The Taxable Muni Bond Debate
Is an "Infrastructure TBO" worth a try?
Buried deep in the House stimulus bill is a provision to permit a taxable municipal bond option (TBO). It's become a controversial feature that will likely spur debate in the Senate tax committees and possibly the conference as the stimulus package moves through Congress.
A taxable municipal bond option has been proposed before, as explained in my previous column on ways to unfreeze the muni bond market. Many of my other proposals were included in the House bill and are well supported by the various state and local interest groups. However, the TBO has drawn opposition from the Government Finance Officers Association (GFOA) and others.
A taxable municipal bond option addresses the economic inefficiency of the federal tax subsidy embedded in the muni bond market. From a strictly economic standpoint -- putting intergovernmental politics aside -- the exemption of municipal bond interest on federal tax returns deprives the U.S. Treasury of more lost revenue than the states and localities actually save in interest costs, because they get lower rates. The benefit goes mostly to high-bracket individuals and insurance companies. In today's markets, for example, tax-exempt muni bonds often carry yields above Treasurys and Agencies. Even after allowing for credit quality, the difference between taxable and tax-exempt yields is far narrower than the 35 percent top federal tax rate, and certainly much less than the combined tax rates in states with income taxes.
Therefore, economists in the 1970s had suggested that it would be more efficient for the federal government to just write checks to states and localities that issue bonds if they elected to forego their treasured tax exemption. If the tax credit or reimbursement were less than the marginal tax rate of investors in muni bonds, Uncle Sam would save money.
Anti-TBO arguments. Traditionally, GFOA and other state and local groups opposed the TBO on two grounds: one was constitutional, and the other practical. On a constitutional basis, the local government groups have long maintained that their exemption from federal income taxes is premised on the concept of reciprocal immunity as sovereign states. That theory went out the door, however, in the 1988 South Carolina decision of the U.S. Supreme Court, which then held that the bond-interest tax exemption is not protected a priori by the Constitution, but rather must be won and defended in Congress. Reciprocal tax immunity is a matter for states to negotiate, just like it is with foreign sovereigns, the Court held.
So, the issue is really not constitutional, although some in the anti-TBO camp would argue that the principles are the same, even if it's now been rendered a legislative debate. Give up your reciprocal immunity once, and set a bad precedent, and you will eventually lose it forever: "Give 'em an inch, and they will ultimately take a mile," the muni lobbyists would say. And once Congress sees how much the tax exemption is costing them, they will try to find ways to reduce the subsidy and thus kill the golden goose. The American municipal bond tax exemption is unique in the world, and will never return if ever lost. To the fundamentalists, it's a slippery slope, regardless of the economic logic.
The second argument against taxable munis has been a more pragmatic distrust of how the proposals have been crafted. So far, every TBO proposal suggests that the Treasury would send a check every year for some percentage of the interest costs paid by issuers who took the option. This would leave skeptical local governments worrying whether a future Congress would change the laws or simply renege on its promise, on grounds of fiscal limitations. As we look ahead to the hyperbolic trendline of entitlement program claims on the federal budget, this is a valid concern.
A better way. There there is a cure for this objection. Congress could instead provide for an up-front payment to the municipality, taking into account the present value of its revenue savings. For example, a taxable bond law could be crafted to pay infrastructure bond issuers a present-value equivalent of the shared federal-municipal tax efficiencies up-front, rather than over the life of the bonds. For a 30 year bond issue, interest payments represent over half the ultimate project cost, so the upfront federal TBO subsidy should be roughly 20 percent of the project budget, which reduces the amount to be borrowed and thus the local tax requirements to fund the project -- even with a higher taxable interest rate. That would eliminate completely the risk that Congress changes its mind later. And if the state or municipality decides that it's better to borrow tax-exempt, that sovereign right remains undiminished.
This up-front payment would work well as part of a second-stage stimulus plan to encourage state and local government infrastructure spending. Those projects typically need some up-front money, and an immediate payment from the feds would help get things underway, as noted in my prior column. I personally would like to see Congress sweeten the incentive with a 15 percent additional up-front grant to incentivize shovel-ready projects paid with local taxes as soon as possible, because the infrastructure portion of the Congressional stimulus package falls well short of what this economy empirically needs to fight the recessionary downdraft. All you have to do is look at the one-million-unit contraction in single-family housing starts alone to see how much public building is needed to replace the dearth of private demand. It's clearly two or three times the $100 billion in the stimulus bill.
With an optional up-front federal share of 35 percent (20 percent TBO + 15 percent federal match) under a qualified TBO infrastructure bond plan, plus a Treasury guarantee of the bonds as advocated in my companion column, there would be an immediate boom in state and local government infrastructure work sufficient to offset the nationwide contraction in private construction. Uncle Sam would get 7-to-1 leverage on federal taxpayer dollars and municipalities would actually pay less in interest costs than they do now under their tax-exempt status because of the federal credit guarantee.
Time for deeper thinking. From a purely pragmatic economist's perspective, then, I would like to encourage the public finance community to think a little deeper about this issue. As a former GFOA staffer, and loyal 30-year member of that association, I fully respect the leadership's policy position on this topic. As a member of the family, I am reluctant to challenge the traditional orthodox view of the TBO. (The last thing I need at this time in my life is to stir up a hornet's nest.)
But I can't help but wonder whether a two-year experiment with this clearly more-efficient model might produce positive results for the nation at large. At the end of the day, we are all government finance professionals, and that should mean we seek optimal solutions at all levels of government, not just the parochial municipal interests. Those who muttered for the past 20 years about insufficient infrastructure investments seem a bit disingenuous to me when they now balk at finding efficient ways to make that happen as the nation stands on the brink of an abyss.
I personally oppose the structure of the 35 percent tax credits and payments contained in the House bill, as they needlessly give away too much Federal revenue as explained above. And I don't understand why the House attached richer subsidy ratios to specially designated issuers, other than special-interest politics. So there is clearly a need for the Senate to reformulate the House proposal before anything becomes law.
Admittedly, the approach I've suggested would raise the 2009-10 deficits because the entire federal cost occurs up-front -- which would be more honest anyway -- while helping to reduce future U.S. deficits with tax revenues from the TBO bonds. For the first time in modern American fiscal policy, our children would benefit from an honest intergenerational tax policy.
TBOs would have no arbitrage requirements, nor would there be a need to restrict taxable refundings. Some muni issuers might find those features attractive.
From a macro-market perspective, the opponents of TBO have not admitted to themselves and their own pension funds that taxable municipal bonds would appeal to more buyers. Pension funds and foreign investors have no interest in tax-exempt paper, whereas the entire world will invest in higher-yielding taxable muni paper. And if some municipals bonds are sold into those markets, the tax-exempt bonds will be distributed at lower rates to the natural investors in tax-exempts, who will still be there. TBO expands the demand for munis, some could argue. Are the TBO opponents cutting off their nose to spite their face?
I don't purport to have all the answers in this dialogue, and simply ask that policy-makers and public finance professionals think much more deeply about this issue than they have since the South Carolina decision. Perhaps a mandatory GAO audit and formal sunset review of the consequences of a temporary TBO provision after a 2009-10 window would be worth considering. Along with other federal backstops for the municipal bond market I'm suggesting in my companion column, we could get the country moving again.
And for those of you readers who never thought about this before, or didn't even know there were these issues, I hope you have gained some insights into one of the great debates in fiscal federalism.