CBO Releases Report on Tax Arbitrage by Colleges and Universities

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May 3, 2010

The Congressional Budget Office published a report examining higher education institutions' use of tax-exempt debt to finance capital expenses. The report, requested in 2007 by then-Senate Finance Chair Charles Grassley (R-IA), states that Joint Committee on Taxation estimates that allowing colleges and universities to do so will cost the federal government about $5.5 billion in 2010.

Generally speaking, arbitrage-the use of proceeds from lower-cost tax-exempt bonds to directly finance the purchase of higher-yield securities-is prohibited. However, current IRS and Treasury rules permit institutions to use tax-exempt debt to finance investments in operating assets (buildings and equipment) while simultaneously holding investment assets earning potentially higher rates of return (publicly held and private securities, real estate, etc.).

The CBO study, which examined data from information returns (Forms 8038 and 990) filed with the Internal Revenue Service for 2003, developed measures of tax arbitrage practiced by colleges and universities using a broader definition of the traditional term, and one that encompasses both direct as well as indirect arbitrage. Indirect arbitrage is defined as the benefit derived by institutions that can earn untaxed returns on investments that exceed the interest they pay on tax-exempt debt.

The report explores the possible revenue effects of a broader definition of arbitrage and discusses potential impact on college and university borrowers, but makes no definitive policy recommendations. Senator Grassley issued a statement indicating that the report raises "further questions to explore," but it is unclear whether any action will be taken by lawmakers at this time.