A Preferential Tax Treatment
One of the unique features of American public finance is the federal tax exemption for publicly issued municipal bonds. Since the federal income tax was established in 1913, the federal government has exempted interest income earned on bonds issued by state and local governments from income taxes.
Because investors can earn interest on these bonds tax-free, they are willing to accept a lower interest rate. For example, an investor in the top 37% income tax bracket would receive the same yield from a taxable bond paying 10% interest and a tax-exempt municipal bond paying 6.3% interest.
This preference allows state and local governments to issue debt at a cheaper rate than can private enterprises or even the federal government. Indeed, the average municipal bond commands an interest rate of 4.7% compared to 5.6% for high-grade corporate bonds with a similar risk profile.
Bonds to Address Bias
This tax preference allows governments to finance infrastructure projects relatively inexpensively but also creates a bias towards government financing of infrastructure relative to private delivery.
Recognizing this bias, Congress created qualified Private Activity Bonds (PABs). When used to finance certain activities as stipulated by Congress (“qualified” activities), PABs allow private entities to issue bonds on a tax-exempt basis and therefore at a rate competitive to publicly issued municipal bonds. This enables privately financed public-use infrastructure projects to command a similar cost of capital to those delivered by governments and make them more competitive on a value-for-money basis.
Technically, applicable governments issue PABs on behalf of the private borrower in a process known as conduit financing. However, importantly, the issuing government generally has no financial obligation to support the repayment of the bonds, which are the responsibility of the private entity building the project.
Limitations on PAB Usage
PABs are subject to several statutory limitations and requirements. First, the tax exemption only applies to qualified activities specified by Congress (other private activities must issue taxable bonds). Second, certain categories of PABs are subject to a volume cap that limits the amount that can be issued annually in each state (set on a per-capita basis). Third, to make matters more complicated, Congress imposed a separate lifetime volume cap on PABs issued for all highway and freight projects.
The PAB cap was originally set at $15 billion and raised to $30 billion in 2021. The U.S. Department of Transportation (USDOT) allocates the limited amount of highway and freight PABs (which also incorporate other transportation projects due to their nexus to highways) to projects. USDOT has since allocated all $30 billion to existing projects.
Lastly, the issuing government must receive approval from its top elected official and hold a public hearing before issuing PABs.
No such limitations exist for publicly issued municipal bonds, creating an unfair disparity between public and private infrastructure financing.
Additional PAB Financing Need
PABs have supported hundreds of billions in investments in critical infrastructure projects, including the 47 major transportation projects listed in the appendix.
Given that USDOT has allocated all available transportation PABs, Congressional action is necessary for this important source of financing to be available for future private investment in infrastructure projects beyond those already authorized.
There is a significant pipeline of highway projects that would qualify for and benefit from PABs. These include improvements to I-285 in Georgia, I-24 in Tennessee, I-77 in North Carolina, and I-495 in Virginia.
The Deficit Impact of Increasing PABs
The “cost” – in other words, the impact on the deficit – to Congress associated with increasing the transportation PAB cap is not the increase of the cap itself; it is the income tax revenue associated with the issuance of such new bonds that is assumed to be foregone. For that reason, the “cost” as scored by the Joint Committee on Taxation is significantly lower than the magnitude of the cap itself, roughly only $30 million in foregone revenues for each $1 billion increase in the transportation PAB cap (3%).
It is also arguable that the assumptions underlying this scoring methodology are inaccurate because they assume the debt financing the projects would otherwise have been issued as taxable bonds, whereas the projects more likely would be delivered via tax-exempt municipal bonds and therefore result in no revenues for the federal government. Furthermore, the private entities delivering the project also pay corporate taxes, further mitigating the revenue impact.
Unlocking Private Investment for Public Good
Short of wholesale reform to the municipal bond tax exemption, Congress can unlock billions in private infrastructure investments by increasing or eliminating the cap for transportation PABs. This would be a low-cost and effective way to increase investment and innovation in infrastructure in the next surface transportation authorization.
