The Biden administration’s Build Back Better plan left out two major provisions aimed at shrinking state and local governments financing costs. Due to intense lobbying by the Bond Dealers Association, the Government Finance Officers Association, the National League of Cities, the National Association of Counties, and the US Conference of Mayors, among others, these proposals should be resurrected in small separate bills Later this year.
But those provisions, which allow financing tools that previously made up large shares of the municipal bond market, may not save taxpayers as much money as proponents claim and should be viewed with skepticism by Congress.
The first provision is the reinstatement of tax-free prepayment bonds, which had been repealed by the Tax Cuts and Jobs Act 2017. These are state and local government refinances sold more than 90 days before the first “call date” of existing debt.
Prepayments, which allow governments to take advantage of market conditions to replace old debt and save taxpayers money, included 27% of the municipal bond market ($120 billion in bond sales) in 2016. However, these financings are costly for the federal government because they result in two bond issues to fund one project, with both sets of bondholders shielding their income from taxation.
Beyond setting a target in the municipal market from such a double grant, the problem with prepayments is that they can leave money on the table for the state and localities.
A controversy Academic study 2017 found that 85% of prepayments over the past 20 years resulted in a net present value loss for governments, which the authors say cost taxpayers $15 billion. Municipal market expert Andrew Kalotay criticized this study and is more optimistic about the potential benefits of prepayments. However, even he thinks governments have previously mishandled the prepayment option and says governments would often have made greater savings in recent years by avoiding prepayments and wait closer to the call date to refinance.
It seems fair to conclude that prepayments can be beneficial in some circumstances while avoiding them, as under current law, can save more money at other times. This hardly demonstrates an absolutely vital program to save taxpayers’ money.
The second provision is the permanent creation of a direct grant bond program modeled after the Build America Bond (BAB) program, which ended in 2010. BABs were taxable bonds in which state and local governments received a direct cash payment from the federal government to offset 35% of the interest cost of the bond.
They were hugely popular with governments and investors, with $117 billion of BABs sold in 2010, or more than 27% of the municipal market that year. Given the perception of greater returns for subsidy money, many economists have long favored direct bond subsidies over current approach to tax-exempt bonds.
However, the funding cost savings of direct grant obligations may be overestimated. I recently co-authored a report that found that the advantages of Build America bonds over tax-exempt bonds were 0.35 percentage points, nearly half of previous estimates. In addition, our research did not take into account the reduction in federal budget sequestration grants which reduced BAB grants. between 5 and 8% each year since 2013.
While proponents say the proposed provision will protect direct grants from future sequestration, it’s unclear how the appropriation mechanism to codify this permanently will work. For example, some state and local finance officials wonder how much governments will even sell direct grant bonds given their previous experience with fiscal escrow.
A direct grant program also threatens greater federal encroachment on state and local financial autonomy. Unlike tax-exempt bonds that have limited restrictions on the types of projects funded, a direct grant program makes it easier for federal policymakers to influence infrastructure decision-making by adjusting the bond’s grant rate. depending on the type of project.
This concern was telegraphed by Senator Ron Wyden in 2010 when he said “I would like to see different flavors of BABs created. This would allow us to adjust the subsidy and give, for example, transport infrastructure investments a bigger subsidy than other types of projects, because transportation projects generally create more jobs and other public benefits.
Both of these provisions can provide state and local financial opportunities that benefit local citizens. And most certainly the deal teams on these financings will benefit from the increase in debt issuance that accompanies them. However, a longer-term perspective may reveal that these arrangements are less financially beneficial than expected and, in some cases, save taxpayers less money than currently available financing options. Moreover, the invitation for greater federal interference in the financial decisions of local governments, a violation of the basic principle of fiscal federalism, may pose a significant long-term risk to these governments and their taxpayers.
Instead of taking another bite of the proverbial legislative apple, taxpayers would be better off in the long run if Congress ignored calls for this so-called “financial assistance” to the state and localities.
Martin J. Luby is an associate professor at the LBJ School of Public Affairs at the University of Texas-Austin. He is also a city councilor with state and local governments.