Josh Barro has an interesting piece on problems with federal tax subsidization of state and local borrowing. I agree that this is an area ripe for reform, and have been trying to emphasize the need for some focus on improving state and local budget practices. Everyone has long known this to be a problem area, but the Great Recession has revealed that excessively pro-cyclical budgeting can be a major macroeconomic problem.
In that light, I think it’s unfortunate that Barro spends so much time criticizing the successful Build America Bonds program which is really neither here nor there in terms of any longer-term issues. He’s correct, however, that there’s something perverse about the way current subsidies scale up as states become less creditworthy:
But even if bond subsidies are a good idea, there is a key flaw in their current structure: the subsidies grow in value when an issuer’s credit profile deteriorates. Because borrowing subsidies are a percentage of interest payments rather than principal, they rise as states are forced by skeptical markets to pay higher yields on new bonds.
This means that instead of simply lowering the level of municipal borrowing costs, we skew the incentives by blunting market signals that should be telling officials to borrow less. Another issue that deserves mention in this vein, however, is simply the fact that attempting to subsidize investment through this kind of tax subsidy is hugely inefficient with the majority of the subsidy simply enriching bond investors rather than spurring new infrastructure creation.