Monday, May 03, 2010

What's Chuck Grassley Up To Now? Identifying Illegal Tax Arbitrage

by Daniel L. Bennett

Iowa Senator Charles Grassley is perhaps the biggest critic of higher education in Congress, seeking out scandals and improprieties in the Ivory Tower in an effort to effect change. He has thus far failed to achieve any great and lasting reforms, but I give him an 'A' for effort and his willingness to travel the road often not taken - battling the establishment. So what's Chuck up to these days? His latest criticism of higher education is the use of tax-exempt bonds by universities for (indirect) tax arbitrage. In other words, Grassley believes that universities are taking advantage of their non-profit status to raise cheap, subsidized capital that they use to bankroll higher risk investments and capital expenditures. So what is the problem you might ask? Tax arbitrage is outright illegal.

Grassley asked the non-partisan Congressional Budget Office to assess the extent to which tax arbitrage is occurring among universities. The CBO report indicates that:
the law as currently implemented allows many colleges and universities to use tax-exempt debt to finance investments in operating assets (buildings and equipment) while, at the same time, they hold investment assets that earn a higher return. (Investment assets are publicly traded and privately held securities, as well as land or buildings held for investment purposes.) To the extent that colleges and universities can earn untaxed returns on investments that are higher than the interest they pay on tax-exempt debt, they are benefiting from a form of “indirect” tax arbitrage.

the cost of allowing institutions of higher learning to borrow using such debt—measured in terms of the revenues that could have been collected if those institutions had borrowed using taxable debt—will be about $5.5 billion in 2010

Using data from information returns filed with the Internal Revenue Service by institutions of higher learning and by issuers of tax-exempt debt, CBO developed measures of tax arbitrage under a broader definition of the term that encompasses both direct and indirect tax arbitrage. Under one such definition, nearly all of the tax-exempt bonds that 251 colleges and universities issued in 2003 would be classified as earning profits from tax arbitrage. If some investment assets were set aside in a reserve, which would be excluded from the arbitrage measure under an alternative expanded definition, the amount of debt earning returns from arbitrage would be lower; even so, about 75 percent of bonds issued in 2003 would still be classified as earning arbitrage profits under that expanded definition.

"On the one hand, if colleges and universities use tax-exempt financing for projects that they would complete even without the subsidy, resources are just reallocated from taxpayers to the schools with no additional social benefit," the report says. "On the other hand, if the subsidy finances capital projects that would not otherwise have been undertaken and that create a social benefit in addition to the institution, it could improve the nation's welfare."
Additional coverage is available here, here and here.

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