Not-for-profit organizations’ outstanding tax-exempt debt has risen from an inflation-adjusted $106.3 billion in 1993 to $388.5 billion in 2010. The Joint Committee on Taxation estimates that the tax exemption on bonds issued by not-for-profit hospitals and educational institutions alone costs the U.S. Treasury more than $5 billion annually in foregone income taxes. Access to the tax-exempt debt market occurs with the assistance of state and local government conduit issuers.

The conduit role played by state and local government, typically with limited transparency, has a number of implications for governmental financial condition. First, the open-ended nature of the tax exemption for debt has expanded tax-financed support for not-for-profits without regular policy deliberation. From the government perspective, there are competing incentives to playing the role of conduit. Although increased tax-exempt debt activity by not-for-profits reduces government revenues, the existence of fee-supported conduit public authorities encourages government to maximize such debt issuance since the credit risk falls squarely on the not-for-profit issuer.

Second, the supply of tax-exempt debt affects interest rates and the increased volume from the not-for-profit sector is expected to increase borrowing costs for all market participants, primarily governments. Tax-exempt debt issued by governments on behalf of not-for-profits represents a nontrivial portion of the overall municipal bond market, rising to an average of 14% of state and local public debt per capita in 2010. Research has demonstrated that increased tax-exempt borrowing within a state can increase costs for government issuers (Toder & Neubig, 1985; Hildreth & Zorn, 2005). Due to higher interest rates rates, conduit issuance for not-for-profits may not be costless to governments, as is frequently claimed (Temple, 1993).

This paper estimates the the financial implications of conduit activity for state and local governments. Not-for-profit tax return data (IRS Statistics of Income), along with structural characteristics of state income tax systems, are used to estimate the variation in foregone state income tax revenue due to the tax exemption of not-for-profit debt. The possible inefficiency of the existing conduit landscape is tested using issuance cost models for tax-exempt debt that isolate the differential costs for the variety of conduit types in California using data from the California Debt and Investment Advisory Commission (CDIAC) and official statements. The CDIAC data are also used to evaluate whether the not-for-profit tax-exempt debt directly competes for investors with governmental debt issues and, therefore drives up government interest costs.