Tax-Exempt Bonds for Beginners

By James Kwak

Felix Salmon linked to an article by David Kotok on Build America Bonds (BAB), which reminded me that I’ve been meaning to write about them (now that they no longer exist). BAB were introduced in the 2009 stimulus bill. If a state or local government issues BAB, the federal government pays 35 percent of the interest on the bonds; the bondholder pays tax on all the interest, as usual for corporate bonds — but not for traditional state or local government bonds (“munis”). BAB were initially only authorized for two years, and were not extended in the recent tax cut compromise.

The Republican attack line on BAB is that they “subsidize states in more imprudent-type budget and debt scenarios” (Rick Santelli, quoted in Kotok’s article) or they are “a back-door handout for profligate state and local governments, allowing them to borrow more money while shifting some of the resulting interest costs to the federal government” (Daniel Mitchell). Well yes, BAB are a subsidy for state and local borrowing. But to criticize them for that without even mentioning the alternative is either uninformed or irresponsible.

Since the beginning of time (OK, the beginning of the income tax), interest on munis has been exempt from federal income tax; this is why munis are also known as tax-exempt bonds. In other words, this is a federal subsidy for state and local borrowing. There are various policy arguments for and against such a subsidy, but the basic fact is that we have a federal system in which power and responsibility are shared between the national, state, and local governments, and this is one way (not the only one) that the national government distributes money to state and local governments. The simplest alternative would be for the national government to simply hold onto its money and decide how to spend it, instead of funneling it to state and local governments to let them decide how to spend it. So the basic principle of the national government distributing money back to the states is one that Republicans should be favorable to.

But the problem is that, like most subsidies effected through the tax code, this one is inefficient. It works like this. Say that, absent the subsidy, a state would have to issue bonds with a yield of 5 percent. (That is, corporate bonds with otherwise equivalent terms issued by a company with an equivalent credit rating would yield 5 percent.) If the bond is tax exempt, however, a buyer in the 35 percent tax bracket would be willing to accept a yield of only 3.25 percent rather than 5 percent (because $5 before tax is equivalent to $3.25 after tax.) In that case, the federal government is giving up $1.75 (per year, assuming a $100 bond), and it’s all going to the state issuing the bond, which has lower interest costs; the buyer is indifferent between the two scenarios. That’s a subsidy.

In practice, however, it doesn’t work like that. The actual yield on tax-exempt bonds is higher than necessary for top-bracket bond buyers to break even. Historically, it’s been about 75 percent of the taxable yields (according to my tax casebook — Graetz and Schenk, 6th ed., p. 224). In the example above, that would be a tax-free yield of 3.75 percent. That means that the $1.75 subsidy is now being shared between the state and the bond buyer. The state gets $1.25 in lower interest costs, and the buyer gets $0.50 in interest she could not have gotten without the subsidy.

And who buys tax-exempt bonds? Rich people. So by funneling the subsidy through this tax exemption, part of it gets siphoned off by the rich. (The $1.25 in lower interest costs do benefit all state residents, who would otherwise have to pay higher state taxes; but they would still prefer $1.75 in lower interest costs.)

BAB were designed to solve this problem. Instead of making the bonds tax-exempt, they are taxable, so in the example above the state would issue them with a 5 percent yield and the buyer would get the same $3.25 after taxes as if she bought a corporate bond. This time, the federal government simply gives the state $1.75 in cash, and none of the subsidy gets siphoned off by rich people.

So it’s disingenous to analyze BAB without acknowledging the alternative; you have to compare them to traditional tax-exempt munis. And on a first-order analysis, the hit to the national fisc is the same ($1.75). The only difference is who gets that $1.75. With BAB, it’s the state as a whole; with tax-exempt munis, rich people get a cut.

Now, it is true that there are second-order effects. In particular, because the subsidy for BAB was set at 35 percent, that did low the effective cost of borrowing for states from $3.75 to $3.25 (in the above example). That means that states will borrow more than they would have otherwise. So while the federal subsidy is $1.75 on a $100 bond in either case, there will be more of those bonds in a world with BAB — so more borrowing, and more national debt. (This problem, if it is one, could have been solved by setting the percentage lower — say, at 25 percent — so that states’ effective borrowing costs would have remained the same.)

Also, because BAB exist, this reduced the supply of munis, increasing demand for munis (since there are still the same number of rich people who want tax-exempt bonds), which increases prices and reduces borrowing costs. So at the margin, BAB did increase state and local borrowing. That was actually the point — this was a stimulus bill, after all — but if you don’t like one government subsidizing another government’s borrowing, it was a bad thing.

But when people like Daniel Mitchell rail against BAB because they subsidize state and local borrowing, without mentioning tax-exempt bonds, what are we supposed to think? Do they not realize that this subsidy has always been part of the bedrock of the tax code? Or do they know it’s there, and are they attacking BAB because they want to preserve a tax exemption that disproportionately favors the rich? I’m not sure which is better.

(By the way, I think this example supports my interpretation of the tax code. BAB probably got slipped into the stimulus bill because tax policy wonks have for decades thought they would be more efficient than the existing subsidy mechanism. But the constituency for efficient tax policy is not as powerful as the constituency for investments that favor the rich.)

22 responses to “Tax-Exempt Bonds for Beginners

  1. From the book “AN AUTISTIC WORLD (1)”

    As long as there are people willing to take advantage of situations by exploiting the limitations of other individuals, there will be all sorts of mercantilist theories that will excuse their actions. The common reference is the ability to profit from manipulating the loopholes in the law, or the modification of such, to accommodate the complete absence of justice, which enables certain governments or individuals to act in a selfish and amoral manner. The superfluous vision of a theoretical present based on those simplistic but effective actions, includes the creation of dream societies founded on the rotten supports of misleading imaginations, that happily pass the baton of inflation, corruption, stagnation, etc. to future generations.

    Societies often want to be mesmerized more than enlightened by finding the truth. That predisposition is what misdirects them from their paths into hazardous conditions, because while they are watching the environment and wondering in awe “how” it is possible; someone else is benefiting with their denial by knowing “why” it is possible.

  2. You wrote, “Do they not realize that this subsidy has always been part of the bedrock of the tax code? Or do they know it’s there, and are they attacking BAB because they want to preserve a tax exemption that disproportionately favors the rich?”

    I’m sure you know that none of that has anything to do with the Republican complaints. They complained against BABs because they wanted to criticize Obama.

    Furthermore, as I’m also sure you know, Republicans don’t care if their criticisms make any sense. As Brad DeLong is fond of saying, Republicans lie, always. So it’s useless to try to figure out why they said something that seems nonsensical to most intelligent people. There is no reason — other than that they think the statements they make will have a significant political impact.

  3. There are various policy arguments for and against such a subsidy, but the basic fact is that we have a federal system in which power and responsibility are shared between the national, state, and local governments, and this is one way (not the only one) that the national government distributes money to state and local governments.

    No, we have anti-federalism. A truly federal system would repose all power at the level where sovereignty itself resides, in the people.

    By now, with the definitive failure of trickle-down “representative” pseudo-democracy (it’s now proven this always degrades, sooner or later, into kleptocracy), the only rational alternative left is what was always the only moral and sovereign option, true federalism, that is direct participatory democracy and economic self-management. Nothing else will ever again have any legitimacy.

    That in 1787-88 the anti-federalist centralizers managed to appropriate the term “federalist” for themselves and slap the term “anti-federalist” on the opponents of centralization was simply the first great terminological heist in American history.

    The simplest alternative would be for the national government to simply hold onto its money and decide how to spend it, instead of funneling it to state and local governments to let them decide how to spend it.

    No, both the simplest and the only legitimate alternative is this: Restitute all this political and economic power which was usurped upward. It was stolen under the fraudulent pretense that letting elites extract and monopolize all wealth and power and then having them trickle it back down would in some mystical way render the productive people better off economically (and be even more democractic!) than if we kept our economies and polities in our own hands and managed and distributed it on our own.

    But this Big Lie has been definitively disproven. Neoliberal pseudo-democracy is nothing but a scam, a stalking horse for corporate kleptocracy and incipient fascism.

    As for the gutting of BABs and how this will render the position of states and localities even more parlous, let’s make a virtue of necessity and add it as yet another reason to withdraw recognition and support from the obviously illegitimate Wall Street/Washington kleptocracy.

    Even before this, the moderate Chris Whalen was predicting that in 2011 state governors would start telling people: Stop paying your mortgage, stay in the house, keep paying your property taxes.

    In other words, the only possible legitimate* governments are the ones much closer to our communities; it’s to our own communities that we owe anything; it was always absurd that banks could own land anyway, even before these banks stole tens of trillions from us; we certainly owe the banks NOTHING, and it’s actually self-destructive to keep paying them anything on any debt; instead we need to draw a line and start rebuilding among ourselves, in our own communities.

    Only there can we regain democracy, freedom, prosperity, and human self-respect.

    So let’s take the BAB example as yet more proof of the following:

    1. “Austerity” for everyone but the top kleptocrats intends to crush everyone below it, including the lower-level governments and civil societies.

    2. So here’s the final proof of how the state/local dependence on “federal” trickling-down was always unhealthy and setting ourselves up for destruction. We are now being destroyed, and will be destroyed if we sit still and submit.

    Let’s instead break free completely. We can start by breaking the banks. Jubilate in Place – the land always belonged to we the prodcutive people in the first place, and besides, we now own the banks as unwilling purchasers via the Bailout. So all that’s theirs is ours. Let’s restitute the land on a food production basis, and make that the rock of our redemption of democracy itself.

    [*As I said, only participatory democracy is legitimate. But as this transformation no doubt will have to be undertaken in stages, we can also talk in terms of “more” or “less” legitimate. Certainly a representative local government is far closer to legitimacy than the Wall Street/Washington kleptocracy.]

  4. Herbert Wetherby

    This is all the more reason for a simplfied tax code. Once the laws are straighten out, a consumption tax is levied and all is right with the world again.
    This can not currently occur steming from the hugh congressional corruption problem, but it may be forced upon the congress in five years or so. Another option is we continue with the current confusing tax code for many generations, or until the govt can no longer pay its interest, which ever comes first.
    Personally I would not suggest bonds of any type. And I need to get a life insurance policy for my life insurance agent, with me as the benificiary. Cause I don’t think my agent is going to make it, and that looks like some easy money.

  5. It is still worth considering the possibility that their motives include both venality AND obstructionism. Either explanation is sufficient, but it’s good to know the real lay of the land.

  6. Once the laws are straighten out, a consumption tax is levied and all is right with the world again.
    Surely you don’t truly believe that the result will be more just, given the power structure that exists?

    until the govt can no longer pay its interest
    So long as the government borrows dollars, that day can never come. It might choose to default, whether strategically or through the insane brinksmanship of one political party, but it is by definition impossible for the owner of the dollar press to run out of dollars.

  7. Herbert Wetherby

    I didn’t say they could not run out of dollars, and no longer able to pay interest, is defaulting. As for just, yes, once the power structure is rearranged, it will be more just. How this is to be done though, is for me to know and for you to find out. Simple as that.

  8. “Siphoning” is not the full story by any means. The key difference between munis and BABs is the marginal-tax-rate-risk. You can’t price these bonds based on current tax rates, but only on an estimate of expected *future* tax rates at the maturity date, which, as we all know, is a true uncertainty based on the decisions of future politicians and anybody’s guess.

    This MTR risk has a price, and it’s not at all clear that the “interest-subsidy distribution” isn’t anything other than a natural consequence of that price. For munis – an unexpected rise in expected-marginal-tax-rates-at-maturity (XTRM? Ooh, looks like “Extreme”) means a windfall gain, and an unexpected drop means a loss. For BAB’s, it’s the reverse scenario.

    However – there’s a key difference. In the muni-case, changes in the tax code are irrelevant to the final payout. The USGOV could raise rates and it would make the holders of munis better off than they expected. With BABs, the USGOV (who has to pay the 35% of the interest) could raise rates and it directly effects the after-tax payouts and it would make the holders directly *worse* off.

  9. With BABs, the subsidy primarily goes to institutional and foreign investors, who are normally locked out of the municipal bond market (because the tax exemption does not apply to them).

    So traditional tax-exempt bonds are a subsidy to the rich, while BABs are a subsidy to institutional and foreign investors. Pick your poison.

  10. With muni bonds, there is no incentive to purchase them in a tax-exempt portfolio, such as an IRA–no tax is avoided. By contrast, if a BAB is purchased for a tax-exempt portfolio, the municipality pays $3.25 and the federal government is out both the $1.75 direct subsidy to the municipality and $1.75 in foregone tax revenue, while the buyer earns a full $5.00 payout. Muni bonds are much cheaper for the Federal government which is out only the $1.75 in foregone tax revenue. Data showed that BABs were purchased much more frequently for tax-exempt portfolios than was originally anticipated.

  11. “Republicans don’t care if their criticisms make any sense. As Brad DeLong is fond of saying, Republicans lie, always. So it’s useless to try to figure out why they said something that seems nonsensical to most intelligent people. There is no reason — other than that they think the statements they make will have a significant political impact.”

    Unfortunately, it seems this approach is quite effective for the Republicans. Too bad it’s so toxic for the country and the world.

  12. MR. Kwak,
    thanks for the explanation. Could you includes some demand and supply graphs indicating the sharing of the subsidies the tax-exempt bonds had it been in place for BAB? This is an excellent example of introductory class of microeconomics.

    Thank you.

  13. Yes, their key criteria for what they say is not truthfulness or logic, but maximum favorable political effect. And so yes, there’s no reason to bother trying to make sense of what they say. Time spent refuting their lies gives them more time to lie, and takes time away from making a counter argument. And these people know how to fight back, nasty. But, I say let them bark, just argue past them. I think former Rep. Grayson has the right approach.

  14. Perception about only rich people buying tax-exempt bonds is wrong. OK, for the individual bonds, maybe – but for the state tax-exempt mutual funds, no. In a state like NY, CA, NJ you don’t have to be rich to get into a combined 35% bracket (28% federal + 7% state). BAB subsidy, otoh, goes primarily to the foreigners who prefer them to equally yielding corporates.

  15. Just wanted to say THANK YOU to James Kwak for such a clear and well-written explanation of an esoteric issue (at least for non-wonks)!! Now I get it!!

  16. This is a good explanation overall, but this part:

    “And who buys tax-exempt bonds? Rich people. So by funneling the subsidy through this tax exemption, part of it gets siphoned off by the rich. (The $1.25 in lower interest costs do benefit all state residents, who would otherwise have to pay higher state taxes; but they would still prefer $1.75 in lower interest costs.)”

    …is not correct. Investors will always demand a higher after-tax return on bonds which are less liquid (muni bonds are far less liquid than treasuries) or have more credit risk (state budgets are a disaster). Certainly “the rich” are collecting an extra $.50 compared to buying treasuries instead, but it isn’t a handout; it’s to compensate them for taking additional risk.

    One factor you did not mention is that the BAB structure makes it possible for foreign buyers to benefit from the subsidy. For non-US investors, tax-exempt munis aren’t attractive because the federal tax exemption is worthless to them. I’ll leave it to the politicians to argue about whether the federal government should be paying the PBOC and oil sheiks to help fund state budget deficits…

  17. “I think former Rep. Grayson has the right approach.”

    I would like to agree with you, but it would be easier to agree if Grayson had won re-election.

  18. Didn’t he come a lot closer to winning than the triangulating Blue Dogs? In a heavily Republican district, no less?

  19. BABs were not extended because they were part of ARRA, aka, the Stimulus Bill. The Republicans view is that the Stimulus Bill was a failure so they refused to take part in extending that failure.

    Of course this view is unhinged from reality, but then it’s the Republican Party we are talking about here.

  20. Where does this thinking come from???

    First, I would argue your point that only (or even predominantly) rich people by muni bonds. EG–I am retired & I buy safe (?) muni bonds, and I am not rich. More broadly, hundreds of thousands, if not millions, of people own munis through mufus and ETFs. And institutional investors–most of them pension funds–are probably the largest set of investors in munis, and they’re buying for middle-class America (or what’s left of it). So, in brief, large swaths of Americans own muni bonds either directly or indirectly.

    Second, the “subsidy” that you argue against goes not primarily to the buyers, but the issuers. The buyers have an option to buy a wide variety of bonds, and the risk- and tax-adjusted return on them is about equal (if you believe in a semi-rational market). States and localities can garner relatively low interest rates on their bonds because their buyers find them competitive with substantially higher taxable (largely corporate) bonds. If they did not have this subsidy, they would have to pay much more in interest and, OMG, taxpayers–of every economic stature–would end up bearing the load of those extra interest payments.

    Finally, if one were actually to move forward with taxing munis, one would need to be extremely careful on how to proceed. An overnight loss of that tax-free status would instantly shrink the market value of American wealth (spread broadly as discussed above) by trillions of dollars. The economic effects of that loss of wealth alone would likely throw the country into recession.

    So, some sort of incremental move toward taxation would be required, say, based on the time remaining on all outstanding munis. So, if you’re bond had 25 years to go to maturity, you’d be taxed on 1/25 (4%) of the income. All new issuances would, of course, be taxable. Of course, in our political system, no politician would begin to think of taxing munis until the sky was literally falling so either they’d resort to the wealth-crushing instant taxation or a totally ineffective incremental implementation something like that described here.

    In short, Mr. Kwak, be careful what you ask for!

  21. But isn’t the relevant benchmark corporates, rather than Treasuries? At least, that’s what James suggests in the article. Moreover, muni’s have an exceptionally good track record vis a vis defaults: Orange County in 1994 is the only one in donkey’s years. Its important to remember that state and local governments, like the Federal government, have tax authority which makes their current budget situation a poor indicator of their ability to meet future debt service obligations (in contrast to a private sector borrower). I don’t the the wedge James describes can be credibly explained by credit or liquidity risks.

  22. You can look at the Federal Reserve’s Survey of Consumer Finances to see the concentration of fixed-income security holdings. The top 10% of households by net worth hold about 90% of bonds I believe. Maybe that’s a little different for munis, but since high-income earners get the biggest benefit and since they are most likely to have annual savings in excess of the amounts that can be legally contributed to a tax-shielded account, it makes sense that munis would if anything be more concentrated among the rich. The fact that you own them and aren’t rich does not tell us anything about the aggregate picture, which is what’s important here.

    Also, I don’t think James was arguing for the revocation of the tax exemption for existing munis, but for a switch for future issues to a BAB style subsidy.