Special tax bonds are a unique and critical aspect of municipal bonds that investors often encounter. They are instrumental in funding specific projects by leveraging taxes on specific goods or services. This article will delve into the intricacies of special tax bonds, providing you with a solid understanding of their definition, examples, backing, and security.
Definition and Examples of Special Tax Bonds
Special tax bonds are municipal bonds backed by the revenue from a specific tax, which could include:
- Sales Taxes: Often collected from specific products like gasoline or tobacco.
- Excise Taxes: Levied on particular goods, such as alcohol.
- Hotel Occupancy Taxes: Targeted at tourism-related expenditures.
- Utility Taxes: Imposed on services such as water, electricity, or telephone usage.
These bonds are not backed by the full credit of the issuing municipality, making them a type of non-general obligation bond. They are often issued for specific purposes, such as infrastructure improvements, public projects, or economic development initiatives.
Backing and Security of Special Tax Bonds
How Are They Secured?
Special tax bonds differ from general obligation bonds as they are secured by revenues from a dedicated tax source rather than the general taxing authority or the credit of the issuing issuer. This specificity in funding makes them unique.
How it Works:
- A city decides to improve its park facilities. To fund this, it issues a special tax bond.
- The bond is backed by a dedicated sales tax increase on alcohol.
- As people purchase alcoholic beverages, that additional sales tax collected is earmarked to repay the bondholders.
Risks and Considerations
While special tax bonds offer a secured return backed by a tax, investors must consider the volatility and elasticity of the taxed good or service. Factors influencing these include:
- Decline in Consumption: If the product taxed experiences a significant reduction in consumer usage, revenue might fall short.
- Government Policy Changes: Legislatures could alter or remove the tax, affecting bond security and returns.
- Municipal Bond: A bond issued by local government or territory, or one of their agencies, typically to finance public projects.
- Non-general Obligation Bond: A bond backed by specified revenues rather than the full guarantee of the issuing entity.
- Excise Tax: An indirect tax charged on the sale of a particular good.
- Revenue Bond: A bond supported by the income generated from a project or specific source.
Additional Resources
Quizzes
### What distinguishes a special tax bond from a general obligation bond?
- [x] Specific tax revenue backs it, not general taxes
- [ ] It is backed by the full faith of the issuing authority
- [ ] It is only used for federal projects
- [ ] It requires a municipal referendum for approval
> **Explanation:** Special tax bonds are secured by specific tax revenues, whereas general obligation bonds are backed by the full faith and credit of the issuing authority.
### Which of the following taxes could back a special tax bond?
- [x] Sales tax on hotel rooms
- [ ] Federal income taxes
- [x] Excise tax on tobacco
- [ ] Corporate income taxes
> **Explanation:** Sales tax on hotel rooms and excise taxes on specific goods like tobacco can back special tax bonds, as they rely on specific, dedicated revenue streams.
### A city issues a special tax bond backed by alcohol sales tax. If alcohol sales decline, what risk is introduced?
- [x] Revenue may be insufficient to repay bondholders
- [ ] The bond automatically becomes a general obligation bond
- [ ] The tax rate can be increased without legislation
- [ ] The bondholders can sue the government for losses
> **Explanation:** Decreased alcohol sales can result in lower tax revenues, possibly leading to insufficient funds to repay the bondholders.
### Which statement about special tax bonds is correct?
- [x] They are considered "non-general obligation" bonds
- [ ] They are used to fund federal projects
- [ ] They are backed by property taxes
- [ ] They involve mandatory bond insurance
> **Explanation:** Special tax bonds are "non-general obligation" bonds, secured by specified tax revenues.
### When considering the risk of a special tax bond, what should investors assess?
- [x] Elasticity of taxed goods/services
- [ ] National GDP growth rates
- [x] Potential policy changes affecting taxation
- [ ] Federal interest rate adjustments
> **Explanation:** Investors should evaluate the consumption patterns (elasticity) of the taxed goods and any legislative changes that could impact tax collection.
### In which scenario might a special tax bond offer greater security compared to other non-general obligation bonds?
- [x] When it's backed by historically stable tax sources
- [ ] When the issuing municipality is frequently in deficit
- [ ] When backed by highly volatile tech sales taxes
- [ ] When it is not monitored by regulatory agencies
> **Explanation:** Stability in the tax source provides security to the bondholders, reducing the risk of default.
### A bridge renovation in a city is funded by a special tax bond. The bondholders are repaid with funds from...
- [x] A tax on car rentals
- [ ] General city taxes
- [x] Toll collection fees on the bridge
- [ ] Income taxes from local business
> **Explanation:** Bondholders may be repaid via dedicated taxes on car rentals and toll fees related to the project they fund.
### What is a critical consideration before investing in a special tax bond?
- [x] Revenue stability of the specific tax
- [ ] The overall employment rate in the region
- [ ] Corporate tax rate stability
- [ ] Political party in charge
> **Explanation:** Investors need to ensure the revenue from the specific tax source is stable and sufficient for bond repayment.
### How can government policy changes impact special tax bonds?
- [x] They can reduce or eliminate the supporting tax revenue
- [ ] They can convert the bond to a corporate bond
- [ ] They can change the bond’s purpose entirely
- [ ] They can transfer the bond to another municipality
> **Explanation:** Changes in government policy can lead to amendments or removal of the tax, affecting its revenue source.
### A special tax bond can only be considered a "revenue bond."
- [x] True
- [ ] False
> **Explanation:** True. Special tax bonds are considered a type of revenue bond because they are backed by specific tax revenues, not the general taxing ability of the issuing authority.
Summary
In conclusion, special tax bonds are noteworthy instruments within the municipal bond sector, characterized by their reliance on specific tax revenues for security. Investors who understand the nuances of these bonds, including the scenarios in which they are issued and the risks associated with them, can leverage them strategically in their portfolios. With proper analysis of tax source stability and legislative backdrop, special tax bonds can provide rewarding investment opportunities.