If the purpose of the expenditures of the bonds are not for the general “good of the people,” they must be issued as taxable bonds and the interest income generated is subject to federal income tax. Depending on where the investor lives, the interest might also be subject to state and local income taxes. For this reason, the investor of a taxable bond will require a higher yield compared to a tax-exempt bond.
There are three possible advantages for an issuer to issue taxable bonds:
- Taxable bonds have fewer federal restrictions when being issued
- The universe of potential buyers is larger than for tax-exempt bonds (e.g., international investors)
- Due to tax law, only taxable bonds can be used to execute refinancings of certain outstanding bonds
What’s important here?
For a public issuer to issue tax-exempt bonds, the project generally must meet certain public purpose tests from the IRS. By using taxable bonds issuers have more flexibility on what types of projects they’re able to finance (e.g., sport facilities, pension programs, economic development projects).
