Bring back fair, efficient Build America Bonds
The unemployment rate remains stuck at more than 8 percent. More investment in roads, water systems, airports and other public infrastructure would bring both short- and long-term benefits. And state and local governments face ongoing deficits. So wouldn’t it be great if we could design an efficient way to channel tax subsidies to state and local governments to invest in infrastructure?
Turns out we already have: the Build America Bonds program, which was a huge success in 2009 and 2010, but then expired. If you want an example of how political polarization is impeding sound economic policy, BABs would be hard to beat. Despite no credible argument against it, a divided Congress refuses to reinstate the program.
The traditional approach to subsidizing state and local bonds is to allow the interest to be excluded from federal taxation. The problem with that strategy for both efficiency and fairness is that the tax break varies with the bond purchaser’s marginal tax rate.
Assume, for example, that the interest rate on a tax — subsidized bond is determined by equating the after-tax return of that bond with a taxable Treasury bond for someone in the 25 percent tax bracket. If the Treasury bond yield is 2 percent, the tax-subsidized bond would yield 1.5 percent. As a result, someone in the 35 percent tax bracket effectively would enjoy a windfall of 20 basis points (two-tenths of a percent) — since that person would have been willing to buy the bond at a 1.3 percent yield.
The Congressional Budget Office and the Joint Committee on Taxation have concluded that this type of windfall means that only about 80 percent of the tax expenditure is reflected in lower borrowing costs for state and local governments, and the remaining 20 percent is simply “a federal transfer to bondholders in higher tax brackets.”
Enter Build America Bonds, which provide a direct subsidy that is not dependent on marginal tax rates, and thereby delivers the full federal subsidy to state and local governments. (This reflects a broader point, made by Lily Batchelder, Fred Goldberg and me in a Stanford Law Review article, that linking tax breaks to marginal tax rates is almost never efficient.) BABs have two other subtle benefits: They draw new participants to the market - investors with low or zero tax rates, such as pension funds. And they help drive down the interest rate on traditional state and local bonds.
The original BABs program set the subsidy rate at 35 percent. The response was extremely strong: State and local governments issued more than 2,000 of the bonds, which financed more than $180 billion in capital infrastructure investments. State and local governments saved $20 billion in present value by issuing BABs rather than traditional tax-exempt bonds, the Treasury Department estimates. Lowering the cost of these state and local investments seems more desirable than using the same federal dollars to provide an excess windfall to high-income bondholders.
Although there’s no doubt that we can make better use of the infrastructure we already have (including through more congestion pricing of our transportation systems and more variable pricing of water use), additional investment can bring significant benefits - especially in today’s slow economy. After all, it would create jobs, notably in construction. And evidence suggests that infrastructure investments often help bolster housing values.
So why not revive Build America Bonds? One concern is that the 35 percent subsidy rate in the original program was not deficit-neutral for the federal government. That problem is not caused by the structure of the bonds, however; it just depends on what subsidy rate is chosen. In proposing a new BABs program, the Obama administration has suggested a permanent 28 percent rate, which according to the Congressional Budget Office and the Joint Committee on Taxation, would cost the federal government $7 billion over the next decade.
That $7 billion would be about 10 percent of the estimated size of the proposed program - suggesting that a subsidy rate of about 25 percent would allow the federal government to break even.
Would state and local governments be interested in issuing BABs that carried a 25 percent subsidy rate? I bet they would, and it’s certainly worth finding out.
I can’t think of a reasonable objection to reinstating BABs with a deficit-neutral subsidy rate. That this is not even being tried is as close as you can get to definitive proof that, in a polarized Congress, inertia is a force much stronger than evidence or reason.
Peter Orszag is vice chairman of corporate and investment banking at Citigroup Inc. and a former director of the Office of Management and Budget in the Obama administration.