For all the talk of how our national infrastructure is falling apart and in desperate need of renewed investment, the harsh truth is this: Bipartisan calls to update that infrastructure are unlikely to move past the rhetorical stage unless political leaders fix the U.S. municipal bond market.
Most civil infrastructure in the U.S. is built under the auspices of state and local governments, and, because such projects typically provide benefits over several decades, it makes sense to build them with borrowed money. Thus the municipal bond market is the logical place to finance these projects, especially in today’s era of ultralow interest rates.
Yet, according to Federal Reserve data, municipal bonds outstanding peaked in 2010 at $3.77 trillion and have remained below that level in nominal terms ever since. As a share of GDP, municipal debt has fallen from 25 percent to 21 percent between 2010 and 2015, while publicly held federal debt rose from 63 percent to 76 percent of GDP over the same period. It is also worth noting that only a fraction of today’s $3.71 trillion of outstanding municipal bonds are financing public infrastructure: Governments also use these securities to shore up retirement systems (with Pension Obligation Bonds) and to smooth out annual cashflows (with Revenue Anticipation Notes).
Market watchers will recall that 2010 was the year in which analyst Meredith Whitney predicted a wave of municipal bond defaults, spooking the market. The wave never came, but widely publicized fiscal crises in Stockton and San Bernardino, California; Harrisburg, Pennsylvania; Detroit; and now Puerto Rico have fed the misleading narrative that municipal bonds are highly risky investments. In fact, annual default rates on General Obligation municipal bonds — the type most commonly used to fund infrastructure investments — have been 0.1 percent or less.
Despite their low credit risk, most local government bond issuers receive credit ratings below AAA, scaring away many uninformed investors. Academic research has established that municipal bonds are rated more conservatively than other types of bonds. A 2008 lawsuit alleged that rating agencies conspired with municipal bond insurance companies like Ambac and MBIA to depress municipal bond ratings in order to compel governments to purchase costly bond insurance policies.
Exaggerated risk perceptions translate into higher financing costs and less liquidity — stunting the municipal bond market. In a recent study for UC Berkeley, I found that some local governments incur over 8 percent of principal in issuance costs. This is like paying 8 points on a home mortgage, something that no one in their right mind would do.
Unfortunately, regulators have not helped the situation. In 2014, the Federal Reserve excluded all municipal bonds from the list of High Quality Liquid Assets (HQLA) it requires banks to hold.
Congress may still force the Fed to change that policy. In February, the House passed H.R. 2209, which directs the Fed and other financial regulators to include investment grade municipal bonds in their definitions of HQLA. But even if this legislation is signed into law, banks and other institutional investors will continue to limit their municipal bond holdings due to the tax treatment of these securities. Since the individual income tax was instituted in 1913, municipal bond interest has been exempt from federal taxation; it is also exempt from state income tax in many places. As a result, municipal bonds are generally perceived as an investment for high-income individuals who either hold them directly or through mutual funds.
Elimination of the tax exemption has been proposed by the Simpson-Bowles Commission charged with offering a plan to improve the nation’s fiscal outlook, and by former Sen. Tom Coburn (R-Oklahoma). While such a change would increase municipal market liquidity by bringing more categories of investors into the market, it would also reduce demand among today’s investors who are willing to take lower interest rates in exchange for the tax exemption.
A deficit-neutral solution promoting municipal market liquidity would be to replace the federal tax exemption on municipal bond interest with an interest subsidy to municipal bond issuers. Such an approach has a precedent: As part of the 2009 American Recovery and Reinvestment Act, the Obama administration and a Democratic Congress created a new type of taxable municipal security known as Build America Bonds (BABs). Although these bonds pay higher interest rates than tax-exempt municipals, the federal government pays issuers an interest subsidy that offsets the extra costs. Once ARRA funding was exhausted, no new BABs could be issued because Treasury lacked budgetary authority to continue offering the subsidies.
The administration has proposed replacements for the bonds in recent budgets, but these suggestions have not been acted upon by the Republican Congress. One way to restore the needed funding in a divided government context would be to couple new BAB subsidy authority with elimination of the municipal bond interest tax exemption. If implemented, this reform would have the effect of forcing all new municipal bond issuance into the taxable sector.
A potential risk of this proposal is that Congress would limit the amount of subsidies available, and thereby create a disincentive for local government bond issuance. In the absence of the tax exemption, interest cost on new municipal bond issuances will be higher once funding for subsidies is exhausted. If the subsidies were instead implemented as an entitlement, Treasury could provide them to any eligible bond issuer that applies.
While the word “entitlement” may seem scary, it is essential to realize that this does not represent a material change from the status quo. Today, individual investors have an unlimited ability to reduce their tax liability by purchasing municipal bonds; the proposed entitlement simply shifts the benefit from taxpayers to state and local bond issuers.
Republicans and Democrats agree that the nation’s infrastructure urgently requires new investment. Reforming the municipal bond market is a low-cost way to make progress toward this shared objective.
Marc Joffe is a regulator contributor to The Fiscal Times and president of the not-for-profit Center for Municipal Finance.