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Promoting Infrastructure Investment through Private Activity Bonds

The federal government contributed about 25 percent of total public spending on transportation and water infrastructure over the past decade. So, for good reason, many local governments and transportation agencies are preoccupied these days with the threat of the automatic across-the-board spending cuts from Washington. Even small cuts would be painful to overstretched state and local governments already scrambling for ways to do more with less.

Increased private sector involvement in U.S. infrastructure is frequently suggested as a way to do just that, through financing tools such as private activity bonds. PABs are aimed at those projects that benefit private entities but also serve some public purpose (e.g., airport improvements, water facility upgrades).

PABs are issued by state and local governments, and many are tax-exempt for a range of qualified activities. These qualified tax-exempt bonds, however, are subject to a federally imposed cap that limits the number that can be issued in states each year, which stands at about $32 billion. In other words, since the interest income earned by buyers of many PABs is not subject to federal income taxes, bond issuers can benefit from lower interest rates and ultimately realize greater cost-savings.

As a result, PABs are quite popular. Many public-private partnerships take advantage of PABs as part of their overall finance package, and roughly $15 billion of qualified tax-exempt PABs have been issued annually in each of the past two years. Yet, despite their popularity, PABs activity fell by 13 percent in 2011.

So what happened?

As it turns out, PABs benefitted tremendously from the American Recovery and Reinvestment Act (ARRA). While the recovery package did not establish PABs or infuse the program with extra funding, as it did with Build America Bonds (BABs), it exempted new PAB issuances from certain federal taxes for two years (2009 and 2010) and allowed the refinancing of PABs issued from 2004 to 2008.

In particular, ARRA exempted PABs from the Alternative Minimum Tax (AMT). The purpose of the AMT is to ensure that individuals and corporations pay at least a minimum amount of tax and disallows specific deductions or exemptions, including interest income earned on PABs. (Repealing the AMT, in fact, stands as one of the cornerstones of the tax plan presented by Republican presidential nominee Mitt Romney.)

When the ARRA provisions expired, PABs became less appealing to bond buyers. Meanwhile, to continue attracting potential buyers, state and local governments had to pay higher interest rates on PABs--more than 25 basis points on average compared to other tax-exempt bonds--and bear the burden of higher infrastructure costs.

Without the AMT exemption, cash-strapped municipalities will find it harder to finance a range of projects that could be supported by PABs. For example, among new money long-term, tax-exempt PABs issued nationally in 2009, over $3.7 billion was put toward airports, docks, and wharves and $3.6 billion on sewage and water facilities. More than $14 billion went to hospitals as well. Imagine how many additional projects could be financed if the AMT exemption continued.

A major tax reform bill in 2013 could act as a vehicle for this exemption. Faced with tight budgets following the economic downturn, municipalities will continue to rely on PABs and other innovative financing strategies to move projects forward. It is imperative that policymakers facilitate this process in the long run by addressing certain regulatory barriers, such as the AMT, and by encouraging additional infrastructure investment.