As I was reading Sarah Okeson’s Carolina Journal exclusive on the Build America Bonds program, I was reminded of a piece I wrote several years ago about the drawbacks of subsidizing state and local bonds through the federal tax code. Timely once again, the column follows. Back next week with a new DJ, after a brief beach break.
RALEIGH – Never let it be said that I am against all tax increases. Please raise the tax on state and local government bonds – immediately.
The federal tax deduction on these bonds has a fiscal impact of about $20 billion a year. Most states have income taxes, and most of these tether their deductions in one way or another to the federal tax code, so you can add billions of additional dollars to the $20 billion impact. Unfortunately, it buys only additional problems and inequities for taxpayers, not a valuable public good or service.
The main justification for exempting state and local bonds from taxation is that it helps governments afford important capital projects such as schools and roads. Because the return on the bonds is not taxed, governments don’t have to offer as high an interest rate to investors as they would if the tax treatment of private and public bonds were equivalent. At the lower rates, then, governments theoretically save money on interest than can be passed along to taxpayers.
That’s the theory. The reality differs substantially. Yes, non-taxable bonds pay lower interest rates than taxable bonds do. But all taxpaying investors are not created equally. Because of graduated tax rates, a tax deduction is worth a lot more to wealthy investors than to those of average or below-average incomes. However, it is impossible to sell government bonds only those above a certain income threshold. The interest rate is necessarily the same for rich and poor bondholders alike. As a result, older and wealthier taxpayers gain disproportionately from the tax deductibility of government bonds – their tax savings + the interest they pay is greater than they could earn by buying private bonds, while for the average investor the two figures are roughly equivalent.
Indeed, the Tax Foundation reports that while 52 percent of the value of the federal mortgage-interest deduction and 54 percent of the value of the deduction for state and local taxes flow to the wealthiest 10 percent of American taxpaying households, 71 percent of the value of the deduction for state and local bonds flows to those households.
So, do most taxpayers come out ahead on the other end of the equation – in savings to state and local bottom lines? Not really. All other things being equal, the debt service may be lower, but all other things are not equal. Because government bonds have lower interest rates than private ones, state and local governments end up borrowing more than they would have to finance more infrastructure projects than they would otherwise have built. If mortgage rates go down, allowing you to buy a bigger house with the same monthly payment, congratulations. But you have purchased a bigger house. Don’t pretend that you have pocketed a savings.
Governments have enough perverse incentives to build bigger houses than they truly need. The tax deduction for state and local bonds heightens a particular political temptation: to involve the government in what should be private economic ventures. I can’t tell you the number of times I’ve been in a debate about city-owned conventional centers, arenas, ballparks, and industrial parks, arguing that they are business investments whose risks and rewards are best shouldered by the private sector, only to be told something like this: “You might be right if the costs were the same, but government can do it cheaper because their debt costs less to finance.” Thanks in part to a $20 billion+ federal tax deduction, state and local governments just in North Carolina have issued billions of dollars in bonded debt to finance dozens of questionable local projects with little prospect of net economic returns.
A similar problem crops up with regard to public-private partnerships. In many instances, it might well make fiscal sense for private firms to build, maintain, and lease back facilities such as schools and toll roads to public authorities. But opponents often doubt whether the potential savings – in the form of speedier construction, more economical designs, and better maintenance – outweigh the highest debt service. What’s worse, when politicians do recognize this problem, they end up finding ways to give private firms access to the proceeds of taxpayer-backed debt, a “cure” that is often far worse than the disease.
The tax deduction for state and local bonds should go. If the federal government wants to assist states and localities with infrastructure costs, there are more efficient ways to do it – direct grants, if it comes to that, though I’d prefer that Washington “help” by reducing the number of unfunded mandates and eliminating laws such as the Davis-Bacon Act that increase local infrastructure costs through wage mandates and other regulations.
Of course, fixing this problem needn’t result in a net tax increase. One solution would be to eliminate all taxation of investment returns. But if that’s too much to expect, as it probably is at this political moment, let’s at least take the opportunity to reduce or eliminate other taxes with perverse effects. It’s not as if there’s a shortage of them.
Hood is president of the John Locke Foundation.