After years of BABs subsidy cuts, wariness of new direct-pay tools

The political headaches that have long plagued Build America Bonds in the form of annual subsidy cuts may dampen interest in President Joe Biden's new direct-pay tax credits while highlighting the value of the traditional tax exemption and even sparking new infrastructure finance proposals, market experts said.

"The exposure to the vacillations of the federal budgeting process is really an underappreciated disadvantage of Build America Bonds and the whole notion of direct pay," said Justin Marlowe,  a research professor at the University of Chicago's Harris School of Public Policy. "Today's policymakers are really reticent to think they can rely on the federal government to do its part if any part of federal subsidies are subject to appropriations."

The threat of an investor lawsuit seeking to block issuers from refunding BABs marks the latest skirmish for the popular financing tool. While politicians have often favored direct-pay as more transparent and efficient than the traditional tax exemption, future financing structures could focus on models like a national infrastructure bank, a bond bank or a federal revolving loan fund, said Marlowe and other market experts.

Created under the American Recovery and Reinvestment Act, direct-pay BABs were taxable bonds issued in 2009 and 2010 for which the federal government pledged to make payments to issuers equal to 35% of their interest costs. The instrument enjoyed a strong reception, with governments floating more than $180 billion in two years. Obama administration officials at the time assured issuers that the payments would not be subject to retroactive cuts.

From 2010 through the end of 2012, Treasury paid the full 35% subsidy. But passage of the Budget Control Act of 2011, which featured a sequestration provision, changed the calculus. Since 2013, Treasury reduced the 35% subsidy under the Office of Management and Budget's calculations anywhere from 8.7% to 5.7%. The 2019 budget maintained sequestration cuts to direct-pay bond subsidies through 2030.

The constant subsidy reductions reduce the effectiveness of direct-pay bonds for infrastructure finance, issuer groups say. And the debate over BABs subsidies remains ongoing as muni market participants worry that the subsidies may be denied entirely if Congress does not pass a so-called PAYGO waiver every year.

Congress never intended for BABs to be subject to sequestration, and OMB could — and should — simply unwind the decision, said John Godfrey, senior government relations director at the American Public Power Association. 

"The effect of OMB not making that decision falls directly on our customers," Godfrey said.

Subsidy cuts since 2013 have cost state and local governments $2.7 billion, Godfrey estimated. "We think about $260 million of that alone has fallen on public power utilities," he said. APPA filed an amicus brief with other issuer groups as part of a lawsuit that challenged the BABs subsidies cuts and that led to last year's court decision that prompted issuers to consider refundings.

Godfrey warned that the subsidy cuts may impact issuers' willingness to partake in the newly created direct-pay tax subsidies that are at the heart of Biden's Inflation Reduction Act. Under the IRA, issuers could see 30% of project costs covered, making the stakes substantially higher than the 35% interest reductions, said Godfrey.

"Since they've reneged on BABs subsidies, it's hard not to take that under consideration," he said. "It has to dampen interest or increase the cost of the project. You couldn't do the project and take at face value the idea that the full payment would be forthcoming."

The IRA's direct-pay tax credits share similar political exposure as BABs, said Martin Luby, associate professor at The University of Texas at Austin's LBJ School of Public Affairs.

"The mechanics are similar and the subsidies are much greater," Luby said. "That's why the issue is more salient now."

The "mercurial nature of Congress" worries counties that are eying tax benefits in the IRA, said Mark Ritacco, chief government affairs officer for the National Association of Counties.

"Local governments are concerned that the types of promises made by Congress when it comes to direct subsidies will be undone by future Congresses as we've seen in the last 10 years" with BABs subsidy reductions, Ritacco said. "There is this consensus feeling that long-term funding is difficult when Congress can change its mind every two years."

The traditional tax exemption "removes the need to have the conversation about the level of the subsidy; it does take some of the volatility out of this space," Ritacco said.

Luby noted that direct-pay tax credits give Congress more control over projects. They're also considered by many as more efficient and transparent than the tax-exemption.

"This debate about BABs has been going on since the '70s," he said. "A direct pay is viewed as more efficient, more equitable and more transparent relative to [the tax exemption] being in the tax code," he said. "Economists have been pushing for decades for this form of subsidy over the indirect subsidy."

Issuers have faced other challenges with BABs subsidies beyond just sequestration, including the IRS making late payments during COVID and withholding subsidies from governments that owe taxes, said Luby, who's working on a paper estimating the total cost of the subsidy cuts to issuers through 2030.

While Congress has its tax exemption skeptics, many remain broadly supportive of federal assistance for infrastructure, Marlowe said.

"There's a lot of advocacy in D.C. around the idea that there are ways the federal government can provide support that are not subject to the same year-in-year-out uncertainty as BABs and the tax credits," Marlowe said. The expansion of private activity bonds in the Infrastructure Investment and Jobs Act is one successful example, he said. Other ideas include a federal mechanism similar to state revolving funds, or federal infrastructure or bond banks, he said.

On the other hand, the IRA, if successful, could fundamentally shift the debate, said Marlowe, who has written a paper on the topic.

"The exemption has persisted mostly out of inertia and political gridlock and not being able to come up with anything else," he said. "If you get a couple of blockbuster IRA-financed projects, maybe that gets people's imagination going to think there's another way to finance infrastructure."