The Biden administration’s Build Back Better plan left out two major provisions that aim to reduce state and local government 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 U.S. Conference of Mayors, among others, those proposals are expected to be resurrected in smaller separate bills later this year.
But these provisions, which authorize financing tools that previously comprised sizable parts of the municipal bond market, may not save as much money for taxpayers as proponents claim and should be viewed skeptically by Congress.
The first provision is the reinstatement of tax-exempt advance refunding bonds, which had been repealed by the 2017 Tax Cuts and Jobs Act. These are state and local government refinancings sold more than 90 days in advance of the first “call date” of existing debt.
Advance refundings, which allow governments to take advantage of market conditions to replace old debt and save taxpayers money, comprised 27% of the municipal bond market ($120 billion in bond sales) in 2016. However, these financings are costly to the federal government because they result in two bond issues to finance one project, with both bondholders groups shielding their income from taxation.
Beyond placing a bull’s-eye on the municipal market from such double subsidy, the problem with advance refundings is they may leave money on the table for state and localities.
A controversial 2017 academic study found 85% of advance refundings over the last 20 years resulted in a net present value loss to governments, which the authors estimated cost taxpayers $15 billion. Municipal market expert Andrew Kalotay was critical of that study and is more sanguine about the potential benefit of advance refundings. However, even he believes governments previously mismanaged the advance refunding option and claims that governments would have often realized greater savings in recent years by avoiding advance refundings and waiting closer to the call date to refinance.
It seems fair to conclude advance refundings can be beneficial in certain circumstances while eschewing them, as under current law, may save more money at other times. This hardly evinces a program absolutely vital for saving taxpayer dollars.
The second provision is the permanent creation of a direct subsidy bond program modeled after the Build America Bond (BAB) program, which sunset 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 bond’s interest cost.
They were very popular with governments and investors alike, with $117 billion in BABs sold in 2010, or over 27% of the municipal market that year. Given the perception of bigger bang for the subsidy buck, many economists have long favored direct bond subsidies over the current approach of tax-exempt bonds.
However, the financings cost savings from direct subsidy bonds may be overstated. I recently co-authored a report that found the benefits of Build America Bonds versus tax-exempt bonds to be 0.35 percentage point, almost half that of previous estimates. Moreover, our research did not account for the subsidy reduction from the federal budget sequester that reduced BAB subsidies between 5 and 8% each year since 2013.
While advocates claim the proposed provision will protect direct subsidies from future sequestration, it is unclear how the appropriation mechanism to permanently codify this will work. As such, some state and local finance officials question how many governments will even sell direct subsidy bonds given their previous experience with budget sequester.
A direct subsidy program also threatens greater federal encroachment on the financial autonomy of states and localities. Unlike tax-exempt bonds that have limited restrictions on the types of projects financed, a direct subsidy program makes it easier for federal policy makers to influence infrastructure decision-making by adjusting the bond subsidy rate based on project type.
This concern was telegraphed by Sen. Ron Wyden in 2010 when he said “I would like to see different flavors of BABs created. That would allow us to adjust the subsidy and give, for example, transportation infrastructure investment a larger subsidy than other types of projects because transportation projects typically create more jobs and other public benefits.”
These two provisions may provide some financial opportunities to state and localities that inure to the benefit of local citizens. And most certainly the deal teams on these financings will profit from the accompanying increased debt issuance. However, a longer-term lens may reveal these provisions to be less financially advantageous than expected and, in some cases, save fewer taxpayer dollars than the currently available financing options. Moreover, the invitation of greater federal interference into the financial decisions of local governments, a violation of the basic principle of fiscal federalism, may pose a significant longer-term risk to these governments and their taxpayers.
Instead of taking another bite at the proverbial legislative apple, taxpayers would be better off in the long-run if Congress ignores calls for this so-called “financial assistance” to 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 municipal adviser to state and local governments.