Replace Tax-Free Municipal Bonds With Build America Bonds

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Josh Barro is making some good points about tax-free municipal bonds and tax preferences favoring the wealthy:

It doesn’t have to work this way. We can reform subsidies for municipal borrowing so that 100 percent of them actually go to municipalities, and so that municipal issuers have access to a broader bond market than one consisting of domestic corporations and wealthy individuals. We should also question whether we should subsidize municipal borrowing as much as we do.

There is a ready model for reform. For 2009 and 2010, states and municipalities were allowed to issue so-called Build America Bonds. These bonds were taxable, but the federal government made 35 percent of the interest payments. These bonds can be sold to individuals, but are also attractive to investors who can’t take advantage of a tax preference, such as pension funds and foreign entities.

That program gave municipal governments access to a deeper and more liquid bond market. Because essentially any bond-market participant can purchase them, the limited set of buyers who benefit from tax preferences can’t use their special position to claim a portion of the subsidy.

In 2011, Congress let the Build America Bonds program expire but kept traditional tax-free munis. It would be better to do the opposite: Abolish the municipal bond tax preference and allow a direct subsidy for municipal borrowing. Rather than simply resurrecting the Build America program, however, the subsidy structure that was used for it should be tweaked and restricted.

This entry was posted in Budget.

6 Responses to Replace Tax-Free Municipal Bonds With Build America Bonds

  1. phillydem says:

    I’m not rich and I’m able to and do invest in tax-free munis through the magic of a mutual fund. I view the munis as a way to invest in my state while getting a tax free and steady, if small, returns.

  2. Bond Vivant says:

    If we make Municipality debt taxable, investors would be able to take advantage of CDS and short Municipalities. Then investors could short Municipality debt, as they have done in Greece, Spain, Portugual, Ireland… Need I go on? Tax exemept debt is a public/private partnership protecting state and local investors and encouraging investors to participate in community investing. Take away the exemption and it won’t be long until the municipal market becomes another playground for the oversized quarterly beta driven mutual and hedge funds driving our individual participation. And not to the benefit of the issuers with lower interest rates. The corporate debt world talk about where a bond ‘breaks’ after issuance for a reason.

  3. Frank says:

    The tax exemption for municipal bonds is one component of the federal government’s financial contribution to construct and maintain infrastructure across the country, and I think everyone would agree that this is an essential government function. Yes, the federal government forgoes collecting revenue on municipal debt, but the exemption lowers the cost of capital projects (roads, bridges, water and sewer treatment plants and transmission lines, schools, university buildings, and so on) for state and local governments. This happens because investors are (generally) willing to accept a lower interest rate on the bonds in consideration of the tax benefits they receive from holding them.

    It is short-sighted to argue that only wealthy investors benefit from the municipal bond exemption because they are the ones who have large incomes to shelter from taxation. Entire populations (and multiple generations) benefit from using the projects constructed with the proceeds of municipal bond issues. If the federal government eliminates the tax benefits for holding municipal bonds, it will become more expensive for state and local governments to undertake new capital projects, meaning that either fewer projects will be feasible or infrastructure investment will crowd out other political priorities. Eliminating a “tax loophole that benefits the rich” will produce very real social costs for everyone else.

    • Jon says:

      Again though, what’s wrong with Build America Bonds? Those were very popular despite being taxable.

      • phillydem says:

        If you want “Build America” bonds, then they should be issued by Uncle Sam just like Savings Bonds and the War Bonds of WW II. I’m sure many people would buy them and they could be used for major federal capital and infrastructure projects that would benefit communities large and small as well as all Americans.