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New BABs Could Cause Old Problem: Too Many Deals

The Obama administration’s proposal to renew the Build America Bond program may suffer from the same problem it had the first time around, when the federal government didn’t think municipalities would use BABs that much.

The 35% interest subsidy bestowed upon state and local governments issuing taxable bonds under the American Recovery and Reinvestment Act turned out to be too generous.

Comparing the cost of selling long-term tax-free debt with long-term taxable debt minus 35% of the interest cost, municipalities resoundingly found it economical to take the subsidy.

The result was a far more mammoth wave of taxable bond sales under the BAB program than expected — $181.5 billion in 21 months, according to Thomson Reuters.

The federal government’s assumption that the subsidies would cost $340 million annually now seems laughable. Thanks to the heavier-than-expected issuance, Washington is on the hook for roughly $2.6 billion in cash subsidies a year.

This time around, the administration wants to cut the subsidy to 28% — the rate it believes will be “revenue-neutral.”

Revenue neutrality is a way of saying the subsidies the government pays municipalities on taxable bonds will be roughly equal to the taxes the government doesn’t collect on the tax-exempt bonds municipalities otherwise would have issued. In that sense, the subsidy pays for itself, relative to the tax exemption.

The federal government projects it would pay out $14.3 billion in subsidies to state and local governments over the next five years under the renewed BAB program, and effectively collect every cent of it back, in the sense that municipalities issuing taxable bonds are refraining from issuing tax-exempt bonds.

Tax-exempt bonds have a cost to the government, too, because it is not charging taxes on the interest income. The government estimates this abstract cost at about $230.4 billion over the next five years.

Though the budget does not estimate what the cost of the tax-exemption would be should BABs be renewed, presumably the federal government believes the reduction in the cost of the tax-exemption along with the taxes charged on BABs’ interest income would equal the cost of the BAB subsidy.

The current average yield on BABs is a little less than 6.4%, according to a Wells Fargo index. Holding this rate steady, the federal government’s assumptions for subsidy outlays imply it expects municipalities would sell about $17 billion of BABs next year, and an average of $45 billion a year over the next five.

But opening the subsidized taxable market up to municipalities again would almost assuredly result in a resurgence of issuance in excess of that ­assumption.

The 30-year tax-exempt borrowing cost for a double-A rated borrower right now is 5.11% — and that’s with minimal long-term tax-free issuance so far in 2011.

Selling taxable bonds at the average rate in the Wells Fargo index would result in an after-subsidy cost of 4.6%, a clear benefit to the municipality.

Granted, if the budget is correct that 28% is the revenue-neutral rate, the cost of the additional taxable bond issuance would be offset by the benefit of the reduction in tax-exempt issuance. In that respect, there would be no cost for underestimating issuance, unlike the original program.

Reports in past years have implied the federal government believes the average tax rate paid by investors in municipal bonds is lower than 35%. So every time a municipality issued BABs, the federal government ended up paying a 35% interest subsidy instead of not collecting less than that in taxes.

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