Tax Changes Spark Innovation In Bonds for Small Borrowers
LAST YEAR'S federal tax legislation has already had one of the effects intended by the free-market thinkers who designed it: There has been a sharp cutback in interest-rate subsidies. That has forced many small businesses with financing needs into the public credit markets, where the cost of borrowing is higher.</br></br>But the tax legislation also has spawned innovations aimed at keeping the added interest burden to a minimum. "We're in the infancy of a whole new bond-financing technology," says Ronald E. Muller, chairman of Developing Systems Ltd., a Washington, D.C., company that designs financing mechanisms for businesses and government agencies.</br></br>A prime target for cutbacks on subsidized interest rates were industrial development bonds, a source of low-cost financing that had grown increasingly popular over the past decade. Issued by state, county or other municipal development agencies on behalf of small-business borrowers, IDBs had two main attractions. First, the interest they paid was exempt from federal taxes. And second, banks could deduct 80% of the interest they paid to borrow money to invest in IDBs. That made banks by far the biggest buyers of such bonds.</br></br>The tax bill took several whacks at tax-exempt IDBs. It disallowed their use in many kinds of projects, particularly real-estate development. It cut in half the amount of such IDBs a state could issue each year. And, most important, it eliminated the 80% exclusion for banks, which lost much of their incentive to buy the bonds.</br></br>THE IMPACT was dramatic. The Council of Industrial Development Bond Issuers in Washington estimates the volume of new IDBs issued by state and local development authorities on behalf of small businesses in 1986 was only about half the previous year's $17.5 billion total. (Though the tax bill didn't become law until Jan. 1, 1987, uncertainty about its provisions kept banks out of the market for small-issue IDBs most of the year.)