If you want a concrete example of the unanticipated harm that could come from the United States going over the fiscal cliff, look no further than Build America Bonds, an efficient alternative way to subsidize state and local investments. They are part of the spending that is scheduled to be reduced in January.
Build America Bonds, which were created in the 2009 stimulus bill, are a shining example of the right way to subsidize activities through the tax code. The wrong way — which is also the way virtually all other tax subsidies are structured — is to provide a tax deduction or exclusion. This means that the tax break per dollar of subsidized activity varies with the taxpayer’s marginal rate, and that is both unfair and inefficient.
Consider, for example, the exemption allowed for interest paid on state and local bonds. A high-income taxpayer gets a larger tax break for each $1 of interest paid on the bond than a middle-income taxpayer who owns the same bond does. This creates a windfall for high-income taxpayers, a variety of analyses have concluded. The interest rate on state and local bonds falls by less than the tax break the high earners enjoy. As a result, only about 80 percent of the forgone federal revenue shows up in reduced state and local government borrowing costs.
Build America Bonds, by contrast, provide a direct federal subsidy, an explicit tax credit that isn’t dependent on marginal tax rates. As a result, it is delivered fully to state and local governments. As I emphasized in my previous article on the topic, these bonds have two other benefits: They attract new participants, such as pension funds, and they help lower the interest rates on traditional state and local bonds.
Build America Bonds were created by the 2009 stimulus bill for issuance in 2009 and 2010. During that time, state and local governments used them to finance more than $180 billion in capital infrastructure projects, saving, according to the Treasury Department, an estimated $20 billion in present value relative to the cost of traditional tax-exempt bonds.
Which brings us to the fiscal cliff. If the sequester — the automatic budget cuts Congress agreed to as part of the 2011 deal to raise the debt ceiling — takes effect, issuers of Build America Bonds will see an increase in their costs because the bonds’ credit is included in the sequester.
Federal interest payments are protected from the sequester, for good reason. If the federal government were to miss or unilaterally reduce interest payments, investors would no longer want to buy the affected asset. For most other types of spending, though, the damage lasts only as long as the spending reduction is in effect — and then quickly fades.
The problem for Build America Bonds could be fixed in various ways, including by reclassifying them into one of the categories that are protected against sequestration. If the Barack Obama administration has the authority to do that, as some experts believe, it should.
Given the bonds’ more efficient structure, it is a travesty that the authority to issue more of them has not been extended past 2010. Subjecting the credit payments on the bonds to a sequester would only make things worse.
This illustrates just one of the multiple ways in which going over the fiscal cliff would cause substantial problems. Reducing the federal credits provided by Build America Bonds would harm not only those who have already purchased the bonds but also any hope of reviving the program.