The U.S. needs bold proposals that can quickly address America’s crumbling roads, bridges, airports, dams and more. I believe part of solution lies with direct-pay taxable bonds.
The President and Democratic Congressional leadership met at the end of April to discuss the country’s infrastructure and announced a $2 trillion plan. But both sides of the aisle didn’t discuss how to offset the costs for the long-overdue investments. That topic, which has stymied progress in the past, as well as how to invest $2 trillion to infrastructure, was punted to a future meeting, which could occur this week.
How can it be done?
Federally funded infrastructure programs are critical. Sometimes they are the only viable means for infrastructure investment for certain projects. However, spending programs come with a high federal price tag, and raising taxes can be challenging in any political environment. Is there a way to leverage federal dollars through programs that reduce the price tag while still increasing overall infrastructure investment?
Tax-preferred federal financing is part of the solution. Financing brings private investment alongside public dollars at a much lower price tag to the federal government while granting state and local governments greater responsibility over the investment projects.
Let’s be clear: there is no free lunch. Financing cannot substitute for direct funding and legislators will need to find revenues if they want to pay for infrastructure investment. Ultimately, taxpayers will be paying for infrastructure, whether through federal or state investment (taxes) or private investment (tolls, etc.). But even small changes to improve markets can lead to significant savings. Cheaper financing means more dollars in taxpayers’ pockets and ultimately more infrastructure investment.
Century-old municipal bonds are one of the most successful financing mechanisms Congress has authorized. On average, states and localities issue $350 billion of tax-exempt municipal bonds annually. In fact, two-thirds of all U.S. infrastructure is financed through the tax-exempt muni market. As a result, municipal bonds have helped build this country’s infrastructure — from schools and fire stations to community centers, to fixing crumbling bridges and underwater tunnels, all for the benefit of our citizens.
However, there are other, complementary ways in which the federal government can help its counterparts at the state and local level in their efforts to build bridges, highways and hospitals.
This brings me to 2009 when Build America Bonds (BABs), a direct pay taxable bond, were introduced as part of the American Recovery and Reinvestment Act. They were created to help stimulate the economy at the height of the global financial crisis and when the tax-exempt market was in distress. I directly worked on creating BABs. Direct-pay bonds are taxable bonds that allow the issuer to elect to receive a payment for a portion of the interest on the bond. Due to the nature of it being a temporary stimulus program, the interest rate reimbursement for BABs was set at 35% and it expired in 2010. I worked on various proposals to create a permanent BABs program, with a reduced subsidy to accommodate revenue concerns and investor demand.
I should note that these bonds were particularly attractive to investors who are not “tax sensitive,” since the payments travel directly to the bond issuers, rather than indirectly through the tax-exemption to the investor. Those investors were primarily institutional with long investment horizons as well as tax-exempt and foreign (also tax-exempt) buyers. As such, BABs tapped a new investor class for public infrastructure investment. This was somewhat unprecedented in the municipal space.
In hindsight, we can realize how successful BABs were in their intended goals of stimulating the economy and building infrastructure. More than $182 billion of BABs were sold that allowed state and local governments to continue to make public infrastructure investments that would have been delayed or not occurred.
Not surprisingly, some politicians were critical of the program, arguing that the BABs subsidy was too high and the benefit to smaller states and localities too low. And then, of course, state and local governments felt burned – rightfully so – when a portion of the interest subsidy was haircut when an automatic budgeting mechanism called “sequester” was triggered. To control federal spending, Congress enacted this automatic mechanism that in a relatively indiscriminate manner limits federal payments, even payments effectuated through the Tax Code.
Ironically, by providing a taxable bond option for issuers, the BABs program made the tax-exempt market more efficient, by relieving $182 billion of supply pressure that was driving up interest rates in the tax-exempt market. Shortly after introduction, tax-exempt bond yields fell to pre-financial crisis levels, and jolted state and local government financing.
Other proposals sought to address at least some of the concerns raised with the BABs program. President Obama’s 2012 budget proposal lowered the subsidy level to 28%, and Sen. Ron Wyden’s (D-OR) Clean Energy for America Act would reimburse issuers for any future sequester on newly issued bonds. Addressing these issues is critical for any potential policy to succeed.
The tax-exempt muni market is the gold standard for affordable infrastructure financing. Incorporating a direct-pay taxable bond alongside tax-exempt bonds not only enhances the muni market but attracts a different, larger investor class who have longer-term investment horizons and don’t necessarily need the tax subsidy. It makes little sense to leave any investor classes representing trillions of potential investment, such as pension funds and endowments, on the sidelines because there is no efficient way for them to invest in U.S. public infrastructure.
Accessing a permanent BABs-like program along with traditional municipal bonds would give states and localities the option to choose which program best fits their needs. By adding new private investor groups, market efficiencies would be created that add up to significant cost savings for infrastructure projects.
Finally, allowing a comparable private activity bond program for direct-pay taxable bonds would finance more than governmentally owned projects and it would generate even more investment.
This is a win-win-win for the U.S.
It’s a win to the federal government by lowering its cost of subsidizing infrastructure, and it’s a win for states by lowering their cost on their debt financing. The win on the demand side is equally significant by providing a creditworthy investment vehicle that matches investor appetite.
You want fiscal federalism? Here it is.
Even if the multitrillion-dollar infrastructure effort fails – which it very likely might-- Congress is already working to reauthorize the surface transportation program that expires at the end of fiscal 2020.
We’ve got a long road ahead. Congress and the White House should learn from prior successes and include long-term, scalable, simple financing programs direct-pay taxable bonds as part of infrastructure legislation.
