⁾

But many state-local governments historically have subsidized electricity for their citizens through publicly owned utilities, not by conveying the subsidy to IOUs or independent power producers. These publicly owned facilities also have the potential for allowing private businesses to garner the benefits of the tax exemption for private use. Thus, rules were developed that required public power contracts for the sale of electricity to private businesses to be executed at non-preferential rates and with terms that did not otherwise transfer additional portions of the tax-exempt bond benefits to a private business. Those contracts that did not meet these requirements would be counted against the 10% rules. ⁽¹⁶⁾

This is a confusing situation. As discussed in the preceding section, electricity has all the characteristics of a private good. About 75% of all electricity consumption in the United States is provided by the private, not the public, sector. By its very nature, public power converts the federal tax-exempt bond subsidy to private use. But the only portion of the subsidy considered by the private-activity bond tests to be private use is that portion associated with contracts offered at preferential rates not available to the general public. ⁽¹⁷⁾

Not counting as private use those contracts issued by public power at non-preferential rates to large users located beyond its traditional service area conceivably could have led to the expansion of public power's market share at the expense of IOUs. This has not happened because the binding constraint here is the private market, not the tax law. Before investors will purchase the bonds used to build public power output facilities, they must be reasonably certain the facilities will generate revenue sufficient to pay the interest and principal on the bonds. Substantial expansion of capacity directed to large users outside public power's traditional service area cannot provide such assurances. The buyers' demand for electricity is subject to fluctuation with the business cycle, and, being beyond public power's traditional service area, the buyers have an alternative supplier. In addition, the public power entities are dependent upon other utilities for transmission and distribution services beyond their traditional service areas, and these other utilities might charge rates that prevent it from passing much of the tax benefit through in lower prices.

Nonetheless, congressional concern with the spread of power subsidized with tax-exempt bonds caused it in the 1986 Tax Reform Act to impose more severe restrictions on private use of bond proceeds for output property than it did for all other eligible private activities. Any bond issue for which 5% or more of the proceeds are used to finance output facilities is limited to a maximum $15 million of private use. Thus, any bond issue for which 10% private use (the standard for all other private activities) would exceed $15 million in effect is limited to less than 10% private use if the private use is electricity generation. In addition, the $15 million limit applies to all outstanding bonds for the project, not to each individual bond issue as is true for all other private activities. Given that electric facilities often cost hundreds of millions of dollars, for most projects the $15 million limitation imposes a private use share much smaller than 10%.

Congress deemed this special treatment necessary because pre-1986 law permitted IOUs temporary use of more than 25% of multiple billion dollar public power bond issues. This occurred because bonds could be issued to finance public power facilities whose output for public power customers would not be needed until far in the future. The determination of private use of electricity output in a given year from these bond-financed facilities was calculated as a percentage of the expected electricity production over the facilities' life, thus allowing sale of excess capacity to IOUs that far exceeded the allowable 25% that prevailed from 1969 through 1986.

Congressional desire to limit the spread of electricity subsidized by tax-exempt bonds was further demonstrated by two additional actions that followed the 1986 act. First, the Omnibus Budget Reconciliation Act of 1987 adopted a provision that treats as private-activity bonds subject to the volume cap any tax-exempt bond issue for which 5% or more of the proceeds are used to acquire output property owned by IOUs. ⁽¹⁸⁾ The only exceptions are for public power to acquire property to provide service to an area currently served or an annexed area contiguous to and not more than 10% of the area currently being served. Given the size of the volume cap and the size of most power projects, this provision virtually precludes expansion of public power's market share through this means.

Second, the Omnibus Budget Reconciliation Act of 1996 further restricted IOU or independent power producer use of private-activity bonds for "local furnishing" (discussed earlier in this Section) to service territories that were using the bonds prior to January 1, 1997. In effect, those providers using the bonds at that time were grandfathered; additional "local furnishers" were prohibited.

In summary, allowing tax-exempt bonds to be used for new output facilities after deregulation of generation and retailing has been implemented would give public power a competitive advantage over IOUs. It would increase the share of the market in which consumers are paying a price that does not reflect power's real resource cost. This would be desirable only if the electric power market is characterized by a market failure that is corrected by public power's use of tax-exempt bonds. This does not appear to be the case. Furthermore, three decades of tax legislation seems to have been directed to controlling the spread of the tax-exempt bond subsidy to areas not served historically by public power. Denying use of these bonds for new public power output facilities that are used to participate in the competitive market would prevent differential treatment of IOUs, minimize distortions in the electricity market, and continue the thrust of long-term federal tax policy in this area.

V. Are Transmission and Distribution Facilities a Special Case?

Because the transportation of electricity over long distances is most economically performed by one provider, transmission facilities do not appear currently to be a good candidate for competition. The potential for an unregulated owner of such facilities to provide favorable rates for its own power has caused FERC in order 888 and some states to propose that all transmission facilities be placed in the hands of an independent system operator (ISO). This operator would be responsible for maintaining a system open to all generators of electricity for the transmission of their power at nondiscriminatory rates, thereby encouraging maximum retail competition.

Some have argued that an ISO, whether organized as a private, nonprofit, or public firm, will in effect be a public utility providing services to the general public, much as a public highway. As such, it is argued that new transmission facilities are a special case and should be financed with tax-exempt bonds, even though privately owned facilities are not currently eligible for tax-exempt financing. ⁽¹⁹⁾

In fact, the economic characteristics of the transmission network are not analogous to those of a public highway. Why are highways most often provided by the public sector? First, if they are not congested, an additional user can be accommodated at virtually zero marginal cost, which implies a price incompatible with private provision. Second, even if the highway is congested, it can be very costly to exclude those who do not pay for the service, particularly on local highway networks. And as a practical matter, it is inexpensive to price the service through a user charge such as the gasoline tax. In effect, this brief discussion indicates private highway provision in many circumstances might result in too little and unnecessarily costly service being provided.

Transmission services are very different. They may or may not be subject to congestion. But it is not expensive to exclude those who don't pay. Such services can easily be provided by the private sector, as is evidenced by the fact that these services currently are overwhelmingly provided by the private sector.

Any failure of privately owned transmission facilities to provide the correct amount of services is due to it being a decreasing cost industry conducive to monopoly provision. This problem can be corrected by regulation. Allowing continued use of tax-exempt bonds would mean the customer would be paying less than the real resource cost of transmission services, even though this reduced cost is not correcting a market failure.

Providing a tax-exempt bond subsidy would give the ISO the potential for under pricing transmission services and encouraging too much electricity consumption. Or it might lead to inefficient management that incurs unnecessarily high variable costs. Or it might be used to continue the funding of the numerous subsidies of related activities that are financed from the existing regulatory system's monopoly rents. However the ISO might use a tax-exempt bond subsidy, Congress might consider whether taxpayers receive benefits commensurate with the federal tax dollars they forego because of the bond subsidy.

Although transmission facilities often are placed on property reserved solely for transmission of electricity, distribution facilities often share property being used for other public utilities such as street lighting. Denying tax-exempt bonds would raise difficult administrative questions about what share of the investment in this shared property is devoted to electricity, which should receive no financing subsidy, and street lighting, which appears to have the characteristics of a public good and perhaps should receive a subsidy. One might think of the tax-exempt bond financing as being for street lighting, and the incremental costs for distribution facilities as being minimal. This decision to allow tax-exempt bond financing of new distribution facilities probably has at least as much to do with the practical realities of local public services as it does with the economic principles discussed earlier.

VI. Analysis of Proposed Legislation

Numerous bills have been introduced that deal with electricity restructuring. This report considers three bills that cover the spectrum of proposed changes to tax-exempt bond law for electric output facilities: S. 1048 (Senator Murkowski, introduced by request of the Administration); S. 386 (Senator Gorton) and its companion H.R. 721 (Representative Hayworth); and H.R. 1253 (Representative English). The purpose here is to compare the treatment these three bills would impose on tax-exempt bonds to the findings of the preceding economic analysis. The information is organized in two tables. Table 1 asks: "Can New Public Power Electric Output Facilities Be Financed with Tax-Exempt Bonds?" Table 2 asks: "Do Private-Activity Bond Rules Apply to Outstanding Bonds That Financed Public Power's Existing Electric Output Facilities?" These questions are addressed separately for the three types of facilities: generation (G), transmission (T), and distribution (D).

A. Economic Treatment

The economic treatment developed in sections II through V of this report is presented in the shaded column of both tables in order to highlight it as a reference point to which the three legislative proposals are being compared. Table 1 indicates that were "Economic treatment" implemented, new generation and transmission facilities would not be financed with tax-exempt bonds. This denial would not depend upon whether any or all of these facilities are used in the competitive network. Distribution facilities could be financed with tax-exempt bonds if the property used to provide retail electric services is also used to provide other utility services that possess public good characteristics, such as street lighting.

Table 1. Can New Public Power Electric Output Facilities Be Financed with Tax-Exempt Bonds?:
Comparison of Economic Treatment with Three Legislative Proposals

Table 2 indicates that were "Economic treatment" implemented, outstanding bonds for existing output facilities would not be subjected to the private-activity bond rules. This relief would not depend upon whether the facilities are used in the competitive network.

B. Discussion of S. 1048

The Administration's "Comprehensive Electric Energy Competition Plan" provides:

... that (1) private use limitations are inapplicable to outstanding bonds for publicly-owned generation, transmission or distribution facilities if used in connection with retail competition or open access transmission, and (2) tax-exempt financing is unavailable for new generation or transmission facilities. Tax-exempt financing would continue to be available for distribution facilities subject to current law private use limitations. ⁽²⁰⁾

Table 2. Do Private-Activity Bond Rules Apply to Outstanding Bonds That Financed Public Power's Existing Electric Output Facilities?: Comparison of Economic Treatment with Three Legislative Proposals

The legislation that would make these changes, S. 1048, was introduced by Senator Murkowski by request of the Administration. Table 1 shows that S. 1048 would deny tax-exempt bond financing to all new generation and transmission facilities. The denial is universal; any bond issue for which any of the borrowed funds are used to finance new electric generation or transmission facilities is a private-activity bond, and therefore taxable. The denial does not depend upon whether the public power authority joins the competitive network or decides to maintain its monopoly franchise.

This change would deny a competitive advantage that public power could use to charge less than the full resource cost of its electricity. It would enhance economic welfare by forcing electricity prices to more nearly approximate real resource costs, or by denying use of the tax benefits to subsidize other state-local services or to over compensate labor. And it would provide no incentive to keep public power facilities out of the competitive network.

The proposed legislation would continue to allow use of tax-exempt bonds for distribution facilities.

Table 2 shows that S. 1048 would allow outstanding tax-exempt bonds that were used to finance existing electric output facilities to remain tax exempt if they violate the private-activity bond rules, provided the facilities are part of the competitive network. The economic analysis presented earlier suggests the private-activity bond rules should be waived whether or not the facilities are part of the competitive network.

C. Discussion of S. 386 and H.R. 721

This proposed legislation would allow future transmission and distribution facilities to be financed with tax-exempt bonds. As indicated in Table 1, allowing new transmission facilities to be financed with tax-exempt debt is not consistent with the economic analysis presented. It would allow transmission services to be priced at a level that does not reflect full resource cost and could lead to over consumption of transmission services. It could lead to inefficient production decisions. High-cost (but subsidized) transmission facilities might be extended to satisfy increased demand when it might be more efficient to use low-cost (but unsubsidized) generation capacity from another source to satisfy this demand increase.

The exception for local distribution facilities is consistent with the economic analysis and S. 1048's proposed treatment, provided the facilities are also used to provide other public services, such as street lighting.

Comparing the remainder of the bill's provisions to economic treatment is complicated because the bill gives public power a choice about whether to use tax-exempt bonds to finance future generation facilities, a choice that then affects the treatment of outstanding tax-exempt bonds. The most direct way to present the results is to describe each cell in the S. 386/H.R. 721 columns of Tables 1 and 2, and follow with more detail about some of the provisions.

Table 1 shows that public power can elect to continue using tax-exempt bonds for new generation facilities. If a utility's transmission and distribution facilities provide open access to other electricity retailers, these facilities would enjoy more private use than is currently permitted by the tax law. Of course, as discussed earlier in this report, allowing these generation facilities to be financed with tax-exempt debt gives a public power authority a competitive advantage in pricing over the potential competitors for whom open access provides entrance to the public power authority's market. Table 1 also shows that, as noted at the beginning of this section, new transmission and distribution facilities can be financed with tax-exempt bonds, and these facilities would enjoy unlimited private use if they are open access facilities.

Table 2 shows that the application of the private use rules depends upon whether the utility has chosen to renounce the use of tax-exempt bonds for future generation facilities. If use of the bonds for generation facilities is renounced, the private use rules do not apply to outstanding debt. If use of the bonds is not renounced, the private use rules do apply, but more private use is permitted for generation facilities if the utility's transmission facilities are open access.

Table 2 also shows that the private use rules do not apply to existing transmission and distribution facilities if these facilities are open access. The private use rules do apply if the facilities are not open access.

What is meant by the language "more private use permitted" that appears in the S. 386/H.R. 721 column of Tables 1 and 2? Section 2(a) of the bill would relax private use restrictions for utilities that allow open access on its transmission or distribution facilities. Sales on terms other than those available to the general public would not count as private use if the sale is to an on-system purchaser. An on-system purchaser is one who purchased output from the governmental unit some time during the 1996-98 period and whose facilities are directly connected with the governmental unit's transmission or distribution facilities. Sales on terms other than those available to the general public would not count as private use if the sale is an existing off-system sale, provided open access service is provided for transmission or distribution. An existing off-system sale is one made to an entity that was an off-system purchaser some time during the 1996-98 period, and for which the sale does not exceed the pre-adoption purchase of kilowatt hours.

Thus, the permissible private use of generation facilities would increase because existing on-system and off-system sales would not count against the limits. Only new sales would count as private use. Thus, the capacity for private use would be increased.

The election to renounce future use of tax-exempt bonds for generation facilities is limited only to bonds issued for electric facilities. It does not apply to:

• bonds that "qualify" for other exempt private activities, such as solid waste disposal;

• refunding bonds that meet the requirements of current law;

• transmission and distribution facilities in service on the date of enactment;

• pollution control facilities for output facilities in service on the date of enactment;

• repair of facilities in service on the date of enactment.

To the extent these various facilities are in competition with IOUs, the bond subsidy would enter into the pricing decision and would provide a competitive advantage for public power. For example, some suggest that the repair exception might be used to finance new turbines in a hydroelectric power plant, thus extending its productive life for another 50 years. This would substitute tax-exempt debt for what otherwise would have been a new facility financed with taxable debt.

D. Discussion of H.R. 1253

Section 1(b) of the bill classifies any public power bond issued for the construction or acquisition of electric generation and transmission facilities as private activity bonds, and therefore not eligible for tax-exempt status. This is reflected in Table 1 as "NO is general rule." This treatment is consistent with achieving the objectives of electricity market restructuring.

Certain facilities placed in service after enactment of the rule are excepted from this rule and would still be eligible for tax-exempt financing.

• facilities owned by "local government utilities" that are located in the utility's service area (except for generation facilities that can be located outside), sell services only to consumers located in the service area, and which are not designed differently, sized larger, built sooner, or constructed in a more costly manner than necessary to provide services to service-area consumers.

• the share of facilities a "local government utility" owns in a Joint Action Power Agency.

• facilities owned by a "small governmental utility," which provides services to fewer than 5,000 consumers, and for which at least 30% of average gross income in any 3-year period is from residential customers.

• local distribution facilities if located within the service area.

These exceptions are reflected in Table 1 as "YES if ..." The requirement that consumers be located within the utility's service area is waived if:

• the sales outside the service area are to another "local governmental utility" for sale to its service-area customers; the sales represent qualified pooling arrangements for which annual pooling sales do not exceed annual pooling purchases;

• the sale is required by a binding contract in effect on the date of enactment or if the contract renewal is at the option of the purchaser;

• the sale is to a utility for distribution through its facilities and the value is de minimis, that is, it does not exceed 10% of the selling utility's average de minimis-type sales in the preceding 3 years;

• the sale represents transmission or distribution services over facilities placed in service prior to enactment of the bill, and any associated sales of the utility's own electric power generation are to consumers within its own service area.

Most of these exceptions would maintain the tax preference for facilities whose use is restricted to within the service area. If this induced public power not to join the competitive network, consumers outside the area would be prevented from benefitting from peak-load capacity in the public power system. In addition, the tax-exempt bond subsidy can still be used to assist in keeping electricity prices low within the service area, possibly leading to more consumption than would otherwise occur.

The exception for local distribution is consistent with economic treatment if the facilities are also used to provide other public services, such as street lighting.

Section 1(c) would eliminate private use rules for tax-exempt bonds that were used to finance existing transmission and distribution facilities, if the facilities provide open access to competitors. This is reflected in "NO if T (D) is open access." This treatment is consistent with the economic welfare analysis above. Tax-exempt bonds that were used to finance existing generation facilities would continue to be subject to existing private use rules ("YES" in Table 2). This is not consistent with economic welfare; it would discourage public power competition in circumstances where the tax preference does not provide public power with a competitive advantage.

VII. H.R. 1253 and Federal Taxation of Public Power Income

H.R. 1253 includes one additional provision that has nothing to do with tax-exempt bonds, but that nonetheless has the potential to affect the relative competitive positions of public power and IOUs. Section 115 of the Internal Revenue Code excludes from taxation the net income derived by state and local governments from the operation of any public utility. ⁽²¹⁾ In effect, public power does not have to pay one of the significant variable costs of electricity production. As a result, the choice of public power versus IOU production of electricity is distorted in favor of public power.

H.R. 1253, alone among these bills, would subject some government electric utility income to federal income taxation. This taxation would apply only to income earned on sales outside its service area, and exceptions would be made for sales that qualify for the "small government utility" exception, the pooling exception, or the de minimis exception. Nonetheless, removing the near-absolute protection Section 115 provides for government business income would be consistent with economic welfare, since the income tax exemption is a variable cost and would enter into the utility's pricing decision. It could, however, raise major legal questions. Not taxing sales within the service area would likely lead to a host of practical problems similar to those that arise in assigning income to domestic and foreign sources for purposes of income taxation. The firm has a strong incentive to assign its income to the jurisdiction with the lowest rate of taxation, thereby avoiding some portion of its properly measured tax burden. Such practical problems could be avoided if the tax were extended to sales within the service area.

Footnotes

1. ^(back)Private use is not dependent upon whether the purchaser is located within the geographic area of the power authority's governmental unit(s). Rather, it depends upon the nature of the authority's contracts with the non-general-public purchasers. If contracts transfer the benefits and burdens of the ownership of facilities financed with the tax-exempt bonds to these purchasers, the contracts are considered to be made on terms other than those available to the general public and thus constitute a private use. Such use might take the form of a "take or pay" contract that requires the purchaser to pay for all power specified in the contract, whether or not the power is used.

2. ^(back)American Public Power Association, Public Power and the Myth of the Electric Utility Industry's "Level Playing Field," undated. See p. 1-2.

3. ^(back)U.S. Department of Energy. Supporting Analysis for the Comprehensive Electricity Competition Act. DOE/PO-0059, May 1999.

4. ^(back)A more complete discussion of legislation relevant to electric deregulation appears in CRS Issue Brief IB10006, Electricity: The Road Toward Restructuring, by Amy Abel and Larry Parker, updated October 1, 1999, 15p.; and CRS Electric Utility Restructuring Briefing Book

5. ^(back) See Electric Utility Restructuring Briefing Book for information about state-local policies.

6. ^(back)A second cost advantage is provided by public power's exemption from paying federal income taxes. Some argue that these public power federal tax benefits only work to offset federal tax benefits received by IOUs. IOUs' tax benefits may reduce their effective tax rate on net income below their statutory rate. However, unless this tax treatment reduces the effective federal tax rate to zero, the cost advantage enjoyed by public power's exemption from federal income taxation is reduced, but not eliminated.

7. ^(back)The same cannot be said for two other federal cost advantages enjoyed by public power: (1) exemption of its income from federal income tax; and (2) preferences for the purchase of low-cost federal power. Both of these advantages do enter into variable cost and will affect pricing decisions on output from existing facilities. For a discussion of federal power preferences, see: CRS Report 95-356, Power Marketing Administrations: A Time for Change?, by Larry Parker. (Archived).

8. ^(back)The Joint Committee on Taxation has provided a variety of specific examples to illustrate how such post-issuance violations might occur. Joint Committee on Taxation, Federal Income Tax Issues Arising in Connection with Proposals to Restructure the Electric Power Industry, (JCS-20-97), October 17, 1997, 18-20.

9. ^(back)American Public Power Association, Public Power and the Myth of the Electric Utility Industry's "Level Playing Field," undated. See p. 1-2. Washington, D.C.

10. ^(back)Few issues are ever entirely resolved, and this one could arise again some time in the future. Some argue the Supreme Court's South Carolina decision is incorrect on the basis that it presumes the federal government has a property right to the interest income on tax-exempt bonds. If this federal property right does not exist, the exemption cannot be equated to a subsidy, and the economic argument justifying taxation of the interest income of state-local debt is incorrect. "By way of illustration, one certainly would not label the decision by a thief not to rob an owner a subsidy to the owner from the criminal." Maxwell A. Miller and Mark A. Glick, "The Resurgence of Federalism: The Case for Tax-Exempt Bonds," Texas Review of Law & Politics, v.1, Spring 1997, 25-59.

11. ^(back)This may be attributable in part to direct federal programs such as the Rural Utilities Service and in part to the regulatory process subsidizing some service with monopoly rents. The reduction in these monopoly rents is a byproduct of industry restructuring and could put such subsidies at risk. The Administration's restructuring proposal would finance these subsidies from a Public Benefits Fund financed with an excise tax on every electric bill.

12. ^(back)In fact, public power does not pay state or local income taxes. In some cases, it does make some smaller payments in lieu of state-local income taxes.

13. ^(back)For more detail concerning the legislation discussed in this section, see CRS Report 96-698, Tax-exempt Bond Legislation, 1968-1996: An Economic Perspective, by Dennis Zimmerman.

14. ^(back)The most comprehensive discussion of legislative changes affecting public power appears in Joint Committee on Taxation, Federal Income Tax Issues Arising in Connection with Proposals to Restructure the Electric Power Industry, (JCS-20-97), October 17, 1997, 9-20.

15. ^(back)Additional restrictions on local furnishers were enacted in 1996, discussed below.

16. ^(back)A discussion of these contract rules is provided in Temporary and Proposed Private Activity Bond Regulations: Public Utility Output Facilities, Fulbright & Jaworski L.L.P., January 1998.

17. ^(back)This internal inconsistency is inherent in the form of the subsidy, one that is provided to any service state-local governments choose to provide. In the absence of constitutional protection for tax-exempt bonds, Congress could choose to eliminate such inconsistencies and many difficult tax-exempt bond policy issues by taxing the interest income on state-local debt and providing an explicit subsidy to those state-local services it believes provide significant economic benefits to federal taxpayers. Such a "taxable bond option" has been considered by previous Congresses but not enacted. The Taxpayer Relief Act of 1997 instituted Zone Academy Bonds, a variant of the taxable bond option structured to provide a taxable federal tax credit rather than tax-exempt interest income. These bonds, which effectively pay all of the state-local government's interest cost, are restricted to certain capital facilities for education. See CRS Report 97-828, Tax-Exempt Bond Provisions of the Taxpayer Relief Act of 1997, by Dennis Zimmerman.

18. ^(back)This provision is discussed in CRS Report 88-174, Tax-exempt Bond Financed Takeover of Investor-owned Utilities: An Issue of Privatization and Competition, by Dennis Zimmerman. (Archived).

19. ^(back)Were the ISO organized as a private firm, it would violate existing tax-exempt bond law and could not use tax-exempt bonds. The fact that it could be organized as a private firm essentially says that these services possess the characteristics of a private good and public subsidy is only economically justified if the "correct" amount is not provided.

20. ^(back)U.S. Department of Energy, Comprehensive Electricity Competition Plan, March 25, 1998.

21. ^(back)Section 115 of the Internal Revenue Code excludes from taxation the gross income state and local governments receive from the operation of utilities and the provision of other "essential" services. The economic and legal aspects of taxing this income is largely unexplored. See Moshe Schuldinger and Dennis Zimmerman, "Taxing State and Local Government Production: Economic and Legal Perspectives," Nation Tax Journal, v. 52, no. 3, September 1999 (forthcoming).