What is Tax-Exempt Commercial Paper?

Tax-exempt commercial paper is short-term debt for which the interest payments are tax-exempt at the federal, state or local level.

How Does Tax-Exempt Commercial Paper Work?

Universities are some of the most common issuers of tax-exempt commercial paper. For example, let's say University XYZ needs to borrow money for, say, 90 days to finish construction on a new basketball arena. The university obtains permission from the federal government and from the government of the state in which it exists to issue $2 million of tax-exempt commercial paper. This permission essentially allows buyers of the debt to avoid paying income tax on the interest payments from the commercial paper.

Because the interest rates on tax-exempt debt are typically lower than interest rates on taxable debt, this allows University XYZ to borrow money at lower rates than it might otherwise have to pay if it borrowed the money from a bank. The commercial paper also might attract more buyers because the buyers don't have to pay taxes on the interest they receive.

Why Does Tax-Exempt Commercial Paper Matter?

Tax-exempt commercial paper is a way for governments to support the funding efforts of certain entities and institutions without having to provide cash to those entities and institutions directly. Although the government 'gives up' the taxes it might otherwise collect on the interest payments that the bondholders receive, it may do so knowing that the funding that the borrowing entity obtains will serve the area's citizens in a way that is more valuable than the lost tax income.