EFAB
Richard Torfcolson
Chair
Frieda K. Wallteon
Vice Chair
Herbert Barrack
Executive Director
Members
Honorable Pete Domenicl
Honorable Boryt Anthony, Jr.
Honormbto Anno Northup
Henerablo William Hudnut, III
Honorablft Holland Uwle
J. Jama* Barr
Philip Beaehom
Joseph Blair
Jack Bond
William Chow
Thomas Christensen
Roger Foldmsn
Dr. Richard Fonwiek, Jr.
Dr.WmiamFox
ShocJday Gardner, Jr.
Oi.vld Gilbert
Harvoy Goldman
John Gunyou
W.JaekHargett
William Jamoa
Steven Ueberman
Robert Mabon, Jr.
Martin Moeby. Jr.
John McCarthy
George Rattella
Heather Ruth
Roberta Savage
Warren Tyler
Douglas Wheeler
Elizabeth Ylell
EFAB Advisory
INCENTIVES FOR ENVIRONMENTAL INVESTMENT:
CHANGING BEHAVIOR AND BUILDING CAPITAL
The views and opinions expressed in this advisory do not
represent those of the U.S. Environmental Protection Agency,
nor are they intended to reflect consideration of other fiscal
issues which may be overriding in terms of the direction of
Administration domestic policy.
Augusts, 1991
Printed on Recycled Paper
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Mr. WffiamK. Betty
U.5. Environmental Protection Agency
Washington.!*: 20460
Dear Mr. ReQly:
. -
15
We STB very pleased to transmit to yon die fist Advisory Statement of die Envirc
Financial Advisory Board (the Board). Hoi Advisory presents a series of perspective* related
xoles in flffpffinpft'frfr'ff mo environinenxBl agenda of the 1990k These include?
KTTT>g EPA*5
and Tfg"1^*4^!!! by coonnehensiveiy accounring fir die budgetary and financial
impHcadons of TT****"1^ die nation's environmental goals*
Identifying ways to systematically orinauutaudly aojutt die fiaaacial bamen to
stale and local setf-finanring tinongh die iax-eaoanpt bond market;
Endomng and broadrrnng die transition to ^FI*""*' ^Tf^yfi and
as iroiu'lfff*1!'!!! to tndidonal compliance soategies? and
that public ntvntmeuu in *"Min'"tm«"i*i ^^'"finivturc can help
boost productivity **** yield new revenuei to offtrt ^pttial inv*"Ml<*iHf
While tfaiS ffp* AAmmnry maW* nn frwmfll T^»m«ni^it^»lif»ti« » rh«r«rBfpiy>^ tfam
Jld CTtftlT fff fW** ftr< matt pi^tiing"nnBnra«i aummnps. fatuiig ma aMum'iiiiiiKiit«l
in tne 1990s. Otber Advisories address ways to nap alleviate cunainums on private inv
in ffit>T>^t'"><*!iM!a^ ^V**^*1**^ improve die cfncicncy and effectiveness of public
*« financial and numMgerial Kmtnmnn« t«M» ytnidl ^
&ce in providing eavmrnmeaol services.
I would Ito to dunk Frieda Waflison, Vice Chair of die Board and Chair of the
leadeaMp, On behalf of the entire Board, I would like
to CApigts to yon our deep appzeclation for die opportunity to assist EPA in addressing
iitiim»miiMit«l fiiMgeiag taanei while looking farwairi in pmvifKag tfag gnppaft nM-ptmy to bring
to & successful resolution.
Respectmlly snbmmedt
Richaid Tozkelson
Chain Environmental Knanciai
Advisory Board
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TABLE OF CONTENTS
EXECUTIVE SUMMARY i
L INTRODUCTION 1
n. iNsrmmoNALiziNG ENVIRONMENTAL FINANCE 5
A. STATEMENTOFTHEISSUE 5
B. DISCUSSION 6
m. IMPEDIMENTS FACING TRADITIONAL FORMS OF
STATE AND LOCAL FINANCING 8
A. THE IMPACT OF THE 1986 TAX REFORM ACT ON FINANCING
STATE AND LOCAL ENVIRONMENTAL INVESTMENTS 8
B. RECENT DEVELOPMENTS IN TAX POLICY . 9
C. STATEMENT OF THE ISSUE 12
D. DISCUSSION 12
IV. USING ECONOMIC INCENTIVES TO PREVENT POLLUTION 22
A. STATEMENT OF THE ISSUE 22
B. DISCUSSION 23
NOTES 31
APPENDIX A 35
EFAB members, Workgroup Support Staff,
and Expert Consultants to the EFAB
ACKNOWLEDGEMENT 40
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EXECUTIVE SUMMARY
The Environmental Financial Advisory Board was established in August 1989 to advise
the Administrator on ways to encourage and facilitate investment in environmental facilities.
This, the first of the Board's Advisories, presents the analysis of the Board's Economic
Incentives Workgroup.
CHANGING THE DEBATE OVER FINANCING ENVIRONMENTAL INVESTMENTS
The Board's single most important observation is mat the nature of the debate over the
financing of environmental improvements needs to change. Environmental problems of the future
will be unlike those of the past, future investments in the environment are expected to be much
higher than past levels, and strategies to meet public demands for a cleaner environment must
respond. Just as the environmental protection paradigm is shifting from controlling discharges
to reducing the generation of pollutants, the financing paradigm must evolve from the notion of
spending to one of investment EPA has a unique, opportunity to demonstrate that environmental
investments are good not only for human health and the ecology, but for the health and
productivity of the nation's economy.
As a sensible first step, this Advisory examines new ways to structure incentives for
building environmental capital and discouraging polluting behavior. Rom a very new
perspective, it evaluates the merits of strategies that stress economic incentives and reliance on
markets to allocate public and private capital to their most productive environmental uses, with
public subsidies provided only to the extent that they leverage efficient and effective overall
investment in the environment
EXPECTED GROWTH IN STATE AND LOCAL ENVIRONMENTAL INVESTMENTS
In reviewing the literature on the rising cost of environmental protection, the Board was
struck by two forecasts:
By the year 2000, the U.S. is expected to invest roughly $260 billion or 2.8
percent of its Gross National Product (GNP) on the environment compared to two
decades ago, when the U.S. economy devoted $26 billion, or less man one percent
of its GNP, to environmental protection.1
* The state and local share of the public bill for environmental protection is
expected to grow to more-than-92 percent by the year 2000; just a decade ago
their share was 82 percent2
The gap between current investment for environmental purposes and the anticipated needs
of environmental programs a decade from now is large. If the gap between investment and needs
continues to increase, along with demands for an ever cleaner environment the demand for state
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and local finance also will grow. Some of these demands may be difficult to satisfy without a
critical evaluation of current environmental finance policy.
NEW STRATEGIES TO CHANGE BEHAVIOR AND BUILD CAPITAL
This Advisory examines three basic strategies that could change the nature of the debate
over environmental finance and establish a legacy of EPA leadership in the field of
environmental investment:
Strengthen and institutionalize an environmental finance capability within EPA,
which, in turn, would serve as a guide for the international community;
Enable state and local governments to self-finance all environmental infrastructure;
and
* Reduce the costs of environmental protection through the creation of new
economic and market-based incentives.
Institutionalize an Environmental Finance Capability Within EPA
Recognizing the high and rising costs of environmental protection, EPA must strengthen
its capacity to work with Congress, other federal agencies, state and local governments, and its
counterparts in other nations on issues of public finance. .
EPA has a critical role in helping to ensure widespread recognition of the importance of
finance as a prerequisite to achieving environmental goals. A symbolic first step would be to
add environmental finance to EPA's short list of priority concerns for die 1990s. This action
would put environmental finance on a par with pollution prevention, strengthened enforcement,
international environmental leadership, enhancement of natural resources, and risk-based priority
setting. With greater understanding of environmental finance, EPA leaders could present an
environmental perspective on issues of federal fiscal policies in cabinet-level deliberations, public
forums. Congressional testimony, and joint ventures with other federal agencies and the
international community.
Enable State and Local Governments to Self-Finance All Environmental Infrastructure
Since greater investment in environmental facilities is inevitable, this strategy is intended
to combine the power of federal tax policy to leverage responsible state and local investment with
the discipline of the public tax-exempt bond market
Tax-exempt bonds, backed by user fees or taxes, remain the basic instrument used by state
and local governments to self-finance environmental facilities. Unfortunately, Congress may not
have anticipated that certain provisions of the 1986 Tax Reform Act - the goals of which were
to promote greater tax equity and end abuses within the tax system - would have negative effects
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on financing public-purpose facilities. For example, under die provisions of die 1986 Act, certain
improvements in public-purpose facilities will have to be financed through taxable bonds. Over
the 20-year life of a $10 million issue, a taxable bond yielding 2 percentage points more than a
comparable tax-exempt issue will cost the issuer an extra $2.5 million. Had the issue been
tax-exempt, these funds could have been used to reduce the cost of facility improvements or to
leverage additional investments in the environment
In the absence of direct assistance, providing tax exemption on debt issued by state and
local governments may be the most effective and efficient way to sustain a small federal
investment in the environment At the same time, the Administrator should be aware of certain
potential liabilities associated with advocating a broadening of the tax-exemption. Prom the
perspective of the U.S. Department of the Treasury, such a broadening could have the effect of
reducing tax revenues to the U.S. Treasury, at least in the short-run, and would require off-setting
revenue gains under the Budget Enforcement Act of 1990.
Reduce the Costs of Environmental Programs by Creating Economic Incentives
The third strategy is simply to reduce the cost of environmental protection - not by
lessening our resolve or moving away from the nation's environmental goals, but achieving mem
more efficiently by, for example, creating incentives that encourage pollution prevention and
reduced consumption.
In the 1990 amendments to the Clean Air Act and in recent publications and seminars,
Congress and the EPA have already begun to shift the nation's thinking in this direction. The
Board supports the use of economic incentives such as creating markets for tradeable discharge
permits, which reduce the cost of meeting environmental quality standards, and effluent fees,
which discourage the generation and discharge of pollutants.
ECONOMIC BENEFITS OF INVESTMENT IN ENVIRONMENTAL FACILITIES
Traditionally, the benefits of investment in environmental facilities have been
characterized as meeting environmental goals at least cost to the regulated community. Yet such
a characterization misses the effects of investment on the economy as a whole.
At the Board's request, new research was undertaken by Dr. David Aschauer, which
demonstrates mat public investment in environmental infrastructure also increases the productivity
of the private economy. By providing environmental services water supply, wastewater
treatment, or solid waste management - on a much greater scale than that feasible for a single
private entity, public faculties lower private production costs. In addition, expanding public
environmental faculties enables private factories to operate at greater capacity, putting plant and
equipment to use that might lie idle if access to public environmental management capacity were
unavailable.
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Assuming that tax-exempt bonds financed an expanded level of environmental
infrastructure, the Board's analysis suggests that, within as few as five years, new corporate tax
revenues associated with increased productivity within the private sector would more than offset
revenue losses associated with net new investment using tax-exempt bonds.
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L INTRODUCTION
The reality of environmental protection is that it is not free. In fact, the cost of building
and improving facilities to remove contaminants from drinking water, purify wastewaters prior
to their release to natural waterways, and dispose of household and business refuse increases each
the public demands a cleaner environment.
The Environmental Financial Advisory Board (the Board) is charged with advising the
EPA Administrator on the f*n?*wial implications of attaining the nation's environmental goals as
articulated in the major federal environmental statutes. In so doing, the Board has considered
the potential to reduce the costs of environmental protection and to increase efficient investment
of resources to meet environmental mandates. It has found mat significant opportunities exist
for all levels of government and the private sector to improve the efficiency of environmental
finance and to boost levels of investment needed to ensure that environmental goals are met.
PURPOSE OF THIS AND SUBSEQUENT ADVISORIES
The purpose of this, the Board's first Advisory, is to evaluate the merits of economic and
market-based incentives to finance environmental improvements. Each strategy considered in this
Advisory is based on the recognition of a diminishing federal role in the direct funding of
environmental facilities and an increasing reliance on market mechanisms to achieve
environmental goals. Whether and to what extent these strategies are appropriate from EPA's
perspective remains strictly a matter of Administration policy.
Currently, three other Workgroups are preparing Advisory Statements. The Board's
Private Sector Incentives Workgroup is addressing constraints on private participation in
environmental services. It is examining full-cost pricing as the first step toward putting public
and private provision of environmental services on an equal footing and investigating flexible
federal policies that would allow leveraging of federally funded capital assets. It also is
examining ways to reduce misperceptions on the part of die public and private sectors about the
risks associated with the provision of environmental services, as well as state procurement
policies that would promote public-private partnerships.
The Public Finance Workgroup is examining large-scale federal and state approaches to
financing environmental public works. Among its anticipated suggestions are a change in the
EPA's State Revolving Fund program under Tide VI of the dean Water Act, endorsement of an
expansion of that program to wider water quality uses, and the pursuit of program funding at
authorized levels. In addition, it is considering the merits of a federal environmental trust fund,
state bond banks, and environmental facilities corporations. The workgroup also is reviewing the
usefulness of capital needs analyses, finance guidebooks, and other informational products.
The Small Communities Workgroup is focusing on solutions to the finance and
management challenges facing small or economically disadvantaged communities. It is interested
in three issues: improved coordination among small community financial assistance programs,
expanded use of bond banks, and improvements in the Title VI SRFs to assist small communities.
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SOCIAL AND ECONOMIC EFFECTS OF ENVIRONMENTAL INVESTMENTS
The benefits of environmental infrastructure are generally characterized in terms of
improvements in human health (reduced incidence of disease or death), ecology (restoration of
natural or living resources), or public safety (maintenance of environmental services). At times,
economists have estimated the dollar value of these benefits. According to one recent study, for
example, the nation's clean water programs generated an estimated $14 billion in benefits in
1984. Clean air programs generated another $37 billion in benefits mat year.3 Yet, not all the
social benefits of investments in environmental infrastructure are included in such monetary
valuations.
It is more difficult to assign a monetary value to other benefits that may arise from
environmental investments, such as the provision of outdoor recreation areas or the protection
of biodiversity. Many students of environmental economics point out that it is even more
difficult to measure the satisfaction people derive from the assurance that a pristine natural region
is being protected, regardless of whether this area is accessible to them.
EFFECTS OF ENVIRONMENTAL INVESTMENTS ON PRODUCTIVITY
Investments in environmental infrastructure strengthen the private economy. For example,
sound environmental infrastructure enhances the health of the population, thereby boosting
economic productivity by reducing employee absenteeism due to illness.
Public investment in environmental infrastructure also directly increases the productivity
of the private economy. Public economies of scale help explain this linkage. For example, the
cost of water per. gallon is lower and productivity greater for a beverage producer using publicly
supplied water from a large, central facility than for a comparable producer self-supplying water
at a smaller scale. Public investments, such as in the enlargement of wastewater treatment plants,
also allow private factories to operate at greater capacity, putting plant and equipment to use that
might lie idle if the capacity of environmental services was insufficient A recent study found
that a one-time federal investment in water supply and wastewater treatment facilities of $2.5
billion (equivalent to 1 percent of the value of all wastewater facilities in 1989) would result in
sizeable productivity gains in the private sector. If these gains were taken as higher profitability,
they would result in net new tax revenues to the U.S. Treasury that would exceed the original
investment within an eight-year period4 - that is, because public investment improved private
sector productivity, the original public outlay could be paid back within eight years.
FUNDING GAP FOR ENVIRONMENTAL FACILITIES
There is a large and growing gap between the investments required to meet the objectives
of major federal environmental mandates for clean air and water and the resources currently
devoted to such efforts. In 1987, the states and local governments invested about $10 billion to
build facilities for environmental protection.9 By the year 2000, if recent trends continue, about
$17 billion a year will be needed just to m?famin 1987 levels of environmental quality. This
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amounts to a gap of $7 billion per year between current investment and future investment needs
to comply with federal environmental
Two factors are driving environmental protection costs up. First, the cost of providing
a base level of environmental protection within growth areas increases as population increases.
Second, real dollar outlays for environmental protection have outpaced inflation. For example,
the average annual cost per person of operating the nation's wastewater treatment plants has more
than doubled in real dollar terms from $15.80 in 1960 to $37.20 in 1984.6 These costs reflect
the growth of environmental services in response to demands by the American public for cleaner
lakes and rivers, safer drinking water, and more responsible handling of municipal garbage.
The $7 billion a year gap between current investment and the future requisite resources
to maintain today's level of environmental quality, is just the beginning. By the year 2000, state
and local governments will have to invest another $2 billion a year to build new facilities in
compliance with 22 new federal environmental regulations that have been promulgated or are
being developed. This amounts to a total gap of over $9 billion a year between what state and
local governments invested in 1987 and what they are expected to invest in the year 2000 for
environmental capital facilities in compliance with federal mandates.
Greater efficiency in meeting environmental goals could narrow the gap somewhat
However, the above cost estimates are conservative, and the gap could be substantially larger
than portrayed here. Estimates do not include the costs of many new regulations under
development, the costs associated with new Congressional mandates (such as the 1990 dean Air
Act Amendments), or the growing number of new state and local environmental mandates.
Less is certain about the amount of state outlays that may be needed for environmental
programs (as opposed to environmental facilities) in the future. However, a recent EPA study
suggests that the costs to states of administrating water programs in 1987 will more than double
by the year 2000.7 State administrative costs could triple by the year 2000, if the air and solid
waste nmgnmis impose similar demands.
The key issue in examining the impact of environmental investment on capital markets
is the ability of state and local governments to support higher levels of capital formation. If the
gap between current capital formation and future capital requirements for environmental facilities
were to be financed entirely with new bonds, for example, municipalities and states would have
to issue about twice as much environmental debt as they currently do.
CLOSING THE GAP
This Advisory considers three basic strategies to help close the gap between current
environmental investment and future environmental investment needs:
Making environmental finance a cross-program Agency priority;
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Reducing the cost of achieving environmental goals by creating economic and
market incentives to reduce pollution and discourage overconsumption of
environmental amenities; and
"Financing remaining environmental capital needs by making more efficient use of
tax-exempt bonds.
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EL INSTITUTIONALIZING ENVIRONMENTAL FINANCE
The Board has concluded that environmental policymakers often underestimate the critical
role that finance inevitably plays in the achievement of environmental goals. Similarly, those
concerned with fiscal and tax policies may not fully understand the effects their proposals can
have on seemingly unrelated areas such as environmental policy. Without an adequate dialogue
linking these disciplines, the achievement of environmental mandates will be constrained and may
ultimately be undermined.
This section identifies ways for EPA to play a significant role in ensuring mat issues of
environmental finance command priority attention within the agency's planning, budgeting, and
rule making processes - in short, integrating an environmental finance ethic in EPA's day-to-day
activities.
A. STATEMENT OF THE ISSUE
Within broad statutory authorities, the EPA Administrator has the ability to direct Agency
priorities. Since taking office, the Administrator has articulated a series of themes intended to
guide the Agency's administration of environmental programs:
pollution prevention,
strengthened enforcement of environmental regulations,
ma
a greater leadership role for die EPA in international environmental issues,
enhancement of natural resources,
management of EPA's programs for environmental results,
risk-based priority setting, and
a strengthened role for science in environmental decision making.
The implementation of these priorities and the realization of benefits from these initiatives
will require major investments by all levels of government. The question that must be addressed
is how will these governments raise the funds needed to accomplish environmental goals? The
Board believes EPA has a leadership role in working with other federal agencies, the Congress,
states, localities, and the private sector to develop the capacity to finance environmental services.
One prerequisite is strengthening EPA's own capacity to provide a financial perspective on
environmental goals.
The Board has found that financing of environmental services represents a major segment
of unfinished business in environmental protection. Without a fundamental recognition of the
importance of financing issues, EPA and the federal government will have significantly less
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potential to achieve their goals. Similarly, states and localities will find it increasingly difficult
and costly to build the environmental facilities needed to comply fully with national
environmental objectives.
B. DISCUSSION
There would appear to be great latitude within the Agency to improve awareness of the
importance of environmental finance and to increase agency interaction with decision makers and
legislators on issues of financial capacity. The Administrator may wish to consider the following
steps to take advantage of mis latitude:
Adding environmental finance to EPA's list of priorities;
Strengthening and expanding EPA's role of financial analysis in rulemaking; and
Strengthening the Agency's capacity to provide advice on environmental finance
to administrators and legislators.
Add Environmental Finance to EPA's List of Priorities for This Decade
By adopting environmental finance as a priority concern, the Administrator would send
a message to all senior managers about the importance of integrating finance into their day-to-day
programs.
Benefits. Adding environmental financing to the Administrator's list of priorities would
affirm EPA's commitment to protection of public health, assurance of public safety, and
preservation of die nation's natural environment This action would build EPA's capabilities to
contribute to administrative and legislative debates on financing environmental public works. A
strengthened EPA stance on the importance of finance also would support the Agency's recent
international activities as well as its relationship with state and local governments.
Concerns. Despite its relevance and in some cases urgency, the addition of another
priority in times of budget austerity could put pressure on other Agency activities. Elevating
environmental finance above other matters could displace funds that had.been earmarked for
other agency programs and cause some discontinuity in those programs.
Strengthen the Role of Financial Analysis in EPA's Regulatory Process
Strengthening requirements for financial analysis as part of EPA's rulernaking process
would help assure that financing issues received more attention within the Agency than they now
do. Agency rules that define what is and is not acceptable as a Regulatory Impact Analysis
(RIA), pursuant to Executive Order 12291, could be modified to require (1) analysis of the
affoidability of major new rules and (2) development of fiscal plans or financial strategies to
assure that compliance is not impeded by questions of ability to pay. Similarly, rules on the
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scope of Regulatory Flexibility Analyses (RFAs), which focus on the degree to which small
public and private entities are affected by major regulations, could be modified to examine issues
of public affordability as well as ways to mitigate unmanageable financial burdens.
In the past, RIAs and RFAs have not commanded as much attention as they probably
should have. EPA could review these documents carefully to assure that they adequately
addressed affordability issues from the perspective of states and localities and that the offices
promulgating rules were receptive to rule changes when RIAs and RFAs indicated potential
financial hardship.
Benefits. The most obvious benefit of taking these steps would be the immediate
institutionalization of environmental finance in rulemaking processes. Another benefit may be
some standardization of the methods for assessing affordability. Such standardization would
occur to the extent that one group within the Agency would take the lead in comparing
approaches to analyzing affordability and recommending Agency-wide procedures for amending
rules as appropriate.
Concerns. Methods for assessing affordability may not be sufficiently sophisticated to
indicate how implementation of a national rule will affect individual state and local governments.
This lack of sophistication could complicate or protract the rulemaking process, the length of
which is already a subject of some concern.
Strengthen Agency Capacity to Provide Administrators and Legislators with Advice on
Environmental Finance
Where needed, EPA could strengthen the capacity of its key offices to evaluate the effects
of federal legislation on the ability of state and local governments to finance environmental
public works. Some Agency headquarters and regional offices already have such a capacity;
attention to issues of finance is less well developed in other agency offices.
Benefits. Enhanced capacity to respond to legislative inquiries concerning environmental
financing would strengthen EPA's role in environmental finance and significantly improve the
chances that others would recognize die importance of financial capability to achieving
environmental goals. By working with the relevant legislators as issues are debated and policies
are formulated, the Agency would have the opportunity to build in safeguards for adequate
financing, rather than to react to a lack of financial resources once proposals are passed into law.
Concerns. Congress must seek EPA insights for this activity to be effective. In its
hearings, Congress customarily requests EPA testimony on a wide variety of issues. Nonetheless,
Congress does not typically view EPA as a source of information on issues of finance.
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DX IMPEDIMENTS FACING TRADITIONAL FORMS OF
STATE AND LOCAL FINANCING
Environmental facilities provide essential services such as purifying drinking water;
cleaning rivers, lakes, and streams; and safely disposing of refuse. The U.S. Congress and most
state legislatures have chosen to regulate the delivery of these pubb'c services to ensure that the
tens of thousands of government agencies and private firms delivering mem will observe
standards of public health, safety, and environmental protection. Historically, the
federal government has augmented its regulatory role by offering direct financial assistance (in
the form of grants and loans) and indirect financial aid On the form of tax benefits) to states,
local governments, and private firms mat deliver environmental services in compliance with
national standards. Joint implementation of and shared financial responsibility for national
mandates has formed the foundation for an intergovernmental partnership in environmental
improvement
The Board has observed, however, that changes in fiscal and tax policies in the 1980s
have reduced both direct and indirect federal support to state and local governments. A reduction
in either kind of support has the potential to impede the efficient pursuit of national
environmental goals. Together, reduced direct federal spending and limitations on tax-exemption
of state and local environmental bonds will almost certainly mean that states and municipalities
will face serious challenges in financing environmental mandates.
Changes to fiscal policies and their effects on federal environmental grants and loans have
been well documented in recent EPA and other reports.8 Much less attention has been focused
on the effects of new tax policies on environmental finance. In this first Advisory, the Board has
taken the initial steps toward providing such analysis.
A. THE IMPACT OF THE 1986 TAX REFORM ACT ON FINANCING STATE AND
LOCAL ENVIRONMENTAL INVESTMENTS
While the goals of the 1986 Tax Reform Act promoting greater tax equity and ending
abuses within the tax system - are meritorious, Congress may not have anticipated some of the
negative effects of certain provisions of the Act In its study of the Act, the Board has concluded
mat some of the Act* s provisions hinder the achievement of environmental goals.9 On one hand,
environmental policies call for strengthened enforcement of existing mandates plus the addition
of many new environmental protection and enhancement programs. On the other hand, current
tax policy makes it difficult for state and local governments to comply with environmental
mandates at low cost
Tax-exempt bonds have been an important vehicle for financing investments in
environmental infrastructure. The 1986 Tax Reform Act appeared to have little measurable effect
on the volume of tax-exempt and taxable bonds issued to finance water, sewer, and solid waste
facilities over the 1977-1989 period.10 However, the Act had the unintended effect of increasing
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costs for public-purpose environmental facilities.11 Four major factors contributed to this
increase:
Higher tax-exempt interest rates. The Act required states and localities to offer
higher tax-exempt rates on some types of bonds. According to some estimates,
the rates reflect increases of IS to 30 basis points. (100 basis points equal one
percentage point) These higher rates must be offered to investors to compensate
for the imposition of the alternative mjninumi tax.
Reduced attractiveness of tax-exempt bonds for certain institutional investors.
Provisions of the'Act narrowed the market for tax-exempt bonds by eliminating
certain types of large-volume institutional buyers. Between the first quarter of
1983 and the first quarter of 1989, for example, bank ownership of tax-exempt
securities declined by more than 35 percent, from $231 billion to $150 billion.
This development, in turn, has generally tended to destabilize the market and
increase bond interest rates.
Delays in issuing tax-exempt bonds. Some provisions of the Act have delayed
financing of many environmental projects. According to a recent analysis,
requests for some $2.4 billion in solid waste, water, and sewer bonds were denied
or delayed in 1989 because of the Act's limitations on the volume of
private-activity, tax-exempt bonds that states can issue each year.13
* Restrictions on tax-exemption of bonds. Because the Act restricted the amount
of private-activity, tax-exempt bonds that can be issued each year, many states and
localities have had to issue public-purpose bonds as taxable bonds. The interest
rates for taxable bonds are 2 to 3 percentage points higher man the rates for
tax-exempt bonds. Between 1986 and 1989, the average spread between Aa-rated
tax-exempt municipal bonds and taxable bonds of comparable quality was 224
percentage points.
Fortunately, the goals of the 1986 Tax Reform Act need not be pursued at the expense
of failure to implement environmental policies. The Board has found that the goals of the Act
can be preserved while making low-cost, tax-exempt financing available for investments in
public-purpose environmental facilities. By identifying those circumstances in which the 1986
Tax Reform Act discourages the availability of such financing and evaluating strategies to
overcome the negative effects of the Act on financing environmental infrastructure, this Advisory
hopes to promote improvements in environmental quality without engendering tax abuse.
B. RECENT DEVELOPMENTS IN TAX POLICY
Since passage of the 1986 Tax Reform Act, a number of studies, commissions, and
proposed statutes have attempted to draw attention to the Act's effects on environmental finance.
Among the most prominent are the following:
The Anthony Commission Report on Public Finance;
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The Environmental Infrastructure Act of 1991 (S. 90);
Representative Anthony's 1991 tax simplification proposals (H.R. 710); and
The Environmental Infrastructure Financing Act of 1991 (HJL 2172).
Many of the proposals for alleviating the negative effects of the Act on environmental finance
that were advanced in these reports, acts, and proposals were recommended to the House Ways
and Means Committee during the 101st Congress as ways to simplify the Internal Revenue
Code.13 These proposals are summarized below.
The Report of the Anthony Commission
The Anthony Commission Report on Public Finance, released October 1989, reviewed the
history of tax-exempt financing and examined the effects of current federal law on the ability of
state and local governments to access the tax-exempt bond market14 The commission found
that while federal support for infrastructure projects was declining, the 1986 Tax Reform Act
both reduced access to the tax-exempt bond market and made bonds more costly to state and
local governments. To increase the availability of tax-exempt financing for necessary capital
improvements, the commission's report made the following principal recommendations:
* Treat bonds as tax-exempt public-purpose bonds if the facility financed is publicly
owned and operated or if the primary benefits from a privately owned and
operated facility accrue to the community as a whole, rather than to private
parties.
Create three categories of public-purpose bonds: governmental bonds,
public-activity bonds, and exempt-purpose 501(c)(3) bonds.
* Eliminate the taxation of interest on tax-exempt, private-activity bonds that is
required by the alternative minimum income tax provision and increase the current
$10 million small-issuer exemption to $25 million to facilitate placement of
tax-exempt debt with banks.
Create substantial exemptions from arbitrage rebate requirements that encourage
prompt expenditure of bond proceeds for public purposes, to lower the cost and
burden of current arbitrage rebate restrictions. Eliminate the requirement of a
rebate if the issuer spends at least 25 percent of bond proceeds within one year,
at least 50 percent within two years, and at least 95 percent within three years.
The Environmental Infrastructure Act of 1991 (S. 90)
The Environmental Infrastructure Act of 1991 (S. 90) was introduced in the 102nd
Congress by Senators Domenici, Boren, and Symms to make it easier for state and local
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governments to issue tax-exempt bonds for pollution-control facilities. The bill's major
provisions can be summarized as follows:
* Amend the Internal Revenue Code of 1986 to create a new category of tax-exempt
bonds to be known as "infrastructure bonds." Such infrastructure bonds are
defined as any state or local bond from which 95 percent of the proceeds are used
to provide sewage facilities, solid waste and certain hazardous waste disposal
facilities, water supply facilities, and other pollution-control facilities needed for
state and local compliance with federal environmental statutes and regulations.
Amend the tax code definition of "private-activity bond" to exclude the new
"infrastructure bond." This change would reclassify such private-activity bonds
as "governmental bonds." Governmental bonds are not subject to the constraints
(Le., volume caps, the alternative minimum tax, and the prohibition against
advance refundings) imposed on tax-exempt bonds by the 1986 Tax Reform Act.
Modify the arbitrage rebate requirements to permit state and local governments to
retain earnings from the temporary reinvestment of bond proceeds. Such a
modification would allow state and local governments greater flexibility in
managing bond proceeds and would lower the costs of bond issues.
Assign a 7-year depreciation period to pollution-control infrastructure facilities if
these facilities are financed with tax-exempt bonds or a 10-year depreciation
period if they are leased to a tax-exempt entity.
1990 Tax Simplification Proposals
Representative Anthony's proposals to simplify requirements for tax-exempt bonds were
introduced in HJL 5423 during the 101st Congress. Many of the same proposals were
reimroduced in RR. 710 in the 102nd Congress. Specific provisions of the Anthony bill would:
* Raise the small-issuer exemption on arbitrage rebate restrictions from $5 million
to $25 million and eliminate the requirement that government units must have
general taxing powers to qualify for the rebate exemption.
Make the 1989 rebate relief provision retroactive to bonds issued after August 31,
1986, with no refunds for rebates already paid.
Raise the small-issuer bank interest deduction exemption from $10 million to $25
million.
Repeal the 5 percent unrelated and disproportionate use rule.
Eliminate yield restriction requirements if a rebate is paid.
Require that only 95 percent of arbitrage be rebated.
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The Environmental Infrastructure Financing Act of 1991 (HJL 2172)
»
The Environmental Infrastructure Financing Act of 1991 (HJL 2172), proposed by
Representative Guarim* adopts many of the same approaches as the other proposals aimed at
eliminating die negative effects of the 1986 Tax Reform Act on environmental finance.
Specifically, this legislation would extend tax-exemption to bonds used to finance solid waste
recycling facilities; exempt bonds used to finance environmental facilities from volume caps and
the alternative mummim tax; allow tax-exempt advance refunding of. public-purpose
environmental bonds; and ease restriction on costs of issuance and arbitrage rebate for
public-purpose environmental bonds.
The following sections explain the significance of current tax policy within the context
of financing environmental facilities.
C. STATEMENT OF THE ISSUE
The 1986 Tax Reform Act created two major categories of bonds mat are eligible for
tax-exempt status: governmental and private activity." A bond is classified as a private-activity
bond if 10 percent or more of the proceeds from it will accrue to a trade or business and more
than 10 percent of the security pledged to repay the bond will come from private sources. Many
bonds for drinking water, wastewater, solid waste disposal, and hazardous waste treatment and
disposal facilities are classified as private-activity bonds. While private-activity bonds can be
taxable (see below), those that are tax-exempt require a higher yield than comparable tax-exempt
governmental issues.16
The cost of raising capital under tax-exempt, private-activity bonds is higher dun that
under a governmental bond for two reasons. First, higher yields must be offered to compensate
for the additional restrictions placed on private-activity issues. Second, limitations on the use of
bond proceeds to pay the costs of issuing private-activity bonds restrict the availability of
tax-exempt financing or require contributions from other, higher-cost supplemental funds, if
available.
Interest on private-activity bonds is taxable if more than 5 percent of bond proceeds
finance an activity that is unrelated to the government use being financed with the bonds.
Because of this rule, many issues intended to finance governmental purposes could fail to qualify
for tax exemption altogether. The cost of raising capital under a taxable bond is significantly
higher than under either a tax-exempt, private-activity bond or a governmental bond.
D. DISCUSSION
There are both benefits and concerns associated with implementing several of die most
recent proposals on the tax treatment of state and local bonds for environmental purposes (as
presented above). The Board has considered these proposals and offers its own perspective,
which follows.
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The fust, and most comprehensive of the Board's proposals is the reclassification of
environmental bonds as governmental bonds, if the proceeds of the bonds axe used exclusively
to finance the provision of public-purpose environmental services.
The Board has also considered the following four proposals (they would not be necessary
if die first Board proposal were adopted):
* Exclude bonds used to finance public-purpose environmental facilities from state
volume caps;
Eliminate the currently imposed restrictions on costs of issuing tax-exempt,
private-activity bonds used to finance environmental facilities;
Exempt interest earned on bonds issued to finance public-purpose environmental
facilities as a tax preference item for the purpose of calculating the alternative
minimum tax on personal and corporate tax returns; and
* Allow advance refundings of tax-exempt, private-activity bonds used to finance
environmental facilities.
One other Board proposal is to enable issuers of tax-exempt bonds to earn interest on
bond proceeds without penalty over a reasonable period of time for construction of environmental
facilities, provided that excess interest earnings (earnings above the bond yield) are used
exclusively to reduce the size of the bond issue.
Using tax incentives of almost any kind requires a tradeoff between the desirability of
intended policy goals and the potential loss of tax revenues. Some argue that, almost by
definition, tax incentives can be a relatively blunt instrument to effect policy changes.17 Others
maintain that federal exposure to potential costs is unbounded when tax incentives are made
available with few restrictions on use and amounts.18 Yet the Board has concluded that tax
incentives can be structured to avoid unexpected costs and targeted to achieve desired results.
Moreover, compared to traditional forms of direct assistance, tax incentives allow recipients great
latitude in malting investment decisions, with relatively low federal administrative costs. The
following sections offer the Board's observations on how effective each proposal might be in
meeting environmental goals, what other benefits each proposal may offer, and what types of
fiscal and institutional concerns are associated with each proposal.
The Reclassification of Environmental Bonds as Governmental Bonds
Public-purpose bonds for environmental projects could be reclassified as tax-exempt
governmental bonds, subject to certain restrictions. To protect the federal interest and ensure that
the goals of the 1986 Tax Reform Act are preserved, reclassification could be limited strictly to
state and local bonds that finance environmental investments undertaken to comply with federal
statutes. Congress could help ensure that tax incentives are used to promote only the
highest-priority federal interests by periodically redefining what bonds would and would not
qualify for tax exemption.
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Further restricting reclassificarion to bonds that finance facilities providing environmental
services to die general public would help direct tax incentives to government units. For example,
a bond issued to finance air pollution controls at a manufacturing facility would not qualify for
reclassification as a governmental bond, even though the pollution controls might be needed to
comply with the federal dean Air Act, because such a facility does not provide an environmental
service to the general public.
One issue associated with reclassification is whether private owner-operators of
environmental facilities financed with governmental bonds should continue to deduct depreciation
as a business cost The Board has concluded that private owner-operators of environmental
facilities that provide generally available services to the public should retain the ability to
depreciate their capital plant to the extent allowed under current tax law. However, private
entities should pay taxes on the profits they earn from goods or services made possible by then1
investments in capital plant or equipment From the perspective of tax policy, allowances for
depreciation of that capital plant should be made in the recognition that capital facilities
deteriorate over time, resulting in lowered ability to generate profits. Depreciation is a traditional
way to encourage and maintain the productivity of privately owned and operated capital facilities.
Depreciation should be made available only to private owners and operators of
environmental facilities. In the Board's opinion, bonds to finance environmental facilities that
are owned, but not operated, by private entities should retain their private activity status and
hence should not necessarily be tax-exempt This provision would discourage private owners
who fail to take an active role in providing environmental services from participating in
transactions that are driven principally by tax benefits.
Benefits. Reclassifying public-purpose bonds for environmental projects as tax-exempt
governmental bonds could significantly reduce the cost of financing environmental facilities.
Specifically, it would alleviate the following serious restrictions now associated with private-
activity issues: (1) statewide ceilings on the volume of tax-exempt, private-activity debt mat may
be issued each year, (2) limitations on the costs of issuance that may be financed with bond
proceeds; (3) inclusion of interest earned on private-activity bonds as a preference item in
calculating individual and corporate alternative mininniyn tax; and (4) prohibitions against any
advance refundings.
Concerns. According to the U.S. Treasury's model, classification of all bonds for
environmental facilities as public-purpose governmental bonds could result in a loss of federal
revenues totalling between $400 million and $1.4 billion between 1990 and 1995.19 Under this
model, the most likely loss is $941 million. This estimate is based on the assumption that any
additional environmental debt that is issued displaces.an equal volume of taxable debt, thus
reducing federal revenues from taxes on interest earnings. The $400 million to $1.4 billion range
results from using die U.S. Treasury's model to evaluate the revenue effects of changing the
volume of tax-exempt debt under different assumptions concerning the marginal tax rate of
purchasers and beneficiaries of bonds, whether state and local governments would lower taxes
as a result of decreased costs of capital, the marginal tax rate of bond beneficiaries (those who
pay state and local taxes), and interest rate differentials between taxable and tax-exempt bonds.30
The Treasury's model is similar in design to the Joint Tax Committee's model of revenue losses
associated with changes to the U.S. Tax Code.
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Revenue losses may not be the only effect of issuing more tax-exempt debt Another
effect could be revenue gains attributable to (1) the issuance of more tax-exempt debt as a result
of reclassifying public-purpose bonds for environmental projects as tax-exempt governmental
bonds, (2) productivity increases in the private sector when the increased level of bond issuance
results in increased investment in environmental infrastructure, and (3) increased profits in the
private sector and hence increased tax revenues as a result of increased productivity.
A benchmark estimate of the potential revenue gains from environmental investments may
be obtained in the following manner. Hie projected net increase in environmental bonds issued
as a result of reclassificarion - from $3.305 billion in 1991 to $6.193 billion in 1995 - is taken
to induce an equal increase in the stock of environmental capital facilities. This increase in stock
is assumed to generate a rate of return - measured in the form of higher economy-wide output
of 15 percent The increase in output implies a proportional increase in profitability, and, to
the extent that profits remain on corporate bottom lines, greater productivity implies an expansion
in tax revenue.
Assuming a relatively conservative 15 percent average rate of taxation applied to
corporate income, as well as the realization of productivity gains in the year of new investment,
projected new tax revenues over the period 1991 to 1995 of over $1.3 billion would eclipse the
projected revenue loss of $941 million over the period 1990 to 1995 for a net revenue gain of
$369 million. Under different assumptions namely, that a construction lag delays the
realization of productivity gains and that public investment crowds out private investment in the
near term tax revenue gains to offset revenue losses would not be realized within a five-year
period. However, these gains could more than offset revenue losses within a decade.
The Board recognizes that by lowering the cost of building facilities intended to manage
solid and hazardous waste, reclassification of public-purpose bonds for environmental projects
as tax-exempt governmental bonds may provide an incentive to increase polluting behavior. For
the same reason, reclassification also may create a bias in favor of capital-intensive waste
treatment or disposal technologies. The Board also recognizes that reclassification would not
alleviate arbitrage rebate restrictions.
The Exclusion of Bonds that Finance Public-Purpose Environmental Facilities from State
Volume Caps
Volume caps are dollar limits on the amount of tax-exempt, private-activity debt that can
be issued in each state each year. Under current policy, once a state reaches its cap, the cost
of private-activity bonds for environmental purposes increases. Additional bonds must be issued
as taxable debt, or they are not issued at all
Reclassifying environmental bonds as governmental bonds would exclude these bond
issues from the pool of bonds under state volume caps. In the absence of reclassification, under
the conditions described above, bonds used to finance public-purpose environmental facilities
could be excluded from state volume caps. This more limited change in tax policy would avoid
unintended limits on the ability of state and local governments to comply with federal
environmental mandates at low cost.
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Until 1986, volume caps generally did not constrain tax-exempt financing. Prior to 1986,
the cap on industrial development bonds was $150 per capita or $200 million per state per year
(whichever was greater). As a result of the 1986 Tax Reform Act, the cap on all private-activity
bonds is now $50 per capita or $150 million per state per year (whichever is greater). Moreover,
the non-governmental portion of a governmental bond in excess of $15 million along with
mortgage revenue bonds (which previously had a separate cap) and other bonds (which previously
had no cap) is now included in the calculation for the volume cap.
Benefits. Excluding bonds used to finance public-purpose environmental facilities from
state volume caps would allow significantly more tax-exempt financing of environmental facilities
than is currently allowable. Volume caps already have severely limited access to tax-exempt
capital markets in several states. According to state "fffcMf in California, for example, demand
for tax-exempt, private-activity debt exceeded the California cap by $270 million and $1 billion
in 1988 and 1989, respectively.21 California expects that, in 1990, demand will exceed the cap
in that sate by $1.4 billion. In Massachusetts, the debt demanded has hovered about 150 percent
greater than the cap. In Texas and Illinois, demand has exceeded the cap every year since 1986.
According to the Public Securities Association (PSA), which has recently completed a national
study of volume caps, the number of states facing demand in excess of volume caps has
increased each year since 1986. The PSA forecasts that, in 1990, states will hit their volume
caps even earlier and exceed their caps by wider margins than in the past22
According to the most recent analysis of the effects of volume caps on different types of
bonds, volume caps in 1989 prevented some $2.4 billion in solid waste, hazardous waste, water,
and sewer bonds from being issued as tax-exempt debt23 Most of the denied or delayed bond
issues would have financed some $2.1 billion worth of solid waste facilities. Significantly, the
principal reason for denying access to volume caps was not mat total private-activity volume had
exceeded the states' volume limitations. Rather, most bonds were denied because states had
reserved a large proportion of their caps for other types of bond issues, such as mortgage revenue
bonds. Many states that denied bonds for privately owned and operated environmental facilities
had not used up their total allowable tax-exempt, private-activity debt limit at the end of the year.
Concerns. Perhaps the principal concern associated with the proposal to exclude bonds
used to finance public-purpose environmental facilities from state volume caps is the potential
cost to the U.S. Treasury. Relative to levels of tax-exempt debt issued under the current volume
cap restrictions, tax revenues accruing to the U.S. Treasury would decline to the extent that
additional tax-exempt debt is issued. Tax revenue losses associated with this proposal could
reach $932 million between 1991 and 1995 using the Treasury model for computation.
Elimination of the Costs of Issuance Restrictions on Tax-Exempt, Private-Activity Bonds
that Finance Environmental Facilities
Many analyses and reports issued since the 1986 Tax Reform Act have noted that
restrictions on the cost of issuing bonds places an unnecessary limitation on issuers.24 For
tax-exempt, private-activity bonds, the-Act stipulates that no more than 2 percent of the total
value of the bond issue can be used to pay the cost of the issue.
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In a 1988 study, the U.S. General Accounting Office (GAO) found issuance costs higher
than 2 percent of proceeds.25 GAO found that these costs averaged 3.5 percent in 1985 and 3.4
percent in 1986. These costs, calculated as a percentage of total costs, tended to be larger for
the more common, smaller-value bond issues (see table below). The GAO report showed that
die costs of water and sewer bond issues ranged between 2.7 percent and 2.9 percent of total
bond proceeds. Based on this information, the current across-the-board 2-percent limit on the
value of the bond issues that can be used to pay the cost of issues may be unduly restrictive,
particularly with respect to bond issues of less than $25 million.
COSTS OF BOND ISSUES AS A PERCENTAGE OF PRIVATE-ACTIVITY
BOND PROCEEDS (BY SIZE OF ISSUE)
Size of Issue
($ Millions)
$5 or less
5-10
10-25
25-50
50-75
More than $75
.
Number
of Issues
9,068
1,471
1,173
557
181
296
1985
Average Issuance
Cost as a Percent
of Bond Proceeds
3.4
4.0
4.1
3.2
2.7
22
Number
of Issues
1,476
152^.
64
43
15
18
1986*
Average Issuance
Cost as a Percent
of Bond Proceeds
3.4
3.7
3.6
2.4
2.4
1.4
Total
12,747
3.5
1,768
3.4
'1986 data include only bonds issued before the effective date of the Tax Reform Act
of 1986.
In fact, the 2-percent limit may be ineffective. If they are able, state and local issuers pay
whatever costs of bond issues that the market dictates. If costs are in excess of 2 percent, issuers
must raise funds outside the tax-exempt bond transaction. In some cases, issuers can take funds
from operating budgets or from supplementary taxable bond issues, for example. In others,
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issuers may be unable to raise the needed funds. Using alternative funds to cover issuance costs
raises the overall cost of financing environmental facilities by 15 to 20 percent, according to
some estimates and can produce inefficiencies.26
Reclassification of environmental bonds as governmental bonds would lift the 2-percent
limit on the value of a bond issue that can be used to pay the cost of the issue. In the absence
of ^classification, however, a simple alternative would be to lift this limit on environmental
bonds.
Benefits, Lifting mis limit would benefit all involved with bond-financed projects by
incorporating all the costs of financing including the costs of bond issues into the bond
transaction. To secure the real costs of issuance from sources outside the bond transaction is less
efficient and more costly.
Concerns. On the surface, it might appear that lifting the 2-percent limit confers special
benefits on the parties to a bond transaction, such as underwriters or financial advisors. Yet the
evidence suggests that the market for these services is highly competitive, which in turn, will
tend to hold transaction costs to reasonable levels. Hence, lifting the 2 percent restriction is
unlikely to result in significantly changed transaction costs. These costs of bringing a bond to
market would simply be shifted from sources outside the bond transaction to the bond proceeds
themselves.
Exemption of Interest on Public-Purpose Environmental Bonds from the Alternative
Minimum Tax
Interest income derived from tax-exempt, private-activity debt is classified as a preference
item for the purposes of calculating the alternative minimum tax payable by individuals and
corporations. This tax was created by the Tax Reform Act of 1986 to ensure that all individuals
and corporations contribute some minimum share of income as taxes. With the addition of the
alternative minimum tax, taxpayers must calculate then* tax liability in two ways. They must first
calculate their ordinary tax liability. Then they must calculate their taxable income subject to
the alternative minimum tax This income includes ordinary taxable income as well as certain
other income, including preference items, such as the earnings on private-activity bonds. The
alternative minimum tax rate is 20 percent for corporations and 21 percent for individuals. The
taxpayer must pay whichever liability is greater: ordinary tax or the alternative minimum tax.27
Hence, even if private-activity bonds are tax-exempt, taxpayers may still have to pay taxes on
earnings from these bonds if their alternative minimum tax exceeds their ordinary tax.
In the absence of reclassification of environmental bonds as governmental bonds, the dual
goals of tax reform and environmental compliance would be served if interest earned on bonds
issued to finance public-purpose environmental facilities was no longer included as a tax
preference item for purposes of calculating the alternative minimum tax on personal and
corporate tax returns.
Benefits. Exempting interest on public-purpose environmental bonds from the alternative
minimum ox would reduce the cost of issuing tax-exempt bonds for environmental facilities.
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According to various sources, the possible applicability of the alternative minimum tax to bond
issues increases the cost of bond issues by 15 to 30 basis points.28 This is a considerable sum.
In dollar terms, a 25-basis-point differential in interest rates on a $100 million bond issue would
cost the issuer about $4 million over a 20-year period $4 million mat could otherwise fund
other important needs.
Concerns. The principal concern associated with the proposal to exempt interest on
public-purpose environmental bond issues from the alternative minmunn (^ might be the
potential for losses of tax revenue, as calculated by the U.S. Treasury Department However,
according to the Public Securities Association (PSA), the federal treasury is capturing little or
no income from the current alternative mininum^ tax paid on interest from these bond issues
because investors subject to the tax withdraw their demand. At higher costs to the states and
localities that issue mem, these bond issues are placed with investors not exposed to the
alternative minimum tax. The net effect, according to the PSA, has been an increase in costs to
bond issuers and a limiting of the investors attracted to these issues without a commensurate
benefit to the federal government.29 If this is true, then tax Josses associated with this proposal
would be
Allowance for Advance Refundings of Tax-Exempt, Private-Activity Bonds Used to Finance
Environmental Facilities
Prior to 1986, bonds to refund governmental (and 501(c)(3)) bonds could be issued well
in advance of the redemption date of the original bond, and proceeds on the refunding bond could
be held in interest-bearing accounts until the original bond could be retired. This provision
allowed bond issuers to take advantage of favorable market conditions to reduce the cost of debt,
without die tax-exempt status of interest on the refunding bonds being affected. Before 1986,
industrial development bonds (pre-1986 equivalents of private-activity bonds) could not be
refunded until 180 days prior to redemption.
The 1986 Tax Reform Act shortened the time period for advance refunding to 90 days
prior to redemption. Governmental or 501(c)(3) bonds issued after December 31,1985 could be
refunded in advance, only once, otherwise interest on refunding bonds would no longer be
tax-exempt (Bonds issued before that date could be advance refunded twice.) In addition, the
Act prohibited advance refundings for all private-activity bonds other than qualified 501(c)(3)
bonds. Other restrictions also were imposed. For example, the Act required that refunded bonds
be retired no later than the first allowable redemption date, if refunding would produce debt
service savings.
In the absence of reclassification, one way to place public-purpose environmental facility
bonds on a par with-governmental bonds would be to-allow them-one advance refunding on a
tax-exempt basis.
Benefits. Allowing one tax-exempt advance refunding would provide state and local bond
issuers much needed flexibility to refinance outstanding bonds at favorable rates. While the exact
dollar savings would vary according to the spreads between the. rates on outstanding bonds and
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current market rates, the net effect would be considerable savings on the cost of financing
environmental facilities.
Concerns. A one-time tax-exempt advance refunding could reopen the possibility of tax
abuse and expose the federal government to tax revenue losses. Congress has noted that some
bond issuers had taken advantage of advance refunding by refunding, but not retiring, outstanding
bonds at virtually no cost or risk. Issuers had been able to do this by investing the proceeds of
an advance refunding in federal securities at a guaranteed yield equal to mat of the refunding
issue.30 As a result, multiple issues of bonds would be outstanding at the same time. From the
perspective of the U.S. Treasury, mis resulted in losses of federal tax revenues. For example,
if bonds for a single $10 million sewage project were refunded in advance three times, the federal
government could incur tax revenue losses equivalent to $30 million worth of tax-exempt bonds.
Allowing only one tax-free advance refunding of public-purpose bonds used to finance
environmental facilities in compliance with federal environmental mandates would help limit
potential federal tax revenue losses.
'Allowance for Reinvestment of Arbitrage Earnings for Environmental Bonds
Arbitrage earnings include earnings from bond proceeds invested at rates above the bond
yield. Arbitrage earnings can accrue after bond proceeds are collected from the bond sale and
before construction expenses must be paid. Under the 1986 Tax Reform Act, arbitrage earnings
must be rebated to the U.S. Treasury.
The 1989 budget reconciliation bill (HJL 3299) gave partial relief from the rebate
requirements. However, the bill allows bond issuers to invest bond proceeds without rebating
arbitrage earnings, provided that the proceeds are spent in accordance with a two-year schedule.
However, the Board has found that most environmental projects take longer than two years to
build.31 In a recent review, for example, EPA found that the average time to construct a typical
wastewater treatment plant was slightly over four years.32 Other environmental facilities require
similar construction periods. These periods require issuers of environmental debt to structure
many smaller sequential bond issues to avoid the rebate penalties. Bringing many small bonds
to market, however, incurs significantly higher fixed-issuance costs per dollar of proceeds than
does a single large issue. It also may have the effect of forcing states and localities to issue
bonds in unfavorable market conditions.
State and local costs of financing environmental facilities could be reduced at low federal
costs by enabling issuers of tax-exempt environmental bonds to earn interest on bond proceeds
without penalty over a reasonable period of time for construction of environmental facilities.
This provision would apply only if the excess interest earnings (earnings above the bond yield)
are used exclusively to reduce the size of the bond issue.
Benefits. Current arbitrage rebate provisions displace dollars from state and local budgets
that could otherwise be used to downsize bond issues and reduce the overall cost of
environmental facilities. However, the proposal to enable issuers of tax-exempt environmental
bonds to earn interest on bond proceeds without penalty over a reasonable facility-construction
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period would reduce the cost of financing public-purpose environmental facilities. For example,
consider a $50 million project completed in four equal stages of one year each. Under current
arbitrage rebate provisions, earnings from bond proceeds invested at one-half a percentage point
above the bond's interest rate - nearly $338,000 over the four-year construction period would
have to be rebated to the U.S. Treasury. If Congress changed rebate provisions to allow bond
issuers to keep arbitrage earnings gained during the period of construction, those earnings could
be used to reduce the overall project cost.
Concerns. Like the other proposals described above, this proposal to allow bond issuers
to keep arbitrage earnings gained during the period that an environmental facility is being
constructed has the potential to reduce federal revenues. This reduction would occur to the extent
that current arbitrage rebate provisions are earning the U.S. Treasury such revenues.
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IV. USING ECONOMIC INCENTIVES TO PREVENT POLLUTION
One response to an insufficient number of environmental facilities operating at sufficient
capacity is to spend more to build new facilities and to expand existing ones. Another response
is to lower the demand for environmental services by reducing the generation of garbage, using
less drinking water, and dumping fewer toxins down the drain. If waste reduction and resource
conservation activities cost less man waste management, pollution prevention will reduce the cost
of national environmental programs. .
Experts point to many policies that could prevent pollution. These policies range from
greater information transfer and technical assistance to creation of regulatory mandates and
economic incentives, dearly dissemination of information is important. In fact, one of the
principal impediments to pollution prevention, especially for small generators, is lack of guidance
on just what to do.33 For larger manufacturers, EPA's new program of corporate volunteerism
appears promising, both because results are highly probable and because the program requires
virtually no government intervention.34 In essence, the Administrator has announced to major
producers his intent not to regulate pollution prevention, but to ask for volunteers to demonstrate
that a 33 percent reduction of 17 high-priority toxic pollutants is achievable by 1992 and that a
SO percent reduction is achievable by 1995. ' '
The Board strongly endorses voluntary pollution prevention. It agrees with recent EPA
and other reports that conclude that designing and implementing regulations for thousands of
different situations in which pollutants are produced is inefficient and impractical. In a 1986
report to Congress on waste minimization, for example, EPA pointed to the technological and
administrative problems of regulating waste reduction.35 According to the EPA, there are too
many situations for which to set standards, and the rules setting these standards would be difficult
to enforce. ,.
In keeping with the principles of the Administrator's corporate volunteerism strategy and
recognizing the impracticality of regulating pollution prevention, the Board believes that
economic incentives should be used as they are effective and efficient ways to reduce pollution.
At this time, the Board is not prepared to make formal recommendations on the use of economic
incentives. However, this Advisory presents an array of proposals for the use of economic
incentives, evaluates how effective they might be in reducing pollution, and outlines the concerns
generally associated with each proposal
In a subsequent Advisory, the Board intends to analyze thoroughly the opportunities to
supplement traditional technology-based effluent regulations with market-based alternatives.
A. STATEMENT OF THE ISSUE
The United States has not taken full advantage of opportunities to reduce the cost of
environmental protection by reducing the generation of pollutants. Recently, a great deal of
attention has been focused on reducing the nation's hazardous waste stream from industrial
processes. Many analysts now suggest that a SO percent reduction is economically and
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technologically feasible over the next few years.36 Both economic incentives (tax subsidies,
grants, awards) and economic disincentives (effluent or emission fees, fines) have been tried -
with varying degrees of success to promote industrial waste reduction. One example of an
economic disincentive is a tax of $25 on each ton of pollutant emissions from industrial facilities.
This tax, levied under the 1990 dean Air Act Amendments, is expected to have the effect of
reducing emissions at facilities that have emission control costs lower than the tax they would
pay on emissions. In comparison, relatively few economic incentives target reduced solid waste
generation or reduced demand for drinking water or wastewater treatment37
B. DISCUSSION
In the Board's opinion, opportunities to complement traditional pollution control programs
with economically motivated pollution prevention will be available in the 1990s. These
opportunities will arise within the next five years when nearly all the major federal environmental
statutes will be reauthorized38
Recent EPA reports that have reviewed the last 20 years of environmental progress have
.made two fundamental observations.39 First, these reports suggest mat the environmental control
strategies of the 1970s and 1980s have worked insofar as they have resulted in the removal of
significant amounts of largely conventional pollutants from point sources. Yet, they also noted
that the removal of these pollutants was easier and much less expensive to accomplish than
meeting the environmental challenges of the 1990s and beyond will be. These challenges include
controlling non-point sources of pollution such as agriculture, reducing the discharge of toxic
contaminants from all sources into all environmental media, and restoring the health of natural
and living resources.
One recent.EPA report noted that command-and-control regulations that impose
technology-based standards were more suited to the environmental concerns of the 1970s than
to those of the 1990s and beyond.40 This Advisory argues that to maintain progress on the
environmental front, EPA must move beyond the prescriptive approach by introducing innovative
policy instruments such as economic incentives. Because economic incentives influence rather
than dictate action, consumers and businesses can make their own choices about how to achieve
stated levels of environmental quality. Presumably these choices will reflect a bias toward
least-cost actions. Thus, properly designed, economic incentives can be used to harness the
power of self-interest to work for the environment
The Board has reviewed the following fundamental approaches to reducing pollution that
merit the EPA's attention:
Imposition of economic penalties, such as effluent fees,-to reduce the volume or
toxicity of discharges;
* Use of economic incentives, such as tax or other credits for investments in waste-
reducing technologies or activities, to promote pollution prevention; and
Removal of biases in current policies that inhibit waste reduction.
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Reduce the Volume or Toxicity of Discharges to All Media Using Fees
Many European countries have adopted some form of environmentally based fees or
"green taxes." Some measures tax inputs (feedstocks) to production processes, such as nitrates
in agricultural fertilizers or virgin (non-recycled) packaging materials. Such fees encourage more
efficient use of these inputs or substitution of other, less polluting, inputs such as recycled plastic
or glass, for example.
Other measures tax outputs from production processes. Fees on outputs encourage waste
reduction by making waste generation more expensive. For example, effluent fees encourage
reductions in the volume or toxicity of pollutant discharges and deposits on containers are
equivalent to waste fees when the containers are not recycled.
One kind of fee that has generated considerable interest is a fee on the handling of
hazardous and solid wastes. Such a fee based On the volume and/or content of the waste being
handled ~ can be levied against waste producers, either directly or indirectly through tipping fees
collected from waste haulers and charged back to generators. Materials handling fees, like
effluent fees and waste fees, better reflect the true costs of waste management They also
discourage excessive use of materials that are difficult to dispose of safely. In addition, they can
be used to generate funds to pay for the final disposition of those materials that cannot be
recycled.
Materials handling fees have been introduced in a number of states. In 1982, the state
of New York instituted materials handling fees to promote waste reuse and discourage the use
of landfills, it began charging generators of hazardous wastes a fee of $12.00 for each ton of
waste managed at landfills, a fee of $9.00 for each ton of waste treated or disposed of offsite
(excluding landfills), and a fee of $2.00 for each ton of waste incinerated onsite.41 In 1986,
New Hampshire began charging all generators of hazardous waste a fee of 4 cents per kilogram
of waste unless it was recycled. The state exempted recycled waste from fees. Some 30 other
states now impose similar types of fees on inputs to typically waste-intensive industries or on the
waste generated by industrial processes. In each of these states, waste generation has declined,
as have fee revenues.
Benefits. The imposition of economic penalties in the form of fees would offer two
benefits: raised revenues and reduced discharges. However, the exact cause and effect
relationship between levels of pollution fees and expected reductions in discharges is not known.
Similarly, the exact relationship between levels of fees and expected revenues is elusive, partly
because if fees do their job, discharges, hence revenues,, will decline over time. According to
one estimate, if handling fees ranging from $5 per ton to $25 per ton (depending on toxicity)
were assessed for hazardous wastes produced by industrial facilities, the industrial hazardous
waste steam could be reduced by some 35 percent by 1995 with revenues totalling some $2.8
billion a year.41
Revenues from fees could be used to underwrite a variety of environmental activities,
including complying with and enforcing environmental regulations and conducting research and
development Investing revenues in capital grants for waste reduction activities is especially
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appealing, since some generators might rather reduce waste than generate it if they had access
to low-cost capital with which to make waste reduction investments. Other waste reduction
activities that axe logical recipients of fee revenues include information dissemination, on-site
waste reduction auditing, technology development, and research into modifying production
process that are waste-intensive or substituting more environmentally benign production outputs
for less environmentally benign ones.
Concerns. One of the principal concerns associated with the implementation of waste
fees at the national level is the adequacy of systems to ensure equitable fee collection. First,
mere is some question about whether relevant data are or can be regularly collected. Systems
for collecting data on solid waste generated at the producer and consumer levels are unavailable.
Some states assess effluent fees on the basis of dischargers' reports, but these reports are not
necessarily available nationwide. Air emissions data also are limited to estimates of criteria
pollutants (non-toxics) with no internally consistent data on air toxics emissions. Second, there
is some question about the proper units upon which fees should be based. In the interest of
simplicity, some argue that all dischargers should pay a flat fee when they apply for a discharge
permit. In the interest of affecting behavior, others argue that fees should increase as volumes
or toxicity of discharges increase. Fees set too high, however, could result in illegal discharges
or dumping.
Hazardous waste data may provide the best opportunity for deciding how to implement
fees designed to reduce polluting behavior. Such data are available from two sources. Every two
years, the EPA and the states collect data from waste management facilities and generators on
the amounts and disposition of waste defined as hazardous under the Resource Conservation and
Recovery Act (RCRA). The Toxics Release Inventory, compiled as a result of the 1986
Superfund Amendments, records all releases of a broader group of toxic constituents, but only
by the manufacturing sector. Using either or both these data sets, a fee could be based on:
The type of waste generated, with higher fees charged for more toxic substances
suchasPCBs;
The waste management method used, with higher fees charged for less desirable
disposal methods such as landfilling; or
A combination of the type of waste generated and the waste management method
used, with the highest fees charged for the least desirable combinations of waste
generated and management method employed.
Some observers argue that fee-based approaches to waste management may generate
revenue but still fail to achieve significant reductions in the amount of pollution generated if fees
are set too low. Even so, revenue from fees could be used to finance-remedial infrastructure to
manage waste and meet related environmental needs.
Other observers are concerned about the potential economic and social side effects of
waste fees if they are set high enough to have an impact on behavior. These fees can be
regressive and bear hardest on individuals with low incomes. Analyses conducted by the
Department of Energy indicate that a fuel tax of 25 cents per gallon could reduce the
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consumption of motor fuel use by 4 to 5 percent, thus reducing pollution. However, such a tax
would disproportionately affect low-income automobile users, since these users spend a much
higher percentage of their income on gasoline than high-income automobile users.
The implementation of fee-based approaches to waste management raises other concerns
as well If waste fees are levied only within the United States or are higher than in other
countries, U.S. firms could suffer a competitive disadvantage in the international marketplace.
Production input costs would rise, either due to die fees themselves or to the incremental
investment in alternative inputs and/or capital equipment that the fees would encourage. This
outcome could adversely affect the country's balance of payments and, at the same time, increase
unemployment in export-dependent sectors of the U.S. economy. Moreover, even within the
United States, the effect of waste fees would not be evenly distributed. Depending on the type
of tax or credit, some geographic or economic sectors would be affected more than others. For
example, fees that discourage the use of fossil fuels will reduce economic activity in regions that
depend on the extraction or processing of coal, oil, and gas for their economic livelihood
Although fees levied at the consumer level can be regressive, they do not have to
adversely affect U.S. exports, since they would be levied only if the good is consumed in the
United States. Fees on consumption might also do much to control pollution and promote
recycling of consumer goods, such as batteries, tires, used oil, and plastics.
Several other concerns are associated with fee-based approaches to waste management.
These include the wisdom of implementing any kind of fee during a recessionary period; the
relative efficiency and effectiveness of placing fees on waste generation or on toxic inputs to
manufacturing processes; and the inability of polluters to finance waste reduction actions, despite
the economic pressures of waste fees.
Use Tax Credits to Promote Waste Reduction
A tax credit, a type of economic incentive, is an alternative to a fee, a type of economic
disincentive, for influencing waste generation behavior. Tax credits can change this behavior by
altering the price of production inputs, such as fuels or capital equipment Tax credits can be
used directly to lower producers' net costs of purchasing and installing low- or no-discharge
manufacturing equipment They also can offset private costs of research on and development of
processes or technologies that promote the reuse or recycling of wastes.
Tax credits offer a direct reduction in the recipient's tax liability and can be granted
against income taxes, excise taxes, and property taxes. Like fees, they may be targeted at either
the producer or the consumer and can have two outcomes: either they will result in waste
reduction and an accompanying tax revenue loss, or they will have no effect on waste reduction.
Benefits. Theoretically, credits help overcome financial barriers to waste reduction. For
example, tax credits for producers directly lower the cost of investing in waste reduction
equipment or of undertaking research on and development of waste reduction.
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In practice, however, tax credits for producers can be less effective than anticipated. In
1984, for example, Minnesota passed an income tax credit of 5 percent of the cost of equipment
used primarily to reduce waste. It was never used, so the state repealed it in 1985 as part of an
effort to simplify the tax code. If the credits had been refundable, tradeable, or carried over
from year to year, producers might have taken advantage of them.
Concerns. The use of tax credits raises several concerns. First, although it is easy to
track and verify investment in waste reduction equipment, the identification and approval of
waste reduction technologies (and, to a lesser extent, products) for which producers and
consumers are eligible to earn pollution prevention tax credits will require a reasonable
administrative effort. Second, when tax credits are used, die cost of environmental improvement
is borne by all taxpayers because claimed credits generally reduce tax revenues to the U.S.
Treasury. By contrast, environmental fees are borne only by users and producers of the goods
on which the fees are imposed
Remove Bias in the U.S. Tax Code that Inhibits Waste Reduction
Lifting or amending restrictions in three areas of the U.S. Tax Code could remove barriers
to and create incentives for waste reduction. Proposed changes focus entirely on the producer,
as the relevant section of the code concerns corporate income tax.
i
The three areas of the tax code that act as barriers to waste reduction include limitations
and restrictions regarding: .
deduction eligibility,
depreciation of pollution control or pollution abatement equipment, and
depreciation methods for extracted raw materials.
The Board recognizes that changes to the tax code are not necessarily an activity within
EPA's jurisdiction. Yet it has concluded that the Agency could provide technical guidance to
the Congress and to others, if asked, as these changes are debated. To the extent that these
proposed changes are pursued, the Agency may wish to compare pollution prevention benefits
with potential tax revenue losses.
The feasibility of changing the tax code raises similar concerns to those arising from
implementing tax credits: what is the administrative burden, what types of new information are
needed to establish eligibilities and exemptions, and who should be responsible for reporting and
enforcing these provisions?
Deduction Eligibility. All deductions against income are, in theory, subject to the "public
policy limitation." This limitation disallows any deduction that would "frustrate a sharply defined
governmental policy."43 In the case of waste management versus waste reduction, a strong
argument can be posited that this limitation has been weakened or rendered obsolete. According
to Sections 162 and 167/8 of the U.S. Tax Code, for example, capital assets such as plant and
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equipment that discharge solid wastes, effluents, or emissions in violation of discharge permits
may be depreciated. Deductions also may be claimed for expenses arising from payment of
punitive damages in connection with environmental malfeasance. Payments in connection with
illegal acts (illegal waste disposal, for example) also may be deducted. These allowances thus
act to encourage unsound waste management practices and almost certainly encourage waste
management over pollution prevention.
If EPA wished to oppose the above deductions, it could make a policy statement to the
effect mat pollution prevention should supplant waste management where technologically feasible
and economically efficient This would establish a "sharply defined government policy" which
the above deductions could be seen to frustrate. If these deductions could then be explicitly
disallowed, they could be replaced with deductions for investments in plant and equipment (or
process changes) that prevented the generation of waste.
Depreciation of Pollution Control Plant and Equipment Under Section 169 of the
U.S. Tax Code, plant and equipment used to control pollution can be depreciated over a 5-year
schedule, subject to certain conditions. The code requires, however, that these assets not increase
profitability (by reducing operating costs, for example), not increase capacity either, or extend
plant life. In addition, the cost of pollution control plant and equipment cannot be repaid by the
recovery of wastes. This means mat the value of the recovered material cannot equal or exceed
the annualized cost of the plant and equipment. Finally, the tax code requires that pollution
control plant and equipment be state or federally approved as conforming with prescribed
standards. If a plant's life exceeds 15 years, the write-off is reduced proportionately for
example, only half the cost of the plant can be rapidly amortized if the life of the plant is double
the ntaximum allowed. However, the limit on allowable plant life does not apply if the
investment in the plant might have occurred anyway, and is only applicable to plants in operation
prior to 1976.
One of the major problems with the provision of depreciation of pollution control plant
and equipment under the U.S. Tax Code is that it encourages end-of-pipe waste management over
pollution prevention. For example, Section 169 of the code does not allow depreciation of
investments that add value to a plant by reducing costs or extending plant life, both of which are
benefits of pollution prevention. Compared to an investment in waste management plant and
equipment, which is eligible for rapid depreciation, an investment in a production process or a
piece of equipment to reduce pollution is ineligible for depreciation under Section 169 and hence
receives no tax subsidy. What Section 169 does not do, precisely because it limits the deduction
to plant and equipment that offer no other benefit than pollution control, is to make pollution
control (not pollution reduction) a major issue in corporate investment decisions.
Section 169 could be far more effective if it made pollution reduction part and parcel of
the necessary and continuous assessment of investment opportunities that will improve corporate
performance. To promote waste reduction, allowable depreciation under Section 169 could be
limited to plant and equipment that reduce waste instead of restricted to plant and equipment that
merely control pollution. (In other words, investments in plant and equipment that just control
pollution would no longer be eligible for depreciation, but investments in plant and equipment
that reduce waste would be.) In addition, accelerated depreciation schedules could be shortened
on the basis of the quantity of waste reduced as a result of investments in plant and equipment
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This would mean that the greater the waste reduction is, the shorter the depreciation schedule
would be.
One problem with lifting the restriction on allowable depreciation either to investments
in plant and equipment that reduce pollution or to investments in plant and equipment that merely
control pollution is mat it could invite exploitation in the form of "sham" pollution prevention
investments. It should be noted, however, that exploitation is just as likely under the current
Section 169 credit.
Despite the possibility that lifting the current (or proposed) restriction on allowable
depreciation could invite exploitation, it could be argued that the restriction should be lifted
because it violates the. intent of the Investment Tax Credit. This credit was established to
increase capital spending in general, but the restriction on allowable depreciation discourages
investment in plant and equipment mat reduce pollution. At a minimum, Section 169 could be
modified to provide an incentive to increase capital spending on plant and equipment that reduce
pollution, regardless of any other benefits an investor would receive. Such a modification would
be in keeping with the intent of the Investment Tax Credit
If Section 169 was restructured to confer tax benefits on investments in pollution
reduction, the value of those benefits could be increased by lifting some of the restrictions that
limit the value of the tax benefits. These include allowing accelerated depreciation for
equipment put in place after, not prior to, 1976; lifting the limit of a 15-year plant life to qualify
for full Section 169 benefits; and allowing corporations to claim 100 percent of the cost of then-
investments in plant and equipment, as opposed to the 80 percent they now can claim. These
changes would impose new, but manageable, administrative burdens such as the reporting of
pollution reduction equipment purchased, and deductions can take place on corporate income tax
returns.
The chief argument against allowing Section 169 to confer tax benefits on investments
in plant and equipment that satisfy pollution reduction criteria is that it would not raise revenues.
Yet raising revenue is the priority of tax policy. However, amending Section 169 as outlined
above would induce companies to make investments they might otherwise not make, and these
investments would increase corporate profits enough to raise tax revenue. At worst, the above
described changes to Section 169 would be revenue neutral - that is, they would neither raise
nor lower revenues.
Depreciation Methods for Extracted Raw Materials. An incentive for reducing
hazardous waste could be realized by eliminating depletion allowances for toxic minerals under
certain conditions and by changing the method of depreciating toxic mineral resources.
Currently, the U.S. Tax Code allots depletion allowances for extracted raw materials such as
minerals on a percentage basis. Under percentage depletion, the annual depreciation charge on
an extracted raw material equals a fixed percentage of sales of the raw material divided by the
expected life of the material. (In the case of minerals, life is measured in barrels of oil, tons of
coal, and so on.) When the market price of the raw material rises, the tax liability falls. Thus
any price rise increases the rate of extraction. This is a particularly worrisome occurrence when
the material for which the market price rises is a toxic mineral.
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Some of the most toxic minerals enjoy the highest depletion allowance.44 Eliminating
these allowances for toxic minerals when a less toxic or a non-toxic substitute exists may
discourage increased extraction of these minerals when their market prices rise. Moreover, in
the absence of depletion allowances, users of toxic minerals would be encouraged to substitute
non-toxic minerals for toxic ones or to substitute less toxic minerals fas more toxic ones in many
types of production processes. ,
Substitutions of non-toxic or less toxic inputs also could be encouraged by switching from
a percentage depletion method for depreciating extracted raw materials to a cost depletion
method. Under cost depletion, the annual depreciation charge equals the value paid for the raw
material divided by the life of the material. This depreciation method may not discourage
increased extraction when market prices for raw materials rise, but neither will the depreciation
charge increase (as it does when depreciation is calculated on the basis of percentage depletion)
as a result of those price rises. Alternatively, a percentage depletion allowance could be set on
a sliding scale, with the lowest percentages of minerals sales associated with the most toxic
minerals. This would directly raise the costs of extraction, again leading to die substitution of
less toxic minerals for more toxic ones.
A switch to a cost depletion method for calculating depreciation charges or a percentage
depletion allowance set on a sliding scale would lead to increased tax revenues. Whether or not
these changes would lead to a lower extraction rate depends on the response of purchasers of
products made with toxic minerals when they are faced with higher prices for these products.
If a product made from non-toxic or less toxic materials can be substituted for a product made
from toxic minerals and is available at a lower market cost than the product marte from toxic
minerals, demand for the product made from toxic minerals will *fccfore and, along with it,
extraction of the toxic minerals from which it was made.
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NOTES
1. Office of Policy, Planning, and Evaluation, U.S. Environmental Protection Agency,
Environmental Investment: The Cost of a Clean Environment (December 1990).
2. Office of Administration and Resources Management, U.S. Environmental Protection
Agency, A Preliminary Analysis of the Public Costs of Environmental Protection: 1981-
2000 (May 1990).
3. See Paul R. Portney, ed, Public Policies for Environmental Protection (Washington,
D.C: Resources for the Future, 1990).
4. Apogee Research, Inc., America's Environmental Infrastructure: A Water and
Wastewater Investment Study, prepared for the dean Water Coalition (December 1990).
5. All dollar figures in this section are expressed as 1988 dollars unless otherwise noted.
For details on cost estimates, see OARM, U.S. EPA, Public Costs of Environmental
Protection.
6. See National Council on Public Works Improvement; The Nation's Public Works: Report
on Wastewater Management, prepared by Apogee Research, Inc. (May 1987).
7. Office of Water, U.S. Environmental Protection Agency, State Funding Study: Details
of State Needs, Funding, Funding Gap (August 8, 1988). Trends in the study were
extended from 1995 to the year 2000 to provide consistent data.
8. See OARM, U.S. EPA, Public Costs of Environmental Protection; and Office of Water.
U.S. Environmental Protection Agency, State Funding Study: Draft Recommendations
(1990).
9. The 1986 Tax Reform Act affected many public purposes; however, the Board's
observations are limited to its effect on environmental investment.
10. Based on data from 1980 to 1990, the Board concludes that the 1986 Tax Reform Act has
had little measurable effect on the volume of tax-exempt bonds issued for water, sewer,
and solid waste management projects. It would appear that compliance with existing and
new environmental regulations and replacement of old facilities are more important
determinants of the overall rate of public investment in environmental facilities. The tax-
exempt market for water and sewer bonds declined by 56 percent from 1977 to 1983, a
drop from $5.9 billion to $2.6 billion in inflation-adjusted dollars. Since 1983, the market
has rebounded, growing by 154 percent to an historical high of $6.6 billion in 1989.
11. The 1986 Tax Reform Act had different effects on the supply of tax-exempt bonds, on
the availability of other tax-exempt investments, and on the demand for tax-exempt and
taxable investments. On the demand side, the general reduction in marginal tax rates
reduced the demand for tax-exempt investments of all kinds, including tax-exempt bonds.
All things being equal, this reduction in demand would tend to increase interest rates to
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attract buyers. At the same time, however, the Act also reduced the supply of tax-exempt
bonds and eliminated the tax benefits of some alternative investments, such as real estate.
This reduction in supply would decrease interest rates, as bond issuers would have to
offer less return to attract buyers. On balance, these two effects seem likely to offset
each other.
12. Dennis Zimmerman, The Volume Cap for Tax-Exempt Private-Activity Bonds: The State
and Local Experience in 1989 (Washington, D.C: U.S. Advisory Commission on
Intergovernmental Relations, July 1990).
13. See Margaret C. Henry, "The 102nd Congress and Tax-Exempt Bonds: A Professional's
Look Into the Crystal Ball," The Bond Buyer, 7 January 1991.
14. Anthony Commission on Public Finance, Preserving the Federal-State-Local Partnership:
The Role of Tax-Exempt Financing (October 1989).
IS. Prior to the 1986 Tax Reform Act, the category for tax-exempt debt comparable to
private-activity bonds was the industrial development bond. Debt obligations of nonprofit
501 (c)(3) organizations are considered private-activity bonds, but are exempted from the
many restrictions of private-activity debt, such as the volume cap, die prohibition against
advance refundings, and the alternative minimnm tax.
16. Trend line data on private-activity issues has shown that the interest costs for private-
activity debt are 25 to 30 basis points (roughly one quarter of 1 percent) higher than
comparable governmental debt See testimony of Ralph Horn (on behalf of the Public
Securities Association) on HJL 1761 before the Subcommittee on Select Revenue
Measures, House Committee on Ways and Means, 8 June 1989.
17. See Paul R. McDaniel, Tax Expenditures as Tools of Local Governments," in Beyond
Privatization: The Tools of Government in Action, ed. Lester M. Salomon (Washington,
D.C: The Urban Institute Press, 1989).
18. See Senate Budget Committee, Tax Expenditures: Relationships to Government Spending
Programs and Background Material on Individual Provisions, 97th Cong., 2nd sess.,
1982.
19. For complete details of the methods, model, assumptions, and data used to generate this
estimate of tax revenue losses, see Apogee Research, Inc., "Estimating Tax Expenditures
Associated with EFAB Tax Policy Alternatives," a memorandum prepared for the Office
of the Comptroller, Resource Management Division, U.S. Environmental Protection
Agency (24 October 1990).
20. Larry E. Huckins, Tax Exemption of Municipal Bond Interest Revenue and Resource
Allocation Effects," in Federal-State-Local Fiscal Relations, Technical Papers, voL 1,
prepared for the Office of State and Local Finance, U.S. Department of the Treasury
(September 1986), 313-48; and Eric Toder and Thomas Neubig, "Revenue Estimates of
Tax Expenditures: The Case of Tax-Exempt Bonds," National Tax Journal 38
(September 1985): 395-414.
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21. Personal communication with Cheryl Eckerd, Trust Services Division, California State
Treasurer's Office on 2 February 1990.
22. Personal communication with P. Anders Nybo, Public Securities Association, New York,
N.Y, on 20 February 1990.
23. See note 6.
24. See Anthony Commission, The Role ofTax-Exempi Financing; and Final Report of the
Private Sector Advisory Panel on Infrastructure Financing, a report to the U.S. Senate
Committee on the Budget (1986).
25. U.S. General Accounting Office, Tax Policy: Tax-Exempt Bond Issuance Costs,
GAOA3GD-90-9BR (1988), 18-20.
26. Personal communication with Cathy Spain, Government Finance Officers Association, on
18 June 1990.
27. See testimony of Ralph Horn on H.R. 1761.
28. See testimony of David M Thompson (on behalf of the Public Securities Association)
before the House Committee on Ways and Means, 5 March 1990.
29. See testimony of David M. Thompson before the House Committee on Ways and Means.
30. House Committee on Ways and Means, H. Rept 99-426, 7 December 1985.
*"V
31. The bill specified the following spend-down profile: at least 10 percent of bond proceeds
must be spent within the first 6 months, 45 percent by the end of 12 months, 75 percent
within 18 months, and 100 percent within 24 months. The bill does permit 5 percent of
the bond proceeds to be held over and disbursed in the third year, but only if it is for
"reasonable retainage."
32. See Analysis of Mean Time Intervals Construction Stan to Initiation of Operation:
Construction Grants Projects 2972-1990, prepared by Don Rugh, Policy and Analysis
Branch, Office of Municipal Pollution Control, U.S. Environmental Protection Agency (27
March 1990). This figure was derived by weighing the national mean construction time
interval for each eligible cost class by its dollar share in total eligible costs. If mean
construction time for each cost class is weighted by the number of projects rather than
dollar value (thus biasing the outcome in favor of smaller but more numerous projects),
the mean construction time interval is still greater than two years (2J years). It is unclear
what, if any, bias has been introduced into the Rugh analysis because the projects used
to determine construction times were funded under Title n of the Clean Water Act Many
projects funded without such grants are completed faster.
33. See Kenneth L Rubin, "Factors That Motivate Industrial Waste Management Decisions,"
prepared for the Conference on Industrial Hazardous Waste Treatment and Waste
. Reduction held at the University of Tennessee in February 1987; and Apogee Research,
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Inc., The Nation's Public Works: Report on Hazardous Waste Management, prepared for
the National Council on Public Works Improvement (May 1987).
34. Pollution Prevention Division and Office of Toxic Substances, U.S. Environmental
' Protection Agency, "Industrial Toxics Project, 1988 Toxics Release Inventory, National
Profile of Target Chemicals" (13 December 1990).
35. U.S. Environmental Protection Agency, Report to Congress; Minimization of Hazardous
Waste (October 1986).
36. See Office of Technology Assessment, U.S. Congress, Serious Reduction of Hazardous
Waste (September 1986).
37. One notable exception is a program now under development by the Metropolitan Water
District (MWD) of Southern California-a water wholesaler. MWD offers credits against
water charges to all of its retailers-many of the cities in Southern California-if they can
show that water conservation programs have resulted in reductions in demand.
38. The Clean Water Act, the Resource Conservation and Recovery Act, and the Safe
Drinking Water Act are up for reauthorization in 1991; Superfund will be reauthorized
as early as 1992.
39. Office of Administration and Resources Management, U.S. Environmental Protection
Agency, Paying for Progress: Perspectives on Financing Environmental Protection (Fall
1990); and Science Advisory Board, U.S. Environmental Protection Agency, Reducing
Risk: Setting Priorities and Strategies for Environmental Protection (September 1990).
40. Office of Policy, Planning, and Evaluation, U.S. Environmental Protection Agency,
Economic Incentives: Options for Environmental Protection (March 1991).
41. See testimony of Dr. Joel S. Hirshhom, Office of Technology Assessment, before the
Senate Committee on Environment and Public Works, 10 September 1984.
42. See Apogee Research, Inc., Projections of Demand for Hazardous Waste Management
Capacity in Alaska, Idaho, Oregon, and Washington: 1989,1995, and 2009, prepared for'
the U.S. Environmental Protection Agency, Region X (October 1989).
i .
43. R. A. Westin and S. E. Gaines, The Relationship of Federal Income Taxes to Toxic
Wastes: A Selective Study," Boston College Environmental Affairs Law Review 16, no.
4 (1989): 759.
44. The average rate for all minerals is 12.1 percent; but it is 22 percent for asbestos,
uranium, lead, and mercury.
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APPENDIX
Environmental Financial Advisory Beard
(EFAB)
Richard Torkelson
Deputy Commissioner for Administration
New York State Department of
Environmental Conservation
Albany, NY
EFAB Vice Chair
Frieda K. Wallison
Partner
Jones, Day, Reavis & Pogue
Washington, DC
EFAB Executive Director
Herbert Barrack
Assistant Regional Administrator
Region n, U.S. Environmental Protection
Agency
New York, NY
Economic Incentives Workgroup
Frieda K. Wallison (Workgroup Leader)
Partner
Jones, Day, Reavis & Pogue
Washington, DC
Honorable Beryl F. Anthony, Jr.
U.S. Representative
State of Arkansas
Dr. William Fox
Associate Director
Center for Business & Economic Research
University of Tennessee
Knoxville, TN
John Gunyou
Commissioner
Minnesota Department of Finance
St. Paul, MN
Heather L. Ruth
President
Public Securities Association
New York, NY
Richard Torkelson
. Deputy Commissioner for Administration
New York State Department of
Environmental Conservation
Albany, NY
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Private Sector Incentives Workgroup
Warren W. Tyler (Workgroup Leader)
Vice President
State Savings Bank
Columbus, OH
J. James Ban-
Vice President and Treasurer
American Water Works Company, Inc.
Voorhees, NJ
Philip Beachem
Executive Vice President
New Jersey Alliance for Action, Inc.
Edison, NJ
Joseph D. Blair
Executive Director
Massachusetts Industrial Finance
Agency
Boston, MA
Honorable Pete V. Domenici
U.S. Senator
State of New Mexico
David W. Gilbert
Vice President
Envirotech Operating Services
.Birmingham,
Harvey Goldman
Executive Vice President and Chief
Financial Officer
Air and Water Technologies Corporation
Somerville, NJ
W. Jack Hargett
Vice President Government Relations
The Parsons Corporation
Washington, DC
Honorable William H. Hudnut, JU
Mayor of Indianapolis
Indianapolis, IN
Honorable Holland W. Lewis
Mayor of Mount Vemon
Mount Vemon, JL
Steven Lieberman
Assistant Director for General Management
Office of Management and Budget
Washington, DC
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Public Sector Financing Options Workgroup
George A. Raftelis (Workgroup Leader)
Partner
Ernst & Young
Charlotte, NC
William H. Chew
Senior Vice President
Municipal Finance Department
Standard & Poor's Corporation
New York, NY
Roger D. Feldman, P.C.
Partner
McDermott, Will & Emery
Washington, DC
Shockley D. Gardner, Jr.
Executive Director
Virginia Resources Authority
Richmond, VA
Robert F. Mabon, Jr.
Morgan Stanley and Company, Inc.
New York, NY
Marlin L. Mosby, Jr.
Managing Director
Public Financial Management, Inc.
Memphis, TN
Roberta H. Savage
Executive Director
Association of State & Interstate Water
Pollution Control Administrators
Washington, DC
Douglas P. Wheeler
Secretary for Resources
Sacramento, CA
Small Community Financing Strategies Workgroup
Elizabeth Ytell (Workgroup Leader)
Director, Water-Wastewater Division
Rural Community Assistance Corporation
Sacramento, CA
Jack Bond
City Administrator/Deputy Mayor
for Operations
Washington, DC
Thomas Christensen
(Retired Supervisor)
Charter Township of Ironwood
Ironwood,MI
Dr. Richard Fenwick, Jr.
Vice President, Corporate Economist
CoBank National Bank for Cooperatives
National Credit Services Division
Denver, CO
William B. James
Associate Director
Prudential-Bacbe Capital Funding
Public Finance Department
New York, NY
John C "Mac" McCarthy
State Director
U.S. Department of Agriculture
Fanners Home Administration
Alexandria, LA
Honorable Anne Meagher Northup
Kentucky State Legislator
Louisville, KY
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Workgroup Support Staff
Environmental Protection Agency
David P. Ryan
Comptroller
John J. Sandy
Director, Resource Management Division
David Ostennan
Chief, Resource Planning and
Analysis Branch
Helen Beggun
Chief, Grants Administration Branch
Region H
Alice Jenik
Chief, Policy and Program
Integration Branch
Region n
Ben Abruzzo
Analyst
George Ames
Senior Analyst
*>.
Leonard Bechtel
Analyst
Margaret Binney
Analyst
Ellen Fahey
Analyst
Vera Hannigan
Senior Analyst
Joanne Lynch
Analyst
Timothy McProuty
Senior Analyst
Eugene Pontillo
Senior Analyst
Kim Thomas
Secretary
Ann M. Watt
Analyst
Apogee Research, Inc.
*
Dr. Kenneth Rubin
President
Ann Carey
Vice President
Dr. Susan Jakubiak
Senior Economist
Matthew Hardison
Vice President
Barbara Richard
Senior Financial Analyst
Lisa Akeson
Senior Economist
Amy Doll
Policy Analyst
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Expert Consultants to the EFAB (from EPA)
Stephen Allbee
Chief, Municipal Assistance Branch
Office of Wastewater, Enforcement,
and Compliance
Marian Cody
Analyst
Giants Administration Branch
Office of Administration and
Resources Management
Ann Cole
Small Community Coordinator
Office of Regional Operations and
State/Local Relations
Michael Deane
Environmental Protection Specialist
Office of Wastewater, Enforcement,
and Compliance
Ellen Haffa
Analyst
Grants Administration Branch
Office of Administration and
Resources Management
James Home
Director, Water Policy Office
Office of Water
A. W. Maries
Senior Advisor
Enforcement and Program Implementation
Division
Office of Ground Water and
Drinking Water
Kitty Miller
Environmental Protection Specialist
Office of Water
Donald Rugh
Analyst
Office of Water
Peter Shanaghan
Mobilization Manager
Office of Ground Water and
Drinking Water
Ronald Slotkin
Analyst
Office of Research and Development
Brett Snyder
Economist
Economic Analysis and Research Branch
Office of Policy, Planning, and Evaluation
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ACKNOWLEDGEMENT
The Board wishes to thank the many finance professionals and others who assisted in the
preparation of this statement. To a great extent, this statement reflects the diverse input of
experts in the field from academia, state and local government, the investment banking
community; and professional organizations.
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