For those unfamiliar with BABs, they provide federal reimbursement to states and localities for taxable bonds they sell to fund infrastructure. Since BABs are taxable, rather than tax-exempt bonds, they carry higher interest rates since investors get no tax breaks. To offset the higher borrowing costs, the U.S. treasury sends a rebate of 35 percent of the interest payments.
BABs make imminent economic sense. Tax-exempt bonds issued by state and local governments carry lower interest rates than taxable securities, but the market is limited mainly to high-income individuals, insurance companies and mutual funds. Typically, the tax advantage is reaped by the investor, but it's not a completely efficient subsidy because the tax-exempt market does not include major investors such as pension funds, lower-income investors and foreign investors. Thus, it's cheaper for the feds to write a check to municipalities than it is to waive taxes on interest income from muni bonds. The U.S. taxpayer saves money in the deal and the municipality gets a lower net borrowing cost.
The current law pays a 35 percent subsidy, and the Obama administration proposal would change that to 28 percent beginning next year. That's still a bargain for most municipalities and is probably the right number for the long run. To illustrate, consider a municipality that borrows at a taxable rate of 6 percent and issues tax-exempt at 4.5 percent. The U.S. treasury subsidy could be 28 percent of the 6 percent taxable rate (1.68 percent in interest costs against principal, reducing the issuer's net cost to 4.32 percent) and everybody would come out ahead.
Even though the top taxpayers face a 39.6 percent marginal rate next year when the tax laws revert to pre-Bush levels, there are enough investors in lower brackets who buy tax-exempt bonds to drag the average tax-subsidy lower than 35 percent. It made perfect sense to grant a 35 percent subsidy during a recessionary period, to stimulate state and local infrastructure and construction employment, but the case for an ongoing subsidy at that level is weaker as we enter 2011. Certainly a bill that makes the BABs option a permanent feature should carry a lower rebate percentage. Whether it should be 28 percent or 30 percent is an argument that economists could conduct, but it's far less important to the interests of state and local governments than the extension itself. As more and more municipalities re-enter the tax-exempt market on their own two feet, the need for inflated subsidies will be harder to justify. My advice is to not get piggy and to take what Obama's team has proposed.
Prominent Senator Chuck Grassley has gone on record questioning the underwriting fees that investment bankers receive from BABs bonds. That's all the more reason for the proposal to scale back the subsidy level to 28 percent. It reduces the potential for investment-banker windfalls and makes the ongoing program a better deal for federal taxpayers.
It's important to get the message to your Congressional delegation. Tell them why the BABs provision is really important, how it will encourage needed infrastructure and significantly impact your financial condition while it saves the U.S. taxpayers in the long run. Here's an example of one public official's letter to Congress. It asks for the full 35 percent reimbursement which you might not want to demand, but it's a place to start in your letter-writing campaigns. State municipal leagues and the national associations of finance officers, governors, state treasurers, municipal and school officials can probably provide draft letters ready for your use. For BABs to survive beyond this year, legislators must be persuaded that it's the right thing to do.
