Editorial Board

Fix a Bond, Build a Bridge, Help Taxpayers and Investors

In 2009, with the U.S. roiled by recession and investors fleeing the municipal-bond market, President Barack Obama started a program that allowed cities and states to sell taxable bonds on which the federal government would offer an interest subsidy of 35 percent.

These Build America Bonds, created as part of the stimulus package, were a response to an emergency, but they proved successful in providing much-needed funding for infrastructure, and were a boon for investors, too. In 2010, they fell prey to partisanship, cynicism and an understandable concern about their cost to taxpayers.

Now, with bridges, roads, tunnels and ports in need of shoring up, and with many state and local budgets still in dire shape, the bonds should be brought back to life, but with a few updates to fix the original program’s flaws. And the Obama administration must make clear that it won’t use the bonds as a political tool.

There is no question that U.S. public works are crumbling. The American Society of Civil Engineers estimated last year that without more investment our deteriorating transportation network alone could cost the country more than 876,000 jobs and reduce gross-domestic-product growth by $897 billion by the end of the decade. Failure to invest in congested and aging waterways and airports could cost the U.S. more than $1 trillion in GDP growth and threaten more than 1 million jobs.

Cheap, Efficient, Progressive

Build America Bonds offered states and municipalities the ability to address such problems at a reduced cost. Over the life of the original program -- in 2009 and 2010 -- issuers sold 2,275 Build America Bonds to support more than $180 billion in infrastructure. They saved an average of 0.84 percentage point on interest costs for 30-year loans. That added up to about $20 billion in present value compared with tax-exempt munis, a figure that the Treasury noted was “considerably greater than the net cost to the federal government of the BABs program.”

Raising money in this way was also more efficient and progressive than via the traditional muni market. Remember: To entice investors in lower income-tax brackets, issuers of traditional tax-exempt bonds must offer higher yields, which investors in the top income-tax bracket are free to take advantage of. As a result, according to the Congressional Budget Office and the Joint Committee on Taxation, only about 80 percent of the cost to the government translates into savings for states and municipalities. In other words, 20 cents of every taxpayer dollar is simply “a federal transfer to bondholders in higher tax brackets.” The Center for American Progress estimates the cost to U.S. taxpayers of this inefficiency may be more than $6 billion a year.

With Build America Bonds, by contrast, the government made direct payments to issuers, ensuring that state and municipalities benefited from the full subsidy. BABs also attracted pension funds, foreign investors and others who don’t pay U.S. income taxes and for whom tax-exempt munis typically have little appeal. This gives issuers access to a broader and more liquid market and enables them to sell longer-maturity bonds than retail investors would usually seek.

And with relatively high yields and lower credit risk, BABs have proven popular with investors. As Bloomberg News recently reported, they are on pace to outperform Treasuries and tax-exempt munis for a third straight year.

Confusion and Cynicism

Despite its success, the program was allowed to expire at the end of 2010. Some in Congress argued that BABs were subject to excessive underwriting fees, a problem that diminished as the bonds became more commonplace. Some also argued that the bonds merely replaced a tax cut (the muni exemption) with increased spending (the subsidy), but this criticism misunderstood how tax expenditures work. Worse, the Obama administration the federal subsidy on BABs that have already been issued may be reduced as part of automatic spending cuts that kick in next year -- a hugely cynical move that could tarnish the reputation of a successful program.

This isn’t to say the original BABs plan was perfect. With a 35 percent federal subsidy, it was expensive. It also rewarded profligate states and made it easier for them to stave off tough budget decisions. Fortunately, these flaws can be repaired with a few adjustments.

First, the subsidy in the original program would be too high if made permanent. The Obama administration has proposed reinstating it at a 28 percent rate, which it estimates would be revenue-neutral because of the income gained from investors forgoing tax-exempt bonds. That may be optimistic, but one major advantage of BABs is that Congress can always adjust this rate in response to budgetary or economic needs, rather than being at the mercy of the muni market and marginal tax rates.

Second, whatever rate Congress sets, imprudent states would still be rewarded: The higher the interest rate an issuer must offer to entice investors, the greater their subsidy. One way to fix this skewed incentive is for the federal government to offer the subsidy as a percentage of principle rather than interest, and to place a cap on acceptable yields at the time of issuance. Congress could also vary the subsidy rate depending on how desirable a given project is, and further restrict the types of construction jobs that would be eligible, for instance by prohibiting the use of subsidized bonds to finance for-profit projects.

Another idea, proposed by the liberal Center for American Progress, would pair a new Build America Bonds program with a volume cap on new tax-exempt issuance, with state and local governments vying in an auction process for the right to sell tax-exempts. This, they argue, would reduce yields, eliminate the windfall for those in high tax brackets, and lower costs for borrowers as they increasingly issued BABs.

Imagine for a moment that Congress and the Obama administration can stop using this program for political purposes. If Build America Bonds can finance public works more efficiently, while offering more investors a chance to enter the market, reducing the taxpayer subsidy of the highest earners, and tightening standards for state and local issuers, what does Uncle Sam stand to lose?

    To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net .

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