Forget about Congress and the administration eliminating the private-activity volume cap, repealing arbitrage rebate, or resurecting full bank deductibility for tax-exempt bonds in the next five to 10 years.

But be prepared for them to ease those and other key bond provisions of the Tax Reform Act of 1986, as well as subsequent regulations.

Don't lose any sleep worrying that Congress or federal officials have some grand plan to do away with the municipal tax exemption. But do be concerned that new curbs on tax-exempt bonds could be triggered by the struggle against the federal deficit and bad publicity about the market.

In other words, the forecast from more than two dozen municipal market participants is that bonds are probably heading for a calm 10 years or so in Washington, but that complacency would be a mistake.

"Now we're into an era of good feeling," said Jeffrey S. Green, the general counsel for the Port Authority of New York and New Jersey. That era should last for several years, as long as issuers and investment bankers do not try to push the outer edge of the bond curb envelope, he said.

"I have confidence in the industry, and in state and local governments to behave responsibly," said Green, who is also a member of the Anthony Public Finance Commission. "I can see a continued period of calm in the market from a tax [legislative] standpoint for a period of time."

One reason for the calm is that Congress is satisfied with the tax work it did in 1986.

"I think the organizing framework that the Tax Reform Act of 1986 brought to the tax-exempt bond area continues to be the guiding structure, and is likely to be so throughout the rest of the decade," said a municipal lobbyist who asked not to be identified.

No Big Change

In 1986 Provisions

"There has been little experience subsequent to passage of the act to suggest to the legislators the need for a fundamental rethinking of the structure," the lobbyist said.

Back in 1988, the Supreme Court rocked the bond community by ruling that municipal tax exemption is not protected by the Constitution. The landmark decision, in South Carolina v. Baker, caused widespread fear that Congress would soon pass legislation to make tax-exempt interest taxable. But congressional leaders said at the time they had no plans to do so, and that's not going to change.

"I don't expect to see any wholesale assault" by Congress on the municipal bond tax exemption for the foreseeable future, said Bruce Davie, former chief tax economist for the House Ways and Means Committee. Davie was one of the chief architects of the bond curbs in the 1986 act.

"I worry about a lot of things, but that's not one of them," said Robert Dean Pope, a partner with the law firm of Hunton & Williams in Richmond. Pope is also a member of the Anthony Commission.

One reason Congress will not be mounting a new legislative assault on municipals is that state and local officials have been driving home the argument that bond financing is an appropriate way to fund public projects, said Catherine L. Spain, the director of the Government Finance Officers Association's federal liaison center.

"The grassroots efforts that have sprung from that Supreme Court decision have basically raised that level of awareness [in Congress] about the benefits of tax exemption," Spain said.

But, given that Congress is basically comfortable with the 1986 act, radical loosening of the bond curbs would seem as unlikely as tightening.

"My impression is it becomes more and more difficult with the passage of time" to effect major changes in the bond provisions of the 1986 act, said Milton Wells, the director of federal relations for the National Association of State Treasurers.

"Congress simply gets the feeling that, ~Well, you've lived with it this long; obviously you can live with it,'" Wells said.

Of course, there could still be some modest relaxation. With Congress always short of cash for state and local governments, sources said they see opportunities for a few gradual, incremental changes to the tax code.

"There are so many things that need to be financed out there, where there isn't enough federal money, there isn't enough state and local money, there isn't enough private money," said Micah S. Green, the executive vice president of the Public Securities Association. "I see expanding of the opportunities for issuance of, or investment in, municipal bonds as being a function of all the needs out there that need to be financed."

The federal government will agree to minor bond changes because it "will be looking for ways to give added support to state and local communities to raise the funds they need," especially for transportation and environmental infrastructure projects, said Kevin McCarty, deputy executive director of the U.S. Conference of Mayors.

John C. Bates, a former Internal Revenue Service official, said a weak economy could be the key to prospects for minor relaxation of tax law bond provisions.

If the economy continues to only limp along, it will be easier for state and local officials to argue that they need more flexibility in their financing sources and. thus, in the bond rules, said Bates, who is now a lawyer in Washington, D.C.

Frank Shafroth, the chief lobbyist for the National League of Cities, said he sees a continuing movement "in the direction of greater efficiency for the municipal finance sector, which means not major changes, but continuing changes in the right direction to make access to the market more efficient, easier, and probably more productive." Shafroth is the league's director of policy and federal relations.

For example, although Congress won't repeal the arbitrage rebate requirement, it will probably approve a broader safe harbor that will exempt many general obligation bond issuers of all sizes, bond proponents say.

Fear New Rules

May Creep in

Similarly, there's little hope for going back to the bank-purchase rules that existed before 1986. Then, banks were allowed to deduct 80% of the cost of purchasing and carrying any tax-exempt bonds. Now, the bonds must have been sold by a governmental issuer that expects to sell no more than $10 million annually. Congress will eventually raise the ceiling to $20 million or $25 million, bond proponents say.

The private-activity bond volume cap is another area where the overall structure of the 1986 act is expected to remain intact. Under that provision, states are allowed to allocate the greater of $50 per capita or $150 million each year in private-activity bond authority.

Although the dollar amounts are not likely to be raised. Congress can be expected to take other actions to ease the cap. For example, they may index the cap for inflation. Or they may create new categories of tax-exempt bonds that are not subject to the cap, along the lines of enterprise zone bonds created in 1993.

Amid the hope for small improvements in tax law bond provisions, kind the belief that Congress has no desire to do away with tax-exempt bonds, there is still a certain amount of fear that additional restrictions on municipals may creep into the tax code in the next decade, if circumstances are right.

"It would be a mistake merely to assume that everything is safe and not subject to review at some stage down the road," said the municipal lobbyist who requested anonymity.

Shafroth said his fear is that "someone, sometime, somewhere is going to do something that the press is going to pick up on, and it will seem terribly abusive."

As vague as that fear may seem, several other lobbyists are pointing to a development occurring now in Congress that has the potential for repercussions in the coming years. They are worried about hearings that were held this fall on market regulation by the House Energy and Commerce Committee's subcommittee on securities.

Though the hearings are focusing on regulatory agencies and investor protection issues, the sanguine attitude of the tax-writing committees could ultimately be affected.

"Right now I'm concerned about what the current spate of adverse news stories is going to do to our support on the Hill. People will say, ~See, we told you so,'" Wells said.

"It's definitely a concern we have to consider," said Wooten Epes, a former president of the Arkansas Development Finance Authority, and now a partner with Kutak Rock in Little Rock.

A few other demons are also lurking out there. For example, eventually Congress will begin to focus on ways to increase the nation's savings rate. When that happens, lawmakers are almost certain to consider a proposal for eliminating taxation on interest and dividends.

There will be a trend toward rethinking our tax system to encourage capital formation and savings, and those changes could have major impact on tax-exempt bonds." Shafroth said.

But the biggest demon of them all will be the federal budget deficit. In enacting a five-year budget-cutting law this year. Congress and the President failed to eliminate the deficit. succeeding only in stemming its future growth.

John T. McEvoy, the executive director of the National Council of State Housing agencies, noted that many economic forecasters are predicting that the deficit will still be in the $200 billion range by 1998, when the new budget law expires.

If those predictions turn out to be true, "we're going to be in a budget crunch that makes the one we're going through now look like child's play," McEvoy said.

Under those circumstances, Congress will be searching for every penny it can to stern revenue losses, and there will be a "tendency to reexamine whether the exemption should exist in its present form," McEvoy said.

The Bottom Line, for Some:

Congress Think's Bonds Need Watching

But even without external pressures like the market regulation hearings or the deficit there will always be the posibility of some unwelcome changes to tax law bond provisions, several bond proponents said. It will be hard to completely eliminate Congress' historic dislike of unfettered tax-exempt debt.

"We always face the institutional bias of the tax-writing committees and the Treasury Department, and therefore there is always going to be pressure to restrict us," Pope of Hunton & Williams said. "We're going to have to live with that all the time."

Federal regulatory officials agree.

"The pressure on the tax system is, and will continue to be, the search for revenues. And tax-exempt bonds will always be a candidate." said one federal official.

Consequently, the bond industry should not expect the government to support an easing of the limits on the number of times tax-exempt bonds can be advance refunded or a major relaxation of the 10% private-use and payment tests that are used to determine when bonds are private-activity bonds, the official said.

At the same time, the Internal Revenue Service, in new rules that are being written, may "do some tinkering around the edges" of private-activity bond restrictions to make them less onerous, the federal official said.

The new rules, for example, will probably specify when the public portions of mixed publicly and privately used facilities can be financed with tax-exempt bonds, the federal official said. Until recently, there was a question about whether any portion of mixed-use facilities could be financed on a tax-exempt basis.

Most bond lawyers predict that the federal government will come under increasing pressure to allow more tax-exempt financing of publicly and privately owned facilities or activities, particularly in the areas of infrastructure and health care reform.

The Clinton Administration's health care proposals could force the Treasury and the IRS to focus on this issue and to re-examine other tax policies and regulations that currently affect tax-exempt bonds and exempt organizations, industry and federal officials said.

"I think public-private partnerships, management contracts, and profit sharing will have to be revisited," said David Walton, a lawyer with Jones Hall Hill & White in San Francisco.

The tax-exempt bond officials at the IRS recently issued guidance on the kinds of management contracts that governmental and tax-exempt organizations can enter into with private parties without jeopardizing the tax-exempt status of their bonds. But it is not clear how that guidance would mesh with the recently released health care reform proposals.

"The health care reform proposals are so all encompassing. They are going to have ramifications on the tax system, the insurance system, the financial system. They are very broad," the federal official said.

The IRS' exempt organizations branch, in addition to dealing with health care reform, can be expected to develop a strong tax-exempt bond enforcement program over the next few years, industry and federal officials said.

"I think you'll see a significantly more effective enforcement program that will move beyond the black box deals of the mid-1980s to focus on more currently perceived abuses and transactions that are selected randomly in an audit lottery," said another federal regulator.

A crackdown on tax law violations in the bond area will probably spur renewed calls from the bond community for Congress to give the IRS alternative penalties to revoking the tax-exempt status of bonds and taxing bondholders' interest earnings, industry and federal officials said.

IRS officials in the exempt organization division have said they might want Congress to consider penalties in the bond area that are more sensitive to the different degrees of abuse and more precisely aimed at the parties who commit the abuses.

The biggest area of growth during the next few years will be municipal derivatives, most industry and federal regulatory officials said.

One federal official predicted that either the IRS will publish rules or Congress will enact legislation to authorize firms to set up special tax securitization structures. In the structures, tax-exempt bonds would be sliced and diced into a variety of derivative products whose tax-exempt cash flows could be passed on to investors.

"Looking five to 10 years in the future, the one thing you can be certain of is that there will be forms of tax-exempt bonds that we wouldn't even recognize today," said William Loafman, with Whitman, Breed, Abbott & Morgan in New York.

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