An extension? Muni bond market tongues are already wagging about what Congress may do to extend the BAB program beyond this year. Although some issuer groups such as the Government Finance Officers Association were historically opposed to a taxable bond option (for fear that making muni bonds taxable would erode the sovereign exemption of bond interest from federal taxation which was once viewed as a constitutional immunity), times have changed. State and local governments have bellied up to the bar to swig down the brew of 35 percent subsidies of their taxable bond interest costs -- which make financing via the BAB channel a lower-cost alternative to conventional municipal tax-exempt issuance. Now that they have seen how costs can be reduced, they naturally want more.
Of course, the rate of the subsidy on a BAB is what determines attractiveness. If Uncle Sam only paid issuers 25-28 percent of their taxable interest costs, some of last year's BAB deals might not have looked so pretty. And that is where the debate will center this year, when Congress considers extensions. The 35 percent federal reimbursement was far higher than most municipal officials had ever expected before the Great Recession gave birth to the stimulus legislation. And of course, the top federal taxable income bracket is scheduled to jump back to 39.6 percent next year, so a 35 percent subsidy looks more in-line with the tax expenditures when rich investors buy tax-exempt muni bonds.
Trim the subsidy. That said, there is good reason to expect that if BABs are extended beyond this year, the subsidy rate will be reduced. The average tax rate of municipal bond investors is lower than the top marginal tax rate, because muni mutual funds are often held by lower-bracket investors. The blended effective marginal tax rate of muni bond investors is probably closer to the 28 percent bracket today -- and perhaps would be 30 percent in 2011 when Bush-era tax cuts expire. So a good case can be made for a 30 percent subsidy rate in 2011-12 and even possibly something lower thereafter. Making the BABs tax-neutral would be the right approach.
Economists will debate the fine points of this issue, so I won't waste readers' time trying to pencil out the optimal numbers that Congress should use. They have a very competent staff on the tax committees, as does the U.S. Treasury department's tax group that monitors municipal activity. What I would suggest is that a gradual stair-step approach to a lower rate of subsidy would be wise, because it will avoid silly year-end movements to capture the outgoing rate. Often we see underwriters pushing deals just for reasons like this, and it promotes irrational issuer behaviors. There is no reason that Congress could not reduce the subsidy rate by one percent every six months, for example. That would avoid issuance stampedes at each year-end.
BABs for pensions: I would call these "Sustainable Pension Incentive Funding" (SPIF) bonds. Here's a suggestion for Congress to consider, which some public finance professionals may consider controversial because it goes beyond traditional infrastructure finance. Congress and the Administration should also expand the BAB program's taxable bond option to include qualified pension obligation and OPEB obligation bonds, but with fiscal strings attached and a far lower subsidy rate of 15 percent -- plus a two-year sunset with a mandatory review by the GAO. The idea should be that federal support of proper pension and retirement plan financing will avoid future financial crises, and would actually stimulate the U.S. capital markets, as I'll explain below.
There are five strings that must be attached to this concept, which I'll explain in greater detail in my column in Governing's Management letter. (A link will be provided here when that becomes available). For example, a federal subsidy on "SPIF" bonds should be limited to 10 years. During that period, the recipient of subsidy must pay its full actuarially required retirement plan contributions in years 6-10, as well as annual debt service and the full actuarial normal cost in years 1-10, or else lose the subsidy. Likewise, employee benefits increases would be prohibited during the subsidy period, so that the federal taxpayers' subsidies do not spawn another round of retroactive benefits increases that boomerang on local taxpayers.
The proceeds of a SPIF bond issue should be invested in a separate trust fund as I described in my previous column on Benefits Bonds legislation. Investments should be limited to U.S. stock-exchange listed stocks and government bonds, so that taxpayers are not subsidizing insurance companies and hedge fund managers making 2 percent management fees plus carried interest on taxpayer money. Putting that money directly to work in the stock market would stimulate economic activity and actually improve the condition of pension and 401(k) plans from the market impact. No more than half of a pension or OPEB plan's unfunded liabilities should be funded through such issuances, and no deal should qualify if stocks are trading above 90 percent of their previous high-water mark (e.g., Dow Jones Industrials above 12,700 in this cycle). Selling benefits bonds above that level is an invitation to market losses in a subsequent recession, as history has proven.
Putting state and local government retirement plans on a solid financial footing would remove burdens on future taxpayers at all levels of government, and would be well worth the cost of a federal incentive, if structured properly. State and municipal credit quality would improve as these unfunded "soft debts" are finally funded on a sustainable basis. That would reduce the interest rates on municipal bonds, ultimately reducing the federal tax subsidies throughout the tax-exempt market. That's been the effect of the BAB program in 2009. The SPIF subsidy might thereby pay for itself at the federal level and would clearly reduce taxpayers' total federal-state-local tax burdens over the next 30 years.
Municipal issuers should begin to work with their professional associations to begin work on the lobbying effort that will be required to secure an extension of the BAB program. It won't come automatically from the White House just because they love state and local governments.
