Subsidizing Infrastructure Investment with Tax-Preferred Bonds

October 26, 2009

The public and private sectors in the United States together spend over $500 billion a year on infrastructure projects, including highways and airports, water and energy utilities, dams, waste disposal sites and other environmental facilities, schools, and hospitals. The federal government makes a significant contribution to that investment through its direct expenditures and the subsidies it provides indirectly through the tax system, which are sometimes referred to as tax expenditures. Today CBO and the Joint Committee on Taxation (JCT) released a study on the importance of tax preferences, the types of tax-preferred bonds used in financing infrastructure, and the economic efficiency of such bonds.

That study concludes that the amount that the federal government forgoes through tax-exempt bond financing is greater than the associated reduction in borrowing costs for state and local governments. Some analysts have estimated the magnitude of that differential and conclude that several billion dollars each year may simply accrue to bondholders in higher income-tax brackets without providing any cost savings to borrowers.

The Importance of Tax Preferences in Financing Infrastructure

Most federal tax expenditures for infrastructure are the result of tax preferences granted for bonds that state and local governments issue to finance capital spending on infrastructure. Those tax preferences reduce borrowing costs. The amount of tax-preferred debt issued to finance new infrastructure projects undertaken by the public and private sectors totaled $1.7 trillion from 1991 to 2007. About three-quarters of those bond proceeds, or roughly $1.3 trillion, was for capital spending on infrastructure by states and localities, and the remainder was used to fund private capital investment for projects that serve a public purpose, such as schools and hospitals. That $1.3 trillion amounted to over one-half of the $2.3 trillion in capital spending on infrastructure by state and local governments (that is, net of federal grants and loan subsidies).

Tax preferences for debt are attractive to states and localities because they generally allow those governments to exercise broad discretion over the types of projects they finance and the amount of debt they issue. But unlike direct expenditures, tax expendituresincluding tax preferences for state and local bondsare not subject to the annual appropriation process that determines federal outlays for infrastructure and other discretionary programs. As a result, the cost of tax subsidies for infrastructure is not readily apparent, making the design of cost-effective tax preferences all the more important. For fiscal years 2008 to 2012, federal revenues forgone through the tax-exemot bond financing of infrastructureboth for new investments and for the financing of existing debtare estimated to exceed $26 billion annually.

The Types of Tax-Preferred Bonds and Their Characteristics

The Internal Revenue Code provides for three forms of tax-preferred state and local bonds:

  • Tax-exempt bonds pay interest to the bondholder that is not subject to federal income tax. They are the most well established type of tax-preferred debt (tax exemption dates to the beginning of the federal income tax in 1913) and are issued to finance either the general functions of state and local governments or selected projects undertaken by the private sector. Tax-exempt bonds reduce the issuers borrowing costs because purchasers of such debt are willing to accept a lower rate of interest than that of taxable debt of comparable risk and maturity.
  • Tax-credit bonds, by contrast, generally provide a credit against the bondholders overall federal income tax liability. They are much more recent in origin, and the outstanding amount of tax-credit bonds currently is minuscule in comparison with that of tax-exempt bonds.
  • Direct-pay tax-credit bonds, in effect, require the federal government to make cash payments to the issuer of the bond in an amount equal to a portion of each of the interest payments the issuer makes to the bondholder. Such bonds, which were created by the American Recovery and Reinvestment Act of 2009 (ARRA, Public Law 111- 5), in part because the direct payment to the issuer represents a deeper subsidy to the issuer than the provision of a tax credit represents to the bondholder.

Increasing the Economic Efficiency of Tax-Preferred Bond Financing

Replacing tax-exempt interest with tax credits could, in principle, increase the efficiency of financing infrastructure with tax-preferred debt. Tax-credit bonds transfer to issuers all of the federal revenues forgone through the tax preference; in addition, the amount of the tax credit can be varied across types of infrastructure projects, thus bringing the federal revenue loss in line with the benefits expected from the investment.

Nevertheless, tax-credit bond programs have not been particularly well received by the market for a number of reasons, including the limited size and temporary nature of tax-credit bond programs and the absence of rules for stripping and selling credits. That situation is likely to change, however, as a result of the ARRA, which greatly expanded the size and range of tax-credit bond programs. As those new programs are implemented, it will be possible to gauge more accurately the practical advantages and disadvantages of tax-credit bonds.

This study was prepared by Nathan Musick of CBOs Microeconomic Studies Division and the staff of JCT.