WASHINGTON - Texas and California account for nearly half of the $14.6 billion in direct-pay Build America Bond subsidy payments that the Treasury Department is already committed to paying issuers for the $24.1 billion of BABs they have issued during the past few months, according to a Bank of America-Merrill Lynch research report released yesterday.

Furthermore, the Treasury likely will have to commit to a total of more than $50 billion in subsidy payments over the program's current two-year lifespan, with most of these payments to be made to large states, the report stated. The BAB program is currently scheduled to expire at the end of calendar year 2010.

California is slated to receive $4.653 billion in BAB subsidy payments for bonds it has already issued, accounting for 31.9% of all of the BAB subsidies due thus far. Texas will get $2.546 billion in BAB payments, a 17.4% share of the total. New Jersey comes in third, with $1.406 billion in cash subsidies, for 9.6% of the total.

The report also tackled a recent document released by the Congressional Budget Office that outlined a number of budget moves Congress could make, including several that would substantially affect the municipal market.

The CBO determined the budget impacts of replacing all tax-exempt bonds with tax-credit bonds, limiting or eliminating private-activity bonds, and reinstituting a 1997 cap that limited a nonprofit organization's outstanding holdings of tax-exempt bonds to $150 million.

But Bank of America-Merrill stated that any savings the U.S. government could reap from these moves would "at best be said to be small amounts in the multitrillion-dollar federal budget."

The CBO found that a wholesale replacement of tax-exempt bonds with tax-credit bonds would save $19.8 billion over the next 10 years, while elimination of PABs would save just $23 billion over the same time frame. Capping the amount of bonds nonprofits can issue would yield just $2.1 billion in savings over the next decade.

The CBO said that under the wholesale tax-credit replacement option, Congress could adjust the size of the credit "on the basis of its perceived benefit to the public." However, the research report says such a capacity "opens the door to having the Congress allocate capital in the muni market in a potentially arbitrary and capricious way."

Though the CBO noted that the tax-credit subsidy would not automatically be subject to annual review by federal lawmakers, Congress would not be barred from tinkering with the subsidy in the future.

If Congress required muni issuers to issue tax-credit bonds rather than tax-exempts, the risk that the lawmakers might lower the tax-credit rate would "materially raise the financing cost" as issuers include extraordinary calls in their transactions. This practice is currently underway with most BAB issues, according to the report.

The U.S. government and a few think tanks have argued that tax-exempt interest payments are an inefficient way for the government to subsidize state and local debt and the tax-credit option would provide the government a greater return on its foregone revenues.

However, the research report said that this "is an old argument predicated on a basic misunderstanding of how efficiency is achieved in financial markets." The report contended that any inefficiencies in the muni market stem from the fact that tax arbitrage is largely avoided in that market sector.

"Without tax arbitrage, one should not expect tax efficiency," it stated.

But the CBO document also contained a number of budget options that would be boons to the municipal market by raising the effective tax rate of individual taxpayers, most notably raising all income tax rates by 1% or eliminating the AMT. An income tax hike would also bring in far more revenue than all the muni proposals combined - $454.8 billion over 10 years.

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