New Evidence That the Tax Exemption Matters

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Tax-exempt municipal bonds provide support for infrastructure projects such as the Leonard P. Zakim Bunker Hill Bridge in Boston, pictured above. (photo: Will Damon)

Walking down Commonwealth Avenue in Boston this summer, it was hard to imagine more than six feet of snow in this very place not more than a few months prior. Although the snow has melted (finally), a wake of potholes is a daily reminder to residents, businesses and government of the critical need for sound infrastructure.

Most infrastructure projects, including roads, schools and sewer systems, are paid for by tax-exempt municipal bonds. This places municipal bonds squarely at the center of inquiry between increasing infrastructure needs and decreasing public investment.

A new white paper released this month by ICMA and GFOA, Municipal Bonds and Infrastructure Development – Past, Present and Future, helps to untangle the relationship between bond market conditions and infrastructure investment. Demographics and politics appear to play a larger role in capital spending levels than do interest rates, the study finds, but of critical importance is the tax-exempt nature of municipal bonds.

The post-recession slowdown in local and state infrastructure investment would have been significantly worse had the tax-exemption not been in place. “If the federal tax exemption for municipal bonds were repealed, state and local governments would have paid $714 billion in additional interest expenses from 2000 to 2014,” notes author Justin Marlowe, University of Washington. “For a typical bond issue this would mean $80-210 in additional interest expenses per $1,000 of borrowed money.”

Other key findings from the new report include:

  • In 2014, state and local governments invested nearly $400 billion in capital projects, a significant slowdown in spending. Total state and local capital spending has not yet returned to pre-Great Recession totals.
  • Approximately 90 percent of state and local capital spending is financed by debt.
  • There are more than one million municipal bonds in the market today, issued by more than 50,000 units of government, and their total par value is just over $3.6 trillion.

Financing methods, such as pay-as-you-go and public-private partnerships, are explored as alternatives to tax-exempt municipal bonds. Although effective for some types of capital projects, these methods should be viewed as complements to tax-exempt financing, not robust alternatives, notes the report. For example, “[PAYGO] can take decades to save up the requisite capital, and on a present value basis, debt becomes cheaper at some point in the intermediate to long-term future.”

With limited alternatives, the instability of a federal funding stream and a recession hangover that continues to stifle political inclination toward financial risk, the importance of the tax-exempt municipal bonds cannot be understated.

About the Author:christy-mcfarlandChristiana K. McFarland is NLC’s Research Director. Follow Christy on Twitter at @ckmcfarland.