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Since 1968, the federal government has adopted several measures to curb the use of tax-exempt bonds by states and municipalities to finance loans to individuals or private businesses. The most recent of these measures was the Deficit Reduction Act of 1984, which placed limits on the volume of tax-exempt student loan and industrial revenue bonds that states could issue. The act also required the Congressional Budget Office (CBO) and the General Accounting Office (GAO) to conduct independent studies of "the appropriate role" of tax-exempt bonds in federally guaranteed student loan programs and "the appropriate arbitrage rules for such bonds." As specified in the legislation, this report is being submitted to the Committee on Finance and the Committee on Labor and Human Resources in the Senate and the Committee on Ways and Means and the Committee on Education and Labor in the House of Representatives. The report analyzes the use of student loan bonds under current law, the arbitrage earnings that accrue to issuers of these bonds, and the costs to the federal government of tax-exempt financing. In accordance with CBO's mandate to provide objective analysis, it offers a number of alternatives for changing current law, but no recommendations.

The study was made by Pearl W. Richardson of CBO's Tax Analysis Division, under the direction of Rosemary D. Marcuss and Eric J. Toder. Eric Toder wrote the appendix to the report, which provides the analysis underlying CBO's estimates of revenue losses to the federal government from using tax-exempt student loan bonds. Frederick C. Ribe of the Fiscal Analysis Division also contributed importantly to CBO's efforts to estimate revenue losses from tax-exempt financing.

Many others contributed to the study. The state student loan authorities and the Department of Education were most cooperative. Others who provided useful information and helpful comments included Harry Apfel, Loren Carlson, Bruce Davie, H. Benjamin Hartley, Thomas Neubig, David Reicher, James M. Verdier, and Jillian Watkins. Within CBO, constructive comments were made by Michael Deich, Edward M. Gramlich, Robert Hartman, Deborah Kalcevic, Maureen McLaughlin, and Marvin Phaup.

The paper was edited by Francis S. Pierce. Shirley Hornbuckle and Linda Brockman prepared the manuscript for publication.
 

Rudolph G. Penner
Director
August 1986
 
 

SUMMARY

CHAPTER I. - INTRODUCTION

• The GSL And Plus Programs
• Financing Student Loans
• Key Issues

CHAPTER II. - THE LEGISLATIVE HISTORY OF STUDENT LOAN BONDS

• State Profits On Student Loan Bonds
• Efforts To Restrict The Use Of Student Loan Bonds
• The Ford Amendment
• The Deficit Reduction Act of 1984
• Arbitrage Regulations Governing Student Loan Bonds
• IDE Arbitrage Restrictions
• Arbitrage Restrictions on Student Loan Bonds
• Pending Tax Legislation

CHAPTER III. - STUDENT LOAN AUTHORITY OPERATIONS

• Operating Costs
• The Yield On Student Loans
• Returns To Student Loan Authorities
• Variable/Fixed-Rate Bond Issues
• Taxable Financing
• Tax-Exempt Financing without SAPs
• Surplus Funds
• Reserves
• Unobligated Bond Proceeds
• The Profitability Of Student Loan Authorities
• The Use Of Surplus Funds

CHAPTER IV. - THE COSTS TO THE FEDERAL GOVERNMENT OF STUDENT LOAN BONDS

• Problems In Estimating Revenue Losses
• The Costs To The Federal Government Of Tax-Exempt Versus Taxable Financing
• Tax-Exempt Financing without the SAP
• Supplemental Loans

CHAPTER V. - POLICY ALTERNATIVES

• Increase The Availability Of Student Loan Funds
• Increase the Special Allowance Payments for Student Loans Financed with Taxable Funds
• Ease Restrictions on Student Loan Bonds
• Eliminate Student Loan Authorities' Profits
• Reduce the Special Allowance Payment for Loans Financed with Tax-Exempt Bonds
• Impose the Usual Arbitrage Restrictions on Student Loan Bonds
• Specify Permissible Uses of Surplus Funds
• Reduce The Costs Of Tax-Exempt Financing
• Eliminate Tax-Exempt Student Loan Bonds
• Withhold the SAP on Student Loans Financed with Tax-Exempt Bonds
• The Effects Of Pending Legislation

APPENDIX A. - ESTIMATES OF REVENUE LOSS FROM TAX-EXEMPT STUDENT LOAN BONDS

APPENDIX B. - NEW ISSUES OF TAX-EXEMPT STUDENT LOAN BONDS BY STATE, (IN MILLIONS OF DOLLARS) 1983-1985
 

TABLE 1.	STATE AUTHORITY SPREADS ON 8 PERCENT STUDENT LOANS FINANCED WITH VARIABLE-RATE BONDS UNDER CURRENT LAW
TABLE 2.	STATE AUTHORITY SPREADS AND MAXIMUM PERMISSIBLE SPREADS UNDER CURRENT ARBITRAGE REGULATIONS ON 7, 8, and 9 PERCENT STUDENT LOANS FINANCED WITH VARIABLE-RATE BONDS
TABLE 3.	STATE AUTHORITY SPREADS ON STUDENT LOANS FINANCED WITH FIXED-RATE 7.5 PERCENT BONDS
TABLE 4.	STATE AUTHORITY SPREADS ON 8 PERCENT STUDENT LOANS FINANCED WITH VARIABLE-RATE BONDS ASSUMING COST OF FUNDS AT 75 PERCENT OF T-BILL RATES
TABLE 5.	RATES OF RETURN ON AVERAGE INCOME-EARNING ASSETS FOR LARGE COMMERCIAL BANKS, SALLIE MAE, AND SELECTED STUDENT LOAN AUTHORITIES
TABLE 6.	ESTIMATED ANNUAL COSTS OF PROVIDING $1 BILLION IN 8 PERCENT GSLs THROUGH TAXABLE VERSUS TAX-EXEMPT FINANCING ASSUMING A 22.5 PERCENT MARGINAL TAX RATE
TABLE 7.	ESTIMATED ANNUAL COSTS OF PROVIDING $1 BILLION IN 8 PERCENT GSLs THROUGH TAXABLE VERSUS TAX-EXEMPT FINANCING ASSUMING A 25 PERCENT MARGINAL TAX RATE
TABLE 8.	ESTIMATED ANNUAL COSTS OF PROVIDING $1 BILLION IN 8 PERCENT GSLs THROUGH TAXABLE VERSUS TAX-EXEMPT FINANCING ASSUMING A 35 PERCENT MARGINAL TAX RATE
TABLE 9.	ESTIMATED ANNUAL COSTS OF PROVIDING $1 BILLION IN 12 PERCENT PLUS LOANS THROUGH TAXABLE VERSUS TAX-EXEMPT FINANCING ASSUMING MARGINAL TAX RATES BETWEEN 22.5 AND 35.0 PERCENT
TABLE 10.	ESTIMATED ANNUAL COSTS OF PROVIDING $1BILLION IN 8 PERCENT GSLs THROUGH TAXABLE FINANCING VERSUS TAX-EXEMPT FINANCING WITH NO SPECIAL ALLOWANCE PAYMENT AT DIFFERENT MARGINAL TAX RATES
TABLE A-l.	SIMULATED EFFECTS ON RATES OF RETURN, CAPITAL ALLOCATION, AND ASSET HOLDINGS OF SUBSTITUTION OF $10 BILLION OF TAX-EXEMPT FOR TAXABLE BONDS IN FINANCING GUARANTEED STUDENT LOANS
TABLE A-2.	SIMULATED LONG-TERM BUDGETARY EFFECTS OF SUBSTITUTING $10 BILLION OF TAX-EXEMPT FOR TAXABLE BONDS IN FINANCING GUARANTEED STUDENT LOANS
TABLE A-3.	SIMULATED EFFECTS ON INDIVIDUAL ASSET HOLDINGS BY INCOME CLASS OF SUBSTITUTION OF $10 BILLION OF TAX-EXEMPT FOR TAXABLE BONDS IN FINANCING GUARANTEED STUDENT LOANS: CAPITAL STOCK HELD FIXED
TABLE A-4.	SIMULATED EFFECTS ON INDIVIDUAL ASSET HOLDINGS BY INCOME CLASS OF SUBSTITUTION OF $10 BILLION OF TAX-EXEMPT FOR TAXABLE BONDS IN FINANCING GUARANTEED STUDENT LOANS: FULL MODEL SIMULATION

 

In recent years, the federal government has taken measures to limit the volume of bonds that are exempt from federal taxation and are issued by states and municipalities to finance below-market-interest-rate loans to individuals or businesses. This effort has included placing limits on the use of tax-exempt bonds as a source of financing for federally guaranteed student loans. In 1980, the Congressional Budget Office (CBO) found that state and local student loan authorities were earning millions of dollars in profits from the issuance of tax-exempt bonds. The Congress responded by passing legislation to reduce student loan authorities' profits and to lower the costs of using tax-exempt student loan bonds. This report focuses on developments since 1980.

Student loan bonds are issued by state and local student loan authorities to raise funds at rates lower than those available to commercial lenders. The interest rate that students pay on their loans, however, is set by federal legislation and is unaffected by the source of financing. For many years, the federal government has induced commercial lenders to make guaranteed student loans at below-market interest rates by offering them interest subsidies (called "special allowance" payments) and insuring the loans against default. Even with these inducements, however, banks have at times been reluctant to lend because of the high cost of servicing student loans and the lack of an adequate secondary market for the loans. In some instances, then, tax-exempt bonds have made loan funds available where they might otherwise not have been.

Over the years, the links between tax-exempt financing and the issuance of federally guaranteed student loans have raised many questions, such as:

• To what extent does tax-exempt financing increase the availability of the guaranteed student loans?
  
  
• Are controls on tax-exempt student loan bond issues desirable?
  
  
• Are state authorities realizing profits from operating student loan programs? If so, how might these profits be eliminated without destroying or substantially limiting the authorities' ability to operate?
  
  
• How costly are student loan bonds? Is tax-exempt financing more costly to the federal government than conventional financing?

THE PRESENT SITUATION

Today, more than 50 authorities in 39 states, the District of Columbia, and Puerto Rico issue student loan bonds and relend the proceeds to students or purchase guaranteed loans made by commercial banks. The number of state authorities issuing student loan bonds more than doubled between 1980 and 1985. Since 1983, however, the volume of new issues of student loan bonds has declined as a result of federal efforts to curb tax-exempt financing. The volume of new issues peaked at $3.1 billion in 1983, declined to $1.4 billion in 1984, and was $2.9 billion in 1985.

Profits on bond issues are lower now than they were in the late 1970s, but under some circumstances they may still far exceed the needs of the state authorities operating student loan programs. The profits accruing to the state authorities are the difference between the yield on student loans and the level of associated expenses. The authorities receive student loan interest payments and special allowance payments from the federal government. Their expenses include interest on the bonds, loan servicing costs, and operating costs. Since few authorities receive state or local appropriations, their income must be sufficient to cover expenses, but it need not exceed expenses.

In most cases, financing student loans through tax-exempt bonds is more costly to the federal government than other means of financing. The cost stems primarily from reduced federal revenues, because interest on the bonds is not subject to federal taxation. When tax-exempt bonds substitute for conventional financing, federal costs are generally higher for a given volume of student loans. If tax-exempt financing results in additional funding, federal costs will be higher but more credit will be available to students.
 

THE LEGISLATIVE BACKGROUND

Federal law generally prohibits states from issuing tax-exempt bonds at low interest rates and investing the proceeds at much higher yields. Profits that arise in this way are called "arbitrage." Arbitrage profits provide indirect, off-budget subsidies to state governments at the federal taxpayer's expense.

In the Tax Reform Act of 1976, the Congress made an exception for issuers of student loan bonds to the general prohibition against arbitrage. For arbitrage purposes, the special allowance payment on student loans is not counted in determining the yield on the investments made with bond proceeds. At the time the Tax Reform Act of 1976 was enacted, the portion of the return on student loans that was excluded from arbitrage yield calculations (the special allowance payment) was capped under the education laws at 3 percent. Subsequent higher education legislation changed the way the special allowance is calculated and removed its ceiling.

The Middle Income Student Assistance Act of 1978 made all students, regardless of family income, eligible for in-school interest subsidies on their loans. This increased the demand for student loans by students from high-income families. Current law now sets income limits for guaranteed student loans, but these are high enough to assure strong demand for loans.

Although the Congress had no such intention, the interaction of the Tax Reform Act of 1976, the Middle Income Student Assistance Act of 1978, and high interest rates made it possible for state authorities to realize huge profits from tax-exempt financing of student loans. The profits came primarily from the special allowance that the federal government pays to lenders. Once the Congress became aware of the situation, it took action to reduce these profits and subsequently to limit the use of student loan bonds.

The Education Amendments of 1980 cut in half the special allowance paid on loans originating from or purchased with the proceeds of tax-exempt bonds. The Student Loan and Technical Amendments Act of 1983 required that authorities issue no more bonds than were necessary to meet the need for student loan credit in their areas. Subsequent regulations issued by the Department of Education stipulated that student loans financed with tax-exempt bonds would be eligible for special allowance payments only if taxable financing was demonstrably infeasible. Finally, the Deficit Reduction Act of 1984 set limits on the volume of student loan bonds.
 

THE POTENTIAL EFFECTS OF PENDING LEGISLATION

At present, legislation to reform the tax code and to reauthorize the Higher Education Act of 1965 is pending in both the House and the Senate. In general, pending education legislation would facilitate tax-exempt financing of student loans, while some pending tax reform measures could have the opposite effect. Despite these differences, all of the bills now pending indicate that, in one form or another, the Congress seeks to continue the use of tax-exempt student loan bonds.

If enacted, the education legislation now pending would encourage tax-exempt financing because:

• It would no longer be necessary for state authorities to obtain the approval of the Department of Education in order for loans financed with tax-exempt bonds to be eligible for special allowance payments.
  
  
• The bill passed by the Senate would lower the special allowance by one half of a percentage point, which might make it more difficult for authorities to obtain taxable financing. A significantly lower special allowance might also make banks more reluctant to make student loans.

The tax legislation passed by the House would affect student loan bonds in two ways: it would set new, more restrictive limits on the volume of bond issues, and it would tighten arbitrage regulations for all tax-exempt bonds. The new regulations would make it impossible to use arbitrage profits to pay for the costs of bond issuance. The bill passed by the Senate retains the volume limits in current law and, while it imposes new arbitrage restrictions on all bonds, an exception for student loan bonds would make it possible to recover issuance costs from arbitrage profits.

The interaction of some of the provisions of the education and tax bills could make it difficult for state authorities to continue financing loans from tax-exempt or taxable sources. This could happen if, for example, the special allowance is reduced, making taxable financing less feasible, and at the same time stringent arbitrage restrictions are enacted, making tax-exempt financing less feasible. The Congress seems to be neither anticipating nor seeking such an effect, any more than it intended the combined effect of education and tax legislation in the late 1970s, but the possibility is no less real.
 

THE ALTERNATIVES TO CURRENT POLICY

The justification for tax-exempt financing is that it provides funds for student loans that private institutions otherwise would not make available. The extent to which tax-exempt bonds affect loan availability, however, is difficult to quantify. To some degree, they have displaced lending from taxable sources. In some states, however, they seem to have increased the amount of lending either because of the favorable terms state authorities offered in buying loans from banks or because they were willing to lend when banks refused to do so. At the same time, the bonds represent a cost to the federal government, and the potential for student loan authorities to realize sizable surpluses from issuing them is significant, despite the legislation passed in 1980 and the volume limits and administrative controls instituted more recently.

In considering alternatives to current law, the Congress will have to determine whether its primary objective is to increase the availability of student loan credit, to reduce the deficit, or to eliminate student loan authorities' profits.

• If its goal is to increase the availability of student loans, the Congress either could provide additional incentives to commercial banks and thrift institutions by increasing special allowance payments so that more taxable funds become available for GSL and PLUS loans, or it could ease some or all of the present restrictions on tax-exempt financing.
  
  
• If the Congress seeks to maximize the amount of student credit available and, at the same time, to reduce off-budget, nonvisible tax expenditures, it could increase the special allowance for taxable loans and eliminate tax-exempt student loan bonds entirely.
  
  
• If the Congress wants to lower the deficit, it might consider reducing the special allowance payments for student loans and either imposing additional limits on the use of student loan bonds or eliminating them entirely and reducing the overall volume limits on tax-exempt bonds accordingly.
  
  
• If the Congress's main aim is to eliminate student loan authorities' profits, it might consider lowering the special allowance payment for student loans financed with tax-exempt bonds or tightening the arbitrage provisions of current law by including special allowance payments in calculations of arbitrage income and requiring student loan authorities to rebate arbitrage earnings to the federal government. The Congress could also specify permissible uses of surplus funds resulting from student loan authority operations.

Some of these measures are not mutually exclusive. For example, the Congress could ease the volume limits or retain current limits and, at the same time, tighten the arbitrage regulations for student loan bonds; or, it could impose more restrictive volume limits and tighten arbitrage regulations. The action that the Congress ultimately takes would depend on whether its primary concern is the overall level of tax-exempt financing, the potential enrichment of state student loan authorities at the federal taxpayers' expense, or both.

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