President Barack Obama and top congressional Republicans announced a deal on taxes last night. The agreement will extend unemployment benefits and middle-class tax cuts in exchange for a two-year extension of the Bush tax cuts for the wealthiest 2 percent of Americans. There is, however, no agreement yet to extend the Build America Bonds program, which expires at the end of the year.
It is critical that Congress not allow the Build America Bonds to end as it negotiates the details of the tax legislation and other items on its agenda. The bonds provide critical support for state and local infrastructure projects, and they prevent an unintended tax windfall for the wealthiest Americans.
A backdoor tax cut for wealthy bond buyers
Rich investors will effectively get another tax cut if the Build America Bonds program expires on December 31. That’s because without Build America Bonds, state and local governments will have to rely exclusively on highly inefficient tax-exempt bonds to finance public works projects.
State and local governments usually issue tax-exempt municipal bonds to finance their spending on public works projects. The federal tax exemption allows state and local governments to borrow at lower cost: The tax exemption entices buyers to buy bonds that pay a lower interest rate because the interest is tax free.
The Treasury Department however, estimates that before Build America Bonds were established in 2009, 20 percent of the federal subsidy intended for states and localities was captured by the wealthiest bond investors. For every dollar in revenue that the federal government forfeits from the tax exemption, 20 cents goes to bond buyers in the top income tax brackets. (Read this detailed explanation to understand why this happens.) Tax-exempt bonds became a vehicle through which high-income investors could shield their income from taxes.
Build America Bonds, which were created by the American Recovery and Reinvestment Act of 2009, ensure that the entire federal subsidy goes directly to state and local governments. Instead of providing a tax exemption to bond buyers, the federal government makes a payment directly to the state or local government to cover a portion of their borrowing costs. That is, the federal government reimburses the state or local issuer a percent of the interest on the bonds they have issued. Meanwhile, the bonds are fully taxable, so they cannot be used by high-income investors to lower their taxes.
Build America Bonds have proven to be a popular financial tool for state and local governments over the last two years largely because they are more efficient than tax-exempt bonds. Many governments have issued Build America Bonds as an alternative to tax-exempt bonds. In fact, they now comprise one-third of the municipal bond market.
Build America Bonds have also had positive indirect effects on the market for tax-exempt bonds. The availability of Build America Bonds has reduced the supply pressure on tax-exempt bonds. This has allowed issuers of tax-exempt bonds to reduce yields, with the result that their financing costs are lowered as well.
Removing Build America Bonds from the market would force states and localities to rely only on tax-exempt bonds, as they did prior to 2009. Estimates indicate that this glut in the supply of tax-exempt bonds will increase interest rates on tax-exempt bonds by 12 to 25 basis points (0.12-0.25 percent). Higher interest rates on tax-exempt bonds mean higher state and local borrowing costs, and also more opportunities for high-income investors to shield their income from federal taxes. The expiration of the Build America Bonds program would therefore result in a backdoor tax cut for top-bracket investors.
One tax cut is enough
Our colleagues Michael Ettlinger and Michael Linden note that the compromise to extend all of the Bush tax cuts, including the outsized breaks for the wealthy, “is understandable given the effective veto power of the conservatives.” They estimate that the compromise would save or create 2.2 million jobs. But one tax cut for wealthy Americans is enough. Congress should not provide another by letting the Build America Bond program expire.
Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project, and Jordan Eizenga is a Policy Analyst at American Progress.
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