On December 31 state and local governments will no longer be able to issue Build America Bonds (BABs), federally-subsidized, taxable bonds created as part of the American Recovery and Reinvestment Act (ARRA) to fund infrastructure projects. The idea, in addition to creating construction jobs, was BABs would stimulate the municipal debt market which had contracted after the housing bubble/financial market crash in 2008. At that time investors moved away from tax-free municipal bonds since bond insurers stopped insuring debt.
The attraction of BABs is that the program allowed cash-strapped governments to continue issuing debt. The federal government picked up 35 percent of the interest cost. As taxable bonds BABs were marketed largely to overseas investors, who typically don’t buy tax-free municipal debt.
Who’s been issuing the bonds? The most cash-strapped and fiscally profligate states: California, New Jersey, Ohio and New York. Steven Malanga reported in The Wall Street Journal, that in addition to subsidizing big-spending states to take on more debt BABs were used to finance a convention center complex in Dallas, Texas when no private investor was willing. BABs have allowed the most indebted states to effectively ignore market signals concerning risk and increase their debts thanks to the subsidies provided by a very over-extended federal government.
But don’t expect BABs to fade quietly. They have a constituency. Florida Republican, Rep. John Mica, who will chair the House Transportation and Infrastructure Committee aims to find a way to reincarnate the program.
Meredith Whitney writes in yesterday’s Wall Street Journal, there’s no need to guess if states will be bailed out of their debt troubles.
They are being bailed out right now, many times over. They are being bailed out by federal bonds, federal transfers, and as I and many others have argued, by fictional accounting. One sobering fact: in 2009, 30 percent of California’s new debt issuances were subsidized by Build America Bonds. States with massive budget gaps have been subsidized to take on more debt rather than tackle the drivers of budget crises: a sustained period of unsustainable spending.
Yet, as Ms. Whitney writes, the reaction of some economists should any local or state government end up unable to pay its bondholders (like the City of Harrisburg) is yet another federal bailout.
The [Build America Bonds] program can be interpreted as a wealth transfer from the natural holders of municipal bonds, who are individual U.S. taxpayers, to corporations, pension funds, and foreign investors not subject to individual U.S. income taxes.
The BABs were a part of Stimulus II. They are a new way for municipalities to finance capital projects. Like the traditional method, BABs effectively subsidize state and local borrowing, but the mechanics are slightly different. Traditionally, the interest on muni bonds is not subject to federal taxation. BABs are taxed, but the federal government subsidizes 35 percent of the interest payment.
(Note that under both cases, local governments receive a special privelege that private borrowers do not.) Ang, Bhansali and Xing trace out some of the less-obvious consequences of shifting the method of finance.