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Will New 'Build America Bonds' Kill Off Tax-Exempt Municipal Financing?

Leonard Gilroy
July 27, 2009, 4:14pm

George Mason University finance professor John Petersen suggests in a July Governing article that Buy America Bonds—the new, federally-backed taxable municipal debt instrument created by the stimulus bill—may deal a death blow to traditional tax-exempt municipal financing...and increase the amount of infrastructure investment at the same time:

Buried in the $787 billion stimulus-spending package are some little-noticed changes in the treatment of municipal securities. In particular, the law creates a new kind of federally subsidized instrument for state and local governments: the Build America Bond.

Historically, state and local government debt has been treated as "tax-exempt," which means that the interest state and local issuers pay investors is, for those investors, exempt from federal income taxes. Over the years, that has lowered the cost of borrowing for issuers. But the value of tax-exemption to governments is fickle. During recessions, profits and incomes sink, and so do investor needs for tax shelter. Critics have long argued that the tax-exemption on municipal bonds is inefficient—the treasury loses more in forgone revenues than issuers enjoy in reduced borrowing costs.

Build America Bonds—known as BABs—are full-fledged taxable debt backed by a federal subsidy. A government that elects to sell a BAB goes without the usual tax exemption and receives instead a subsidy equal to 35 percent of the taxable interest cost it pays. Thus, if an issuer sells a bond at 6 percent, it will receive a subsidy of 2.1 percent, which means the borrowing cost will be only 3.9 percent. There are two key points here: First, the BABs can be used for any purpose that tax-exempts can be used for. Second, the level of the subsidy is so bountiful that it may spell the end of new issues of tax-exempt bonds. [...]

BABs have another attraction. They could mobilize long-term funds from pensions (and other investors that have no need for a tax exemption) for infrastructure investments. To them, a traditional muni bond to build, say, a bridge, is valueless. The BABs taxable-bond option solves that problem by making the yields on state and local bonds competitive. Among those investors sure to be attracted are foreign funds that have dollars to spend and have had enough wild rides in recent years with corporate stocks and equities. State and local governments may have their current travails, but as issuers, they have had a superior (and almost incredible) history of creditworthiness. BABs are bound to be popular.

The BAB subsidy is "open-ended," which means that the volume of BABs could soar over the next two years. The markets could see the supply of new-issue tax-exempt bonds disappear and the amount outstanding rapidly recede. In which case, tax-exempts will have been killed by kindness.

» Reason Foundation's Transportation Research and Commentary


Leonard Gilroy is Director of Government Reform


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