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Myth vs. Fact: The Build America Bond

This Successful Financial Tool Deserves Congressional Support

SOURCE: AP/Harry Hamburg

Critics such as Sen. Charles Grassley (R-IA), above, misrepresent the Build America Bonds program. The program radically improves the way federal support for local projects is delivered, helps taxpayers by lowering state borrowing costs, and reduces back-door subsidies for high-income buyers of municipal bonds.

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Opponents of the Build America Bonds program are stepping up their attacks on this innovative public-works financing tool, hoping Congress will let it expire at the end of the year. That would be a shame. The reason: These federally subsidized bonds are proving to be a breakthrough innovation in municipal finance, one that helps states and cities fund thousands of job-creating infrastructure projects at lower costs than traditional tax-exempt municipal bonds.

Critics such as Sen. Charles Grassley (R-IA) misrepresent the Build America Bonds program, created in 2009 as part of the American Recovery and Reinvestment Act. They inaccurately claim it’s a bailout program that bloats the size of state and local governments and rewards fiscal irresponsibility.

In fact, this program radically improves the way federal support for local projects is delivered, helps taxpayers by lowering state borrowing costs, and reduces back-door subsidies for high-income buyers of municipal bonds. This is why Congress should extend the Build America Bonds program before year-end. To prove our point, we address some of the dominant myths coming from misinformed critics of Build America Bonds and then deliver up the facts.

Myth: Build America Bonds are a “bailout” of state governments

Columnist David Reilly of The Wall Street Journal on Tuesday called Build America Bonds a state budget “bailout” that should be scrapped. Grassley that same day called for a Government Accountability Office audit, saying the program provides a “richer subsidy at a much higher cost to U.S. taxpayers.” They are wrong on both counts.

Fact: Build America Bonds save taxpayer dollars

Build America Bonds are no more a “bailout” of local governments than are tax-exempt municipal bonds, which Grassley seems to support, and which Reilly fails to even mention. For nearly 100 years, interest on municipal bonds has been exempt from federal income taxes. That makes them attractive to investors and allows local governments to issue lower cost debt. But it comes at a cost to the federal treasury in the form of income taxes that would otherwise be collected from these investors.

The tax exemption, therefore, is a federal subsidy—and a highly inefficient one. Instead of the entire subsidy going to the local governments, 20 percent of it ends up in the pockets of the wealthiest bond investors, according to the Treasury Department. (To understand how and why that happens, read this detailed explanation.)

Build America Bonds eliminate this windfall to high-income investors by funneling the federal subsidy directly to states rather than to states and rich people through the tax code. Here’s how it works. The bonds issued under the program are taxable, meaning the interest they pay out is considered ordinary income by the Internal Revenue Service, just like the interest on any corporate or federal bond. Once they’re issued, however, the federal government covers a portion of the interest payments made by states. This is a far more efficient way of using federal resources to reduce state borrowing costs.

The Treasury estimates that, even after underwriting fees, state and local governments have saved more than $12 billion by issuing Build America Bonds rather than tax-exempt bonds. The savings are achieved largely by eliminating the windfall to high-income investors.

The bottom line: Whether the federal government subsidizes local projects by giving states money or by forfeiting tax revenues, the effect on the Treasury is the same. A subsidy is a subsidy. If one is a “bailout,” so is the other. The difference between Build America Bonds and tax-exempt bonds is that the subsidy doesn’t flow to high-income investors. That means the federal aid goes entirely toward lowering the state’s borrowing costs.

Myth: Build America Bonds increase the size of the federal government

Grassley’s office said the Build America Bonds program “increases the size of the already-bloated federal government, because it takes what used to be a tax-cutting program, namely municipal bonds, and convert that into Build America Bonds.” That’s not true.

Fact: Build America Bonds don’t grow government—they make it more efficient

Grassley’s statement ignores how tax breaks really work. There is no meaningful difference between a “direct” spending program and a spending program that delivers money to people by allowing them to avoid taxes everyone else has to pay. That’s why economists call tax breaks “tax expenditures.”

Build America Bonds provide federal support directly to states. Tax-exempt municipal bonds redirect federal revenues to bond investors. Both programs subsidize state and local finances at a cost to the federal treasury. The only real difference is that Build America Bonds does so more efficiently.

Myth: Build America Bonds lack “transparency”

“There’s been very little transparency about this program,” Grassley says. He calls Build America Bonds a “disguised spending program run through the tax code.” In fact, it’s just the opposite.

Fact: The costs and beneficiaries of Build America Bonds are far more transparent than tax-exempt municipal bonds

Under the Build America Bonds program, taxpayers know precisely who the beneficiaries of this federal subsidy are: states and localities. There are no windfalls to anonymous investors. The direct payments to states appear in the federal budget as an outlay, just like other federal spending programs.

In contrast, the cost of the municipal bond exemption does not appear in the budget even though it costs taxpayers about $30 billion per year. The cost of tax-exempt bonds is tracked only in a list of tax expenditures prepared annually by Office of Management and Budget and the Joint Committee on Taxation.

Myth: Build America Bonds provide incentives to states to be fiscally reckless

Grassley claims Build America Bonds provide the biggest subsidies to states and local governments that have been fiscally irresponsible. The Journal’s Reilly echoes this argument, saying, “State and local governments need incentives to get their financial houses in order, as painful as that might be. By subsidizing the cost of borrowing with this program, the federal government reduces the incentive to do so.”

The critics’ argument is that spendthrift states pay higher interest rates on their debt due to poor credit ratings. Because Build America Bonds subsidize a portion of the interest payments, so the argument goes, states with poor credit get bigger federal subsidies. Their argument doesn’t hold water.

Fact: Build America Bonds give states strong incentives to maintain healthy credit ratings

The argument that Build America Bonds reward fiscal irresponsibility is wrong because it ignores two critical points. First, only a portion of states’ overall borrowing costs are subsidized, so powerful incentives remain for states to maintain strong credit ratings. Second, and more fundamentally, the critics are again ignoring the federal tax exemption for municipal bonds, which has been a permanent fixture of the tax code since 1913. As with Build America Bonds, the value of a municipal bond exemption subsidy is a function of the amount of interest a state pays. Both bonds “reward” states basically the same way, though Build America Bonds do so more efficiently.

Adding up the facts

The upshot? Taxpayers benefit across the board because Build America Bonds save money, are more efficient and more transparent than tax-exempt municipal bonds, and encourage state and local governments to be fiscally responsible. This is why the 111th Congress needs to take up a proposal from Sen. Max Baucus (D-MT) to continue this essential program for at least another year

Seth Hanlon is Director of Fiscal Reform at the Doing What Works project at the Center for American Progress. Jordan Eizenga is a Policy Analyst with the Economic Policy team at the Center and James Hairston is a Research Assistant with the Doing What Works project.

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