What Are Special Tax Bonds and How Do They Work?

Governments often raise money for infrastructure, schools, and public services by issuing special tax bonds, repaid using specific tax revenues rather than general taxpayer funds. These bonds allow municipalities to fund projects without increasing broad-based taxes.

Understanding how these bonds function helps investors assess risks and benefits while clarifying their role in government finance.

Purpose in Public Finance

Special tax bonds finance large-scale infrastructure projects without diverting funds from essential services like public safety and education. Dedicating specific revenue streams to repayment helps local governments maintain financial stability while improving transportation, water treatment, and public buildings.

Since repayment is tied to designated tax revenues, these bonds are often considered lower risk than general obligation bonds, which rely on broad tax collections. This targeted repayment structure can lead to lower interest rates, reducing borrowing costs. Many are backed by stable revenue sources like sales taxes on specific goods or services, ensuring a predictable repayment schedule that appeals to issuers and investors.

Types of Tax Revenues

Repayment of special tax bonds depends on specific tax revenues chosen for their stability and predictability. The most common sources include sales taxes, excise taxes, and other designated revenues.

Sales Taxes

Sales taxes generate consistent income from consumer purchases, making them a common revenue source for special tax bonds. These taxes are imposed as a percentage of the sale price of goods and services, with rates varying by state and locality.

When sales tax revenues are pledged for repayment, governments estimate future collections based on economic trends, population growth, and consumer spending. A strong retail sector enhances reliability, but economic downturns can reduce revenue. To mitigate risk, bond issuers often require projected tax collections to exceed debt service obligations by a margin, such as 1.5 times the annual debt payment.

Excise Taxes

Excise taxes, levied on specific goods like gasoline, tobacco, and alcohol, often fund projects related to the taxed product. For example, fuel taxes frequently support transportation infrastructure. The federal gasoline tax, set at 18.4 cents per gallon, helps finance road and transit projects.

Unlike sales taxes, excise taxes are typically imposed on a per-unit basis rather than as a percentage of the sale price. This means revenue depends on consumption levels rather than price fluctuations. While this can provide stability, changes in consumer behavior—such as reduced smoking rates—can impact collections. Governments may adjust tax rates or introduce minimum revenue guarantees to ensure sufficient funds for repayment.

Other Designated Revenues

Special tax bonds may also be backed by hotel occupancy taxes, utility fees, or special assessments on property owners. These sources are often tied to specific projects, ensuring those who benefit contribute to funding. Many cities impose hotel taxes to finance convention centers or tourism-related infrastructure, with rates typically ranging from 5% to 15% of the room charge.

Utility fees, such as charges for water or electricity, provide stable revenue since demand for essential services remains consistent. However, regulatory changes or conservation efforts can influence collections. Special assessments, which levy additional charges on property owners in designated districts, are another option. These are commonly used for local improvements like street lighting or drainage systems, with property owners paying based on lot size or frontage length.

Diversifying revenue sources enhances the security of special tax bonds, making them more attractive to investors and ensuring financial sustainability.

Legal Framework for Issuance

Governments must comply with legal requirements before issuing special tax bonds to ensure transparency, fiscal responsibility, and investor protection. The process typically requires legislative or voter approval, depending on the jurisdiction. Many states mandate a public referendum if bond issuance exceeds a certain threshold. For example, California’s Proposition 218 requires voter approval for certain local government taxes that secure bonds.

Issuers must also adhere to federal securities laws, particularly those enforced by the Securities and Exchange Commission (SEC). Special tax bonds are municipal securities subject to the Securities Act of 1933 and the Securities Exchange Act of 1934, which regulate disclosure and anti-fraud provisions. The Municipal Securities Rulemaking Board (MSRB) sets rules on the sale and reporting of these bonds, requiring issuers to disclose financial details, including revenue projections and debt service coverage.

State and local regulations further shape bond structuring, including limits on debt issuance and permissible tax revenue uses. Many states impose debt ceilings, restricting total outstanding bonds relative to annual revenue. For example, Texas limits certain local government debt to 10% of assessed property value. Bond covenants—legally binding agreements between issuers and bondholders—outline terms like reserve fund requirements and revenue collection procedures to safeguard repayment.

Redemption and Payment Structure

Repayment of special tax bonds follows a structured schedule aligned with pledged revenue streams. Debt service may be structured with level payments, keeping principal and interest stable, or with ascending payments that increase gradually to match projected revenue growth. Issuers use revenue forecasts to determine the most sustainable approach.

Many special tax bonds include call provisions, allowing issuers to repay outstanding debt before maturity. This can be beneficial if tax revenues exceed projections, enabling early redemption to reduce interest costs. For example, a municipality issuing bonds with a 10-year call provision may refinance at a lower rate if revenue collections are strong. Conversely, non-callable bonds lock in repayment terms, providing predictability for investors but limiting an issuer’s flexibility.

Reporting Requirements

Governments must adhere to strict reporting standards to maintain transparency and provide investors with financial information. These requirements help bondholders assess creditworthiness and monitor whether pledged revenues meet debt obligations.

Issuers must submit annual financial reports detailing revenue collections, debt service coverage ratios, and material changes affecting repayment. The SEC enforces these requirements under Rule 15c2-12, mandating continuing disclosure agreements for municipal bonds. These agreements require issuers to file financial statements with the MSRB’s Electronic Municipal Market Access (EMMA) system. Failure to comply can lead to penalties and higher borrowing costs.

Governments must also report significant events that could impact bond performance, such as legislative changes, economic downturns, or tax policy shifts. Rating agencies monitor these bonds, reviewing financial reports to assess repayment likelihood. A credit rating downgrade due to insufficient tax collections can affect market perception and future borrowing terms.

Potential Tax Liability for Holders

Investors in special tax bonds must consider tax implications, as federal and state laws impact returns.

Interest earned on most municipal bonds, including special tax bonds, is typically exempt from federal income tax if the proceeds fund qualifying public projects. However, some bonds, particularly private activity bonds, may be subject to the Alternative Minimum Tax (AMT).

State taxation varies. Some jurisdictions exempt interest from municipal bonds issued within the state while taxing income from out-of-state bonds. Additionally, capital gains from selling these bonds at a profit are generally taxable, meaning investors must account for potential liabilities when buying or selling bonds.