The list of higher education business and tax practices that have fallen into U.S. Sen. Charles Grassley's crosshairs -- endowment spending,  big-time intercollegiate athletics,  investments in offshore hedge funds,  presidential compensation  -- has just grown by one.
The Congressional Budget Office on Friday released a study  (which Grassley had requested in 2007)  asserting that colleges and universities may inappropriately benefit from federal tax law by issuing tax-exempt bonds to, essentially, subsidize investments in higher-yield assets.
Although the CBO doesn't come right out and say it, the agency more or less implies that postsecondary institutions are taking inappropriate advantage of their nonprofit status and suggests that Congress could raise money by limiting their ability to do so -- a prospect that could prove appealing at a time when lawmakers are scouring an economically distressed landscape for "offsets" to finance other spending priorities.
Higher education tax experts were divided on how seriously to take the latest salvo from a federal government that has focused intensifying scrutiny on college and university operations.
Charles A. Samuels, a lawyer at Mintz Levin  who works with colleges and other nonprofit organizations on tax and other issues, played down the study's significance, saying it was " 'academic' in the worse sense" and "devoid of real world grounding." "Hopefully it is [dead on arrival]," he said via e-mail.
Others appeared to take the threat more seriously. "CBO has basically said that colleges are doing indirectly what it is illegal to do directly," said Bruce R. Hopkins, who heads the Nonprofit Law Center . "This is a huge invitation to Congress to change the rule, and it's part of a larger pattern in which Congress is looking harder at hospitals and colleges and other nonprofits."
The argument the budget office lays out in the report (which followed a 2006 report  on hospitals' use of tax arbitrage) goes something like this. The tax exemption that colleges and universities have because of their educational purpose affords them numerous benefits, including the ability to use tax-exempt debt to build facilities and finance other capital expenditures. The latter cost the federal government an estimated $5.5 billion in foregone tax revenues in 2010, the CBO report says.
The CBO report does not assert that colleges' ability to issue tax-exempt bonds is bad for society -- but it argues that it is not an unequivocal good, either. "On the one hand, if colleges and universities use tax-exempt financing for projects that they would complete even without the subsidy, resources are just reallocated from taxpayers to the schools with no additional social benefit," the report says. "On the other hand, if the subsidy finances capital projects that would not otherwise have been undertaken and that create a social benefit in addition to the institution, it could improve the nation's welfare."
One reason that tax-exempt bonds are popular and plentiful is because purchasers of the bonds pay no income tax on the interest they earn, and as a result, they generally accept a lower rate of interest than they would otherwise earn on comparable taxable bonds. And the issuers of the bonds -- colleges and other nonprofit entities -- pay no tax on the net income from those bonds.
Federal law expressly prohibits organizations that issue tax-exempt bonds from using the proceeds from those bonds "directly or indirectly to acquire higher-yielding investment assets or to replace funds which were used directly or indirectly to acquire higher-yielding securities." That is known as "direct arbitrage."
But what happens if, as is often the case, "colleges and universities ... use tax-exempt debt to finance investments in operating assets (buildings and equipment) while, at the same time, they hold investment assets that earn a higher return," like stocks and hedge funds? the CBO says in a blog post  about the report. "To the extent that colleges and universities can earn untaxed returns on investments that are higher than the interest they pay on tax-exempt debt, they are benefiting from a form of 'indirect' tax arbitrage," the budget office asserts.
Examining the 2003 tax returns of colleges and universities, the CBO finds that the institutions that borrowed using tax-exempt debt had total investment assets that were seven to nine times higher than their stock of tax-exempt bonds. (Most of the institutions that issued tax-exempt debt had "substantial" investment assets.) "This suggests that, as currently implemented, the subsidy is not used primarily to ease access to financial markets for schools that would otherwise have difficulty undertaking capital projects," the CBO concludes.
(This assertion echoes Senator Grassley's frequent plaints during the 2005-7 debate over college and university endowments that institutions were sitting on assets that they could be spending instead of raising tuitions -- an argument that many higher education leaders sought to counter by arguing that many endowment funds were restricted and that institutions needed to hold on to their funds for when capital markets tanked, as they did in 2008 and 2009.)
The rest of the CBO report aims to calculate how much of colleges' and universities' tax-exempt debt might reasonably be considered to be "indirect arbitrage" from which they earn returns from higher-yield assets -- and finds most of it to qualify. It also explores different ways that federal law might be adjusted to expand the definition of what qualifies as illegal arbitrage, and how colleges and universities might adjust to such a change (issuing fewer bonds and reducing their capital spending, selling or reducing their investments in stocks and alternative funds to finance their building, etc.).
Those and other responses would have a similar result: "the net cost of the tax preference to the federal government would be reduced," the CBO notes.
Sheldon E. Steinbach, a lawyer with the higher education practice of the Washington law firm of Dow Lohnes, said he was stunned that the budget office would be suggesting a change in federal law that would reduce colleges' borrowing at a time when so many of them have found it difficult to borrow in the wake of the collapse of the credit markets. (The CBO study was reportedly prepared in 2008 but its release delayed because the downturn had so changed the climate; the study notes that "there are signs that the pressures created by the financial crisis are beginning to ease.")
"Institutions have not and are not manipulating the tax-exempt bond market to take advantage of investment opportunities that might occur," Steinbach said. "Two years ago everyone was whining about how university endowments are doing. Now, with the market coming back somewhat, but still not to a position where institutions have anywhere near recouped their money, to try to threaten schools with either an investigation of their investment policy or a diminution of their ability to increase funding to aid students and the institutions, is a matter of grave concern."
Hopkins, the tax lawyer, said it was "painful to see tax-exempt organizations charged with doing something that's portrayed as quasi-illegal."
Noting that Congress, in passing the health care reform legislation last month, had imposed additional requirements to which nonprofit hospitals must adhere to maintain their tax exemption, Hopkins said that lawmakers could follow a similar approach in tightening various rules governing colleges and universities, including the arbitrage issue.
Or, Hopkins said, a Congress desperate for money to pay for other priorities without busting the budget could zero in on closing this perceived loophole, as teed up by CBO (despite the assertion in its report that it makes no "recommendations").
In a statement Friday  after the CBO report's release, Grassley was noncommittal -- but made clear his interest in exploring the issue.
“This report raises questions for parents, students, and taxpayers about universities’ issuing bonds and going into debt when they have money in the bank. Issuing bonds costs money on interest and management fees. Does the expense of debt service take money away from student aid or academic service? Do bond issuances occur even as universities raise tuition and build investment assets? These are further questions to explore.”