See also: Re-evaluating GO Zone Bonds by Jordan Eizenga
President Barack Obama proposed in his fiscal year 2011 budget that the Build America Bond program, which is set to expire on December 31, 2010, be made permanent. This proposal is on target. Build America Bonds are more efficient than tax-exempt municipal bonds at subsidizing the financing activities of state and local governments. This column examines how they work and why they are fit to be extended.
But first, a quick finance 101. A bond is a debt security in which the issuer (or seller) of the bond owes the buyer a debt as well as interest on that debt. A bond, therefore, is simply a loan. The borrower is the issuer and the lender is the buyer of the debt.
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 cheaply because tax-exempt bond buyers do not pay taxes on the interest earned from the bonds. This makes them willing to buy the bonds from the governments at lower interest rates. The tax exemption comes at a cost to the U.S. Treasury in the form of forfeited tax revenues. That is why economists call it a tax expenditure. The Joint Committee on Taxation estimates that this federal subsidy of state and local government bond issuances will cost the federal government $147 billion over the 2008 to 2012 period.
Tax-exempt municipal bonds are an inefficient way of subsidizing state and local governments. A portion of the subsidy intended for issuers is instead passed on to bond buyers who are in higher income tax brackets. The reason for this has much to do with how bonds are issued. As tax-exempt bond issuers try to find a buyer for all bonds issued they draw in buyers from lower tax brackets by increasing the yield on the bonds. They do this because buyers in lower rate tax brackets do not get the same benefit out of the tax exemption as buyers in higher tax rate brackets. The higher yield is what makes the bond competitive with the after-tax yield on taxable bonds for lower-income investors.
In this sense, lower-income buyers push up the yield on municipal bonds beyond what a buyer in a higher-income bracket would demand in order to want to purchase the bonds. This is a windfall for the higher-tax bracket purchasers and an excess cost for the state and local governments, who end up paying higher interest payments to wealthy buyers.
Twenty percent of the subsidy goes to bond buyers in higher tax brackets who purchase the bonds in order to reduce their federal tax liabilities.The Department of Treasury notes that only 80 percent of the subsidy goes to the state and local governments that issued the bonds. The remaining 20 percent creates a tax expenditure that is just "a federal transfer to bondholders in higher tax brackets."
Municipal bonds generate a reduction in interest costs for state and local governments that is less than the federal tax expenditure of municipal bond issuances. One dollar in foregone tax revenue generates less than one dollar in savings from lower borrowing costs. In fact, a Congressional Budget Office-Joint Committee on Taxation study noted that "a direct appropriation of funds would purchase more infrastructure on a dollar-for-dollar basis." It would be more efficient to simply have the federal government give the states money to spend on capital investments.
Build America Bonds, which were created by the American Recovery and Reinvestment Act of 2009, resolve this inefficiency by ensuring that 100 percent of the subsidy goes directly to state and local governments.The program initially offered two types of bonds—a tax credit and a direct subsidy bond—but all issuances to date have been direct subsidy bonds.
Direct subsidy Build America Bonds are taxable bonds in which the federal government makes a direct payment to the issuer in order to offset borrowing costs. That is, the government directly subsidizes the issuer in an amount equal to a percent of the interest on the bonds issued. In making direct payments to the issuer the federal government is able to ensure that 100 percent of foregone federal revenue benefits state and local governments alone. Since the program was launched on April 3 of 2009, $129 billion worth of Build America Bonds have been issued and they now constitute 20 percent of the municipal bond market.
The data shows that Build America Bonds lower borrowing costs and reduce tax expenditures in both the tax-exempt and taxable municipal bond market. The Treasury Department estimates that state and local governments have saved more than $12 billion in present value from issuing Build America Bonds. They also note that AAA-rated Build America Bonds offer interest rates 38 basis points (0.38 percent) lower than AAA-rated tax exempt bonds. That might not seem like a lot, but when a government is borrowing billions of dollars, 38 basis points less in interest costs can mean savings of tens of millions of dollars.
Further, Build America Bonds have reduced the borrowing costs in the traditional state and local government bond market. As more issuers have turned to Build America Bonds the amount of tax-exempt bonds issued has fallen. The reduction in supply means that issuers can charge more for tax-exempt bonds. Since bond prices and bond yields move in opposite directions, the higher price translates into reduced yields on tax-exempt bonds by an estimated 20 to 30 basis points . The lower yield means less foregone tax revenue associated with the issuance of tax-exempt bonds.
The president’s Build America Bonds proposal is a sensible one. The proposal lowers the subsidy rate from 35 percent to 28 percent, but research indicates that the program would still be more efficient and less costly to the federal government than traditional tax-exempt bonds. Put simply, Build America Bonds perform the same function as many tax-exempt bonds but at a reduced cost. Given our current fiscal situation, this should be reason enough to make the program permanent.
Jordan Eizenga is a Policy Analyst with the Economic Policy team at American Progress.
. Bond Buyer. November 2, 2009.