WASHINGTON -- The Joint Tax Committee staff leveled both praise and criticism last week at a group of bills that would ease tax law bond curbs involving the arbitrage rebate requirement, infrastructure financing, and 501(c)(3) bonds.

In a report prepared for a hearing on the proposals, the staff members said they were concerned some parts of the bills could revive opportunities for abuse in the tax-exempt bond area that were squelched by the Tax Reform Act of 1986.

But the staff -- which has a reputation within municipal circles for being tough on tax-exempt bonds -- admitted the provisions have their good points as well and might ease some burdens the 1986 tax law placed on municipal bond issuers.

Last week, the Senate Finance Committee's subcommittee on taxation heard testimony on the three bills in question: one by Sen. Max Baucus, D-Mont., to simplify bond provisions of the 1986 tax law, particularly, the arbitrage rebate requirement; one by Sen. Pete Domenici, R-N.M., to remove private-activity curbs on environmental infrastructure bonds; and one by Sen. Daniel P. Moynihan, D-N.Y., to remove the $150 million limit on the amount of bonds any nonhospital 501(c)(3) institution may have outstanding at a given time.

In the report, staff members warned that repealing the $150 million limit in the short run "would primarily benefit a releatively small number of private, nonprofit universities having endowments among the larges tof any in the United States."

These schools would have the opportunity to engage in a kind of indirect arbitrage by borrowing at tax-exempt rates instead of spending their available funds, they said.

But the staff also acknowledged that other tax law bond curbs, such as the rebate requirement and hedge bond restrictions enacted in 1989, probably would address that problem if the volume limit were to be lifted.

Under Sen. Domenici's measure, municipal bonds issued for environmental infrastructure projects, such as hazardous and solid waste control facilities, would be considered governmental rather than private-activity debt regardless of the level of private participation in the project.

The staff noted that the bill would essentially eliminate a host of restrictions -- among them, the alternative minimum tax and the private-activity volume cap -- from bonds designated as infrastructure bonds. Since infrastructure bonds "provide subsidized financing for private business capital" in the same way that other private-activity bonds do, "singing out infrastructure facility projects for more favorable treatment would be inequitable," the staff said.

But the staff also said it may be appropriate to ease restrictions on infrastructure bonds, because the financing aids states and localities in complying with federal mandates in the environmental area.

"Many projects that are defined as infrastructure facility bond projects are required by federal regulations; providing a tax subsidy to these projects is a reasonable response to the need for equitable cost sharing," the staff said.

Most of the staff members' concern with Sen. Baucus' bill centered around their fear that approving the provisions could lead some issuers to revert back to pre-1986 behavior, in which some tax-exempt bond deals were done primarily for the arbitrage profits they generated. But they also acknowledged that many of his proposals would have merit if it could be documented that issuers are having the problems those proposals would address.

For example, one of Sen. Baucus's provisions would allow issuers to retain a small percentage of their arbitrage earnings, to keep them from going to extreme lengths to avoid paying the rebate.

The staff members said they were concerned that giving issuers an incentive to maximize their arbitrage earnings "could lead to earlier and larger issuance of tax-exempt bonds -- at an increased federal revenue cost."

But the staff also admitted the provision has its positive side as well: It would deter issuers from a practice known as "yield burning," in which an issuer enters into a guaranteed investment contract at an artificially low yield in order to avoid the rebate requirement.

"Allowing these issuers to retain a portion of any profit earned will encourage more efficient investment, with the federal government sharing the benefit of these investments," the staff members said.

Sen. Baucus also proposed increasing the $10 million small-issuer exemption from limits on bank deductibility to $25 million, a change issuers say is needed because the 1986 tax law caused banks to sell off large amounts of their municipal bond portfolios.

The committee staff, however, said increasing bank demand is unnecessary because since 1986 individual investors have picked up the slack left by the flight of institutions.

"In light of these market changes, allowing banks an exception from the prohibition on deducting interest incurred to acquire or carry tax-exempt bonds of up to $25 million per issuer provides an unnecessary tax subsidy to these institutions," the committee staff said.

But the staff also said increasing the $10 million exemption "may be appropriate if nonfinancial institution markets are demonstrated to be unavailable for bonds of the [issuers above that amount]."

Rep. Beryl Anthony, D-Ark., has introduced legislation in the House identical to Sen. Baucus' bill, and Rep. Robert Matsui, D-Calif., has offered a bill identical to that of Sen. Moynihan. Rep. Frank Guarini, D-N.J., introduced legislation in the House similar to Sen. Domenici's bill.

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