Are Build America Bonds Up for Grabs?
Let's fix the formula so everybody wins!
When the lame-duck 2010 Congress passed their tax bill extending the Bush-era tax cuts, members went home without extending the Obama-era Build America Bonds (BABs) program. BABs are taxable municipal bonds that qualify for a direct subsidy from the U.S. Treasury instead of the traditional federal tax-exemption of their interest. When the news circulated in late 2010 that BABs would not be renewed or extended, the muni bond market went crazy with a stampede of last-minute issuances (as I had predicted last February), and municipal borrowing costs rose steeply at the same time U.S. Treasury bonds backed up in yield with signs the economy is improving.
The BABs program was authorized (with a December 2010 sunset) in the so-called stimulus legislation (ARRA) -- when there was a clear case for stimulating state and local government infrastructure spending to create jobs. When the tax-exempt bond market fell into disarray in the Great Recession, it made sense to give state and local governments an option to sell taxable bonds to pension funds, foreign investors and individual IRA accounts that otherwise would be uninterested in a federal tax exemption.
BABs were not a new idea in 2009, as I've written before. The concept of a taxable muni bond option had been kicking around for 30 years, but never had a strong sponsorship in Congress or the Treasury Department. Bond geeks and economists thought they made great sense, but nobody else bought in. State and local professional associations were always leery about giving up their legacy tax exemption in the federalist system, for fear that a future Congress might mess around with their tax-exemptions generally. Further, a future Congress could eventually phase out any and all support of local bond markets as fiscal pressures mount on the federal treasury from Social Security, Medicare, Medicaid and other entitlement programs. But last year's experiment proved popular, the markets and issuers have embraced the BABs concept, and most state and local policy organizations would support a continuation of the BABs program on limited terms. The question now is whether they will lobby actively to reinstate some kind of a general taxable bond option.
Inside the Treasury, officials watching out for Uncle Sam and federal taxpayers also have a good reason to favor a continuation of the BABs program. Instead of allowing tax-free income to rich investors in 35 percent tax brackets (which, I believe, ultimately will be higher when the recent two-year extension expires), it is cheaper for the Treasury Department to write a check directly to the local government for 30 percent of the annual interest costs.
Win-win math. Therein lies the reason to continue the BABs program. It's a classical win-win for the federalist system. State and local governments can access capital from non-taxable investors who otherwise would shun their tax-exempt bonds (pension funds, foreign investors, retirement accounts of all kinds -- like 401k and IRA plans and the mutual funds they offer). BABs provide new capital sources besides the traditional insurance companies and high net worth investors seeking tax-exempt income. That adds new demand for muni bonds overall and reduces the supply of tax-exempt paper, which helps keep their traditional muni yields lower. December's surge in muni bond interest rates was clear proof that the BABs had been favorable to the traditional market, and their expiration was a negative to investors and issuers alike.
So what's the catch? Not everybody loves BABs. Influential Republican Sen. Charles Grassley doubts the wisdom of encouraging more state and local debt on general conservative principles. He became especially exorcised when he learned that BABs bond underwriters were pulling down large concessions and spreads in the earliest issuances. Given the public's antipathy toward Wall Street investment bankers, it was an easy issue to demagogue. However, he was inarguably right that there was some profiteering from "flipping BABs" in the early days when these taxable bonds first hit the market -- a time when investors were still shell-shocked from the market meltdown of 2008-09.
On the issuers' side, there are still a number of skeptical local government officials who worry that there will come a day when the cash-strapped U.S. government loses the confidence of investors globally, moves toward extreme austerity and begins to cut back on popular subsidies --from entitlement programs such as Medicare and Medicaid to BABs subsidies. There is no constitutional guarantee that subsidies will continue, even on deals already sold. It would arguably be easier to pull the plug on BABs subsidies to states and localities than the tax exemptions enjoyed by traditional muni bond investors who vote and make big campaign contributions.
On a practical level, the other fly in the soup now is that BABs are unlikely to sail through Congress on their own. A program like this must usually be attached to a "vehicle" bill, either in the budget or a tax bill. With Congress unlikely to touch taxes again in 2011 after the recent lame-duck extensions last December, it could be many months before a bill emerges to which a BABs resurrection could be attached.
Where's the balance? If states and local government policy and professional associations can avoid getting greedy and limit their campaign for BABs renewal to the essentials, they would enjoy the high road in Congress. That means nobody should expect a handout in the form of a higher subsidy than absolutely necessary to make BABs work effectively in the market. The generous 35 percent subsidy of ARRA legislation is now ancient history and won't be seen again. Issuers need to be realistic. As long as they can sell taxable bonds with a federal subsidy at a lower total borrowing cost than traditional muni bonds, the governmental borrowing community should remain satisfied. A federal subsidy in the range of 28 to 30 percent of annual interest rates would seem more prudent all-around. At that level, Uncle Sam's long-term costs are lower than the tax revenues it foregoes with rich investors in the 33 and 35 percent tax brackets. But it makes no sense to provide subsidies to localities at a higher percentage than the tax rates paid by middle-class, mutual fund investors in the 28 percent bracket. That leaves us with an important concept: The BABs subsidy rate should be set somewhere near the effective marginal tax rate of the average municipal bond investor, including those using mutual funds and ETFs. I don't know that number statistically, but I'll bet that the folks at the Treasury Department can dig it up or already know it. It has to be somewhere between 28 and 33 percent: My guess is that it's somewhere near 31 or 32 percent.
Congress could extend the BABs program indefinitely with a provision that the subsidy rate to bond issuers be set initially at 30 percent and decline to 28 percent if the Treasury can demonstrate to the General Accountability Office that the average (mean, not median) muni bond investor's asset-weighted marginal tax bracket is lower than 30 percent. There could also be a provision to reduce the subsidy if Congress ever enacts a lower top income tax rate in a comprehensive tax reform bill. An immediate suspension upon any finding by the GAO that the program has failed to reduce costs to the Treasury might also be worth including in proposed legislation.
Up-front, cash-grant option. President Obama and Congress have a clear mandate to foster job growth. An intriguing variation of BABs that would incentivize states, localities and public authorities to create new jobs is to augment the program with a local option to receive the federal subsidies up front in cash rather than each year when taxable bond interest is paid. If Uncle Sam immediately reimbursed the first 20 percent of an infrastructure project in cash, leaving the state, municipality or financing authority to pay all the taxable interest, it would still be a bargain for both federal and local taxpayers, and help get construction moving sooner. This would provide much-needed up-front cash to initiate a variety of public-purpose projects like airports, highways and toll roads, and other infrastructure projects. Congress could even require that at least half of all projects must be completed within 18 months in order to receive full reimbursement, to assure a fast-track construction timetable. Projects could be ranked by the number of construction and permanent jobs they foster, with heavier weighting to those that produce enduring long-term employment and stimulate private-sector economic development and interstate commerce. They could be promoted as the Economic Development Bond (EDB) option with an expiration once unemployment falls below 6 percent.
Taxable bonds could shore up pension and OPEB funds. Another concept that merits consideration is a limited-purpose, taxable muni bond for states and localities to finance their now-unfunded retirement obligations during periods of economic recession and deflated securities prices. I've explained this concept in a prior column and won't repeat its details here. Expected changes in governmental accounting standards would make this a wise strategy when implemented at the right times in market cycles. A smaller federal subsidy of perhaps 10 to 15 percent could actually benefit taxpayers by reducing the total costs of funding our nation's burgeoning public retirement plan costs while encouraging sound financial practices. This money should have strict standards and prudent strings attached as I explained previously.
A prominent academic researcher in the public pension arena has proposed a similar, larger subsidy to public employers who replace their pensions with defined contribution plans as part of a reform program, which is another angle to consider -- perhaps with a lower subsidy.
The practical problem with both of these proposals is that the federal taxpayers' inherent interest in state and local government pension and OPEB solvency is a much harder case to make than the cost reductions inherent in the BABs program, given the market inefficiencies in the tax-exempt world. There may also be a stigma of rewarding or bailing out past profligacy in public employee benefits, which are increasingly unpopular with the general populace today. Overall it would clearly be taxpayer-friendly, but the benefits inure at one level of government with costs at another, which is always difficult to implement rationally.
Expand the markets and don't get greedy! The most important concept for advocates of BABs renewal is that proper and prudent use of this intergovernmental policy tool can reduce the costs of government at all levels -- federal, state and local. Here's an opportunity for financial professionals, policy and professional associations, public policy reformers and champions of efficient government to make your mark. Getting BABs into the President's upcoming budget would be a good place to start.