The lasting legacy of the taxable bond option program known as Build America Bonds, or BABs, is likely to be measured by the success of the securities in opening up new global credit markets to investment in American infrastructure, a feat that is long overdue.
Lawmakers and Treasury Department officials should, however, consider three changes to the rules for issuing BABs, in order to make the taxable bond option more effective for infrastructure finance:
• The tax code should permit the exemption feature inherent in a tax-exempt bond — a reduction in gross income, not a tax credit — to be stripped and sold separately from the related bond.
• Exemption-stripped BABs should not be limited to governmental bonds, but should instead be available for basic infrastructure facilities developed by private firms.
• Private developers of basic infrastructure facilities that qualify for exemption-stripped BABs should also be eligible for accelerated depreciation.
Each recommendation is consistent with the principles of Madisonian fiscal federalism. Each recognizes and coincides with public policy goals of both the U.S. Treasury and state and local government units, while reducing costs for both.
First, the point of exemption stripping is to align the federal revenue loss (implicit subsidy) with the gain to states and localities, by eliminating the “windfall” gain to high-bracket taxpayers available in the current tax-exempt market. Exemption stripping allows this, without a political determination by Congress of the size of the subsidy, an annual congressional appropriation, or a federal offset.
The utility of trafficking in tax benefits has been recognized by the provisions concerning tax-credit BABs, but the tax benefit more likely to be in demand is a deduction from gross income (shelter), not a credit (yield).
Stripping the exemption would work like this: Assume market interest at 5% and tax-exempt interest at 4% on a $10,000 BAB. A tax-exempt bond would produce $400 in annual interest, together with a reduction in gross income of $400 annually. An investor seeking stable long-term cash returns would buy the cash-flow portion ($400 per annum) at a price that would produce a 5% annual return. A U.S. taxpayer seeking shelter would buy the exemption ($400 per annum) at its present value under expected marginal rates.
High-bracket taxpayers would clear the market for the tax benefit, once they no longer have to link their demand for shelter to the purchase of a long-term, low-interest bond. This would eliminate the high-bracket windfall, reduce the yield municipal issuers would have to offer, and reduce the revenue loss to Treasury.
The expanded market of global investors for the cash flow could, by exponentially increasing demand, further reduce municipal yield, and as a result, the federal cost of the subsidy. It looks like a win-win.
Second, the point of eliminating the requirement that BABs qualify as governmental bonds under the tax code is to level the capital-raising playing field, in cases where states choose to achieve public ends through private means.
One way to do this is to add to the list of exempt facilities in Section 142(a) of the tax code all categories of basic infrastructure — starting with bridges, tunnels, and roadways — without any volume cap. BABs, especially exemption-stripped BABs, should be available for exempt facilities determined to be components of our basic infrastructure.
In this way, the object of the subsidy is the category of infrastructure, whether or not it is owned and operated in substance by a private firm. The latter consideration is largely irrelevant, if the point of the policy is to encourage investment in basic infrastructure. It’s better if things turn on the type of project rather than the type of user. And since basic infrastructure like bridges, tunnels, and roadways is already financed largely with tax exempts, this wouldn’t undercut an understandable federal preference for limiting, at least not expanding, tax-preferred debt instruments like BABs.
Finally, the point of permitting developers to use a tax advantage like accelerated depreciation, along with tax-preferred financing like BABs, in connection with targeted basic infrastructure facilities is that each tax incentive has a separate and distinct purpose. Recognizing one purpose does not require ignoring the other.
Accelerated depreciation aims to encourage capital investment across the board. It does not focus on specific projects thought to be operated in the public interest.
BABs aim to encourage the building of American infrastructure, without regard to the means chosen by the states to do so. BABs should have a laser-like focus on the categories of basic infrastructure, promoting specific types of projects operated in the public interest.
As long as the infrastructure categories are carefully defined, double-dipping concerns appear beside the point. Dual purposes, both important, may require dual incentives, in order to avoid undercutting either purpose.
To summarize, the BAB taxable bond option, to the extent it opens new markets for investment in American infrastructure, is a welcome development. BABs could, however, be improved.
Stripping the exemption is a better way of eliminating the inefficiency in the current market, without undermining principles of fiscal federalism by triggering ongoing federal political involvement.
Eliminating the BAB requirement of governmental bonds and including private activity bonds for targeted categories of basic infrastructure eliminates a counterproductive bias in favor of public means over privatization.
Dropping the need to make a Hobson’s choice like the one between BABs and accelerated depreciation allows us, at this time of crumbling infrastructure (not to mention low employment), to pursue two important policy goals at once — more investment in basic infrastructure and more capital investment itself.
In short, there should be better BABs, and more of them.
Eugene W. Harper Jr., a retired New York bond lawyer, teaches infrastructure finance at the School of Public Affairs, Baruch College, City University of New York.
