Cut to Invest: Revive Build America Bonds (BABs) to Support State and Local Investments
The Build America Bonds (BABs) program, which expired in 2010, should be reinstated to encourage budget-constrained state and local governments to invest in economically critical infrastructure projects. While authorized at a lower subsidy rate than the original program, a permanent BABs program would provide flexible, low-cost financing for a broad range of infrastructure projects that will create jobs and foster economic growth for years to come.
Congress created the Build America Bonds program in response to the Great Recession’s dramatic effect on state, local, and other public entities’ ability to issue debt. According to the U.S. Treasury Department, this credit crunch eventually led to a 68 percent drop in monthly municipal bond issuances and a doubling of borrowing costs. Established through the American Recovery and Reinvestment Act (ARRA, a.k.a. the “stimulus” bill) of 2009, the two-year program authorized state and local governments to issue special taxable bonds that received either a 35 percent direct federal subsidy to the borrower (Direct Payment BABs) or a federal tax credit worth 35 percent of the interest owed to the investors (Tax Credit BABs).
By harnessing the efficiencies of the taxable debt market, the U.S. Treasury found that this unique structure decreased average borrowing costs for states and localities by 84 basis points as compared to standard municipal bonds, saving borrowers an estimated $20 billion. The taxable nature of the bonds provided incentive for a much broader group of investors to participate in the program, including pension funds and institutional investors. In this fashion, the program expanded the traditional infrastructure investment base beyond the $2.8 trillion market for tax-exempt municipal bonds and made BABs appealing investment alternatives in the $30 trillion taxable bond market.
BABs proved wildly popular. From 2009 through the program’s expiration in 2010, BABs financed one-third of all new state and local long-term debt issuances. In total, the Joint Committee on Taxation (JCT) identified more than 2,275 separate bonds that were issued to finance $182 billion in new infrastructure investment, with participation from all 50 states, Washington, D.C., and two territories.
Importantly, and unlike other infrastructure programs and proposals, BABs were not divided equally among states; they were instead distributed based on the level of demand and interest in new projects. An examination of data from the U.S. Treasury shows that nearly half of all funding for BABs issuances (47.6 percent) were for projects in the 100 largest metropolitan areas. Eight percent were in metros outside of the 100 largest metros, and five percent were outside metropolitan America completely. States issued the remaining 40 percent.
Not surprisingly, the states with the largest economies had the largest dollar amount of issuances. Half of the BABs issuances by dollar value went to projects in California, Illinois, New York, and Texas. However, as a percentage of gross state product, the four largest issuers were Kansas, Kentucky, South Dakota, and Wisconsin. Thus even states with smaller traditional tax-exempt debt markets strongly preferred BABs because of their inherent market and yield advantages.
The greatest share of BABs funding (30 percent) went toward educational facilities, with water/sewer projects (13.8 percent), road/bridge projects (13.7 percent), and transit projects (8.7 percent) following behind.
Despite initial skepticism, the BABs program successfully spurred investment in job-intensive and economically critical infrastructure projects across the country, while also stabilizing the municipal bond market. Importantly, it proved that bond issuers and investors were extremely receptive to the tax-credit and subsidy model, which research by Lily Batchelder has shown to be more economically efficient and cost effective than tax-exempt financing techniques. Concerns about high origination costs for these unique structures also proved to be a minor issue, as the U.S. Treasury found that prices fell drastically over the life of the program.
Recently, congressional budget sequestration put a damper on the market as across-the-board spending cuts reduced the federal BABs subsidy by 8.7 percent. Smaller localities, in particular, now face pressure to call in their BABs for a full redemption to cut costs and to take advantage of historically low interest rates in the municipal bond market. Some large BABs have been called in as well, including a nearly $500 million refinancing in Columbus, Ohio.
However, long maturities, large issuances, and contractual provisions against par-value calls are likely to limit the number of BABs redemptions. Even in the face of these challenges, BABs still outperform both Treasury bonds and tax-exempt municipal bonds in U.S. markets.
To encourage needed investment in U.S. infrastructure, the Metropolitan Policy Program at Brookings recommends the reinstatement of a permanent Build America Bonds program at a 28 percent subsidy rate, similar to the proposed America Fast Forward Bonds program in President Obama’s FY2014 budget and in contrast to the previous 35 percent rate under ARRA. Further, a renewed BABs program should include a guaranteed subsidy payment to insulate the bonds from federal budget cuts.
Reinstating the BABs program would:
- Enhance the efficiency of infrastructure investment by matching the cost of the federal program to the interest rate savings at the state and local level
- Expand the market for municipal issuers by attracting investors that are not usually able to take advantage of the tax exemption offered through standard municipal bond investments
- Reduce borrowing costs for struggling state and local governments, thereby supporting and fast-tracking investments in critically needed infrastructure projects
- Increase transparency in infrastructure financing by moving investments into the appropriations process, rather than obscuring their cost through tax exemptions
A permanent BABs program would foster long-term investments in economically critical infrastructure projects for years to come.