The House Tax Proposal Would Eliminate Private Activity Bonds

(The stated rationale makes little sense)

The Republican tax proposal seems to have blindsided the municipal bond community by ending the Private Activity Bond (PAB) program. It certainly blindsided me.

But first, what is the PAB program? PABs are bonds issued to finance infrastructure. The interest they pay is (often) exempt from the federal income tax. PABs are different from ordinary tax exempt bonds because they provide substantial benefit to some private party, such as, for instance, a utility (think water treatment plant), airlines (airports), shipping companies (docks) etc. Ordinarily, the tax exemption provided by IRC 103(a) cannot be used for projects that benefit a private party. The exception to the rule is for “Qualified Private Activity Bonds.” A PAB becomes “qualified” if it used for specific kinds of projects deemed appropriate by Congress, such as “(1) airports, (2) docks and wharves, (3) mass commuting facilities, (4) facilities for the furnishing of water etc.” A qualified PAB retains its tax exemption, but interest on a PAB is subject to the Alternative Minimum Tax, unlike interest on ordinary Section 103(a) bonds. PABs are also subject to a volume cap, which is allocated by state.

Aside from the fact that apparently no one knew PABs were in danger, there are many other reasons to be surprised. Most obviously, these bonds are used to build infrastructure. In the absence of an actual infrastructure proposal, it is alarming that the Trump Administration would be looking to sabotage a program that is working reasonably well.

On conceptual grounds, the PAB program is in some ways the most defensible part of the federal tax exemption. To return to basics, the Section 103(a) tax exemption is available for almost any government borrowing — no matter how local the intended project. It is not at all clear why the national tax base should subsidize paving local roads. The tax exemption is more appropriately used for projects that counter interjurisdictional negative externalities or promote interjurisdictional positive externalities — such as airports, docks etc. So, from a theoretical perspective eliminating PABs is exactly backwards, at least as to many projects.

But perhaps PABs cost the federal government a lot of money? It turns out the estimated savings is a mere 38.8 billion over 10 years, a small portion of the estimated cost of the general Section 103(a) exemption, which was estimated by the JCT to cost $26.6 billion in 2017 alone. It is hard to believe that this money will be better spent cutting the corporate tax rate.

To be sure, the tax exemption is notoriously leaky, which means that the federal fisc pays more than state and local governments benefit. Yet if this is the concern, there are many better options. Here are two: tax-exempt bonds can be replaced with tax credit bonds so that the subsidy will equal the cost. Such bonds were briefly available in 2009–10; they were called Build America Bonds and are generally seen as having been a success. Alternatively, one could just cap the tax benefit, as President Obama proposed. See analysis here.

One could also imagine a whole new infrastructure financing regime. A national infrastructure bank has been a bipartisan idea for a long time. And it is potentially a very good idea. Redirecting the revenue lost by the federal tax exemption to such a bank would be reasonable, but, again, this is not the plan.

Perhaps the most perplexing part of the whole proposal is the “consideration,” i.e., justification, provided in the section-by-section summary, which states:

“The Federal government should not subsidize the borrowing costs of private businesses, allowing them to pay lower interest rates while competitors with similar creditworthiness but that are unable to avail themselves of PABs must pay a higher interest rate on the debt they issue.”

There are certainly some uses of PABs for which this description might still hold true, but for the most part, as the initial summary of PABs in the House report seems clearly to understand and the JCT has explained at length elsewhere, the proceeds of PABs can only be used on specific projects chosen by Congress precisely because of a concern that tax exempt financing was being extended to private projects. For the most part, permitted projects, such as airports and docks, do not seem susceptible to much private competition. Moreover, to the extent Congress did think that certain kinds of project were problematic, then the tax exemption could be denied for that kind of project — as indeed the current House proposal forbids the use of tax exempt proceeds to construct professional sports stadiums, which is a sensible change.

In the end, the simplest explanation would seem to be that the tax expenditure budget was used as a shopping list to pay for tax cuts elsewhere, and PABs were unlucky enough to get chosen, even if for no very good reason. A more suspicious view would wonder about the choice to undermine a program that is particularly targeted towards financing those pieces of public infrastructure that could be the most viable candidates for privatization.