What is a Tax Anticipation Note?

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

A tax anticipation note is a unique form of an IOU that many towns and cities use. In this lesson, we will explore how governments use these notes to finance themselves based on future tax revenue.

Sandwich Shop

Imagine you work at a sandwich shop, and make $10 per hour. You are usually pretty good at saving money, but you recently started dating someone special and you've spent most of your paycheck on dinner and gifts for that person. You now regret that decision because you need to buy your brother a birthday gift. He mentioned he would like a new smartphone, and you also hinted that you would get it for him. So, you turn to your best friend. You tell him that if he lends you $200 you will pay him back in 2 weeks when you receive a lump-sum of $1,000 for selling your old car. Your friend was there when you sold the car. He knows you will receive the $1,000 payment for the buyer in 2 weeks.

That simple example describes, in essence, what a tax anticipation note is. An IOU (i.e. bond) is issued when payment depends on the future collection of money. In this lesson, we'll go into further detail about tax anticipation notes. We'll give the formal definition, along with more detailed examples.

Definition

A tax anticipation note (TAN) is a municipal bond in which payments (i.e. interest and principal payment) are secured by future tax revenue. Governments largely finance themselves through taxes, like property taxes or sales tax, but the collection of those taxes is lumpy. In other words, the collection of those taxes is not spread smoothly throughout the year. For property taxes, for example, collection may only happen once every 4 to 6 months, and yet the government has constant expenses throughout the year. The tax proceeds, then, need to be spread throughout the year.

There are times when they try to spread out the proceeds, but they still do not end up with the funds they need. For example, a town may need $100,000 in the final month before they receive property tax proceeds. In that case, the town may issue a TAN. They will specifically say in the bond contract that the security of the TAN is based on the property tax proceeds they expect to get in a month. In essence, the town is 'pulling forward' their tax collection. You can also think of TANs as bridges. They help the town traverse a 'financial crevasse' by providing the needed money to either fund their operations or to pay for a new project.

Real-Life Examples

Let's imagine that you are the mayor of a small town in the northern part of the country. Winters are quite fierce in your town and in about a month's time snow will start to fall. But you want to build a new wing of the hospital right now. In fact, you guaranteed the residents you would build it before the start of winter. The only problem is the town does not have the extra money to finance the project now. They will have the money in 2 months, however, when property taxes are collected. What you as the mayor could do to alleviate this problem is issue a TAN right now and use the proceeds to build the new hospital wing. when you issue the TAN, you will guarantee the bondholders that they will be repaid with the proceeds the town will collect in property taxes in 2 months. Like we mentioned above, you are 'pulling forward' the tax collections, so you can build the new wing now.

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