States Enjoying an Unexpected Benefit of Federal Tax Reform

The Tax Cut and Jobs Act of 2017 appears to be delivering an unexpected benefit to state governments: It is lowering the cost of their borrowing.

Liz Farmer of Governing describes the unexpected benefit:

While the most direct effects of the 2017 federal tax overhaul have been on tax revenue, the law has also impacted the way governments borrow money.

With banks making fewer direct loans to governments, many expected them to turn to the municipal bond market. But that hasn’t happened.

Governments have continued to be reluctant to increase their debt, a trend that started following the Great Recession. According to the latest report from Moody’s Investors Service, the total net tax supported debt issued by all 50 states in 2018 was essentially flat for the eighth straight year with just $523 billion issued. This puts average annual state debt growth since 2011 at just 0.6 percent.

Moody’s said in its analysis that lagging infrastructure investment has contributed to limited growth in state debt. “State governments are remaining cautious when it comes to bond issuance,” the report continued, “and are increasingly relying on operating revenue to meet their transportation infrastructure needs.”

As a result of this quiet market, the cost of borrowing has dropped—saving governments millions even as interest rates are rising.

This outcome is being realized in part because of the way that interest rates for government-issued debt are determined. In order to entice investors to become creditors by loaning money to a government, the loans need to yield an attractive rate of return to compensate investors for their investment, which is priced as the interest rate on the bonds the government issues.

That price is affected by the supply and demand for the debts being issued. When governments flood the investment market with new bonds seeking to borrow large amounts of money, for a set amount of demand for these kinds of investments, the price they must pay to entice people and institutions to loan them money will rise, making it more costly for governments to borrow.

But when governments are more fiscally prudent in managing their spending and reduce the amount of money they seek to borrow, the price they pay through interest rates will fall for the same set level of demand for these investment options, reducing the cost of their borrowing.

Farmer explains how the 2017 tax reform law is promoting this outcome:

Governments have been reluctant to issue municipal bonds in part because officials fear that Congress may once again meddle with the bonds’ tax-exempt status, says Hilltop Securities analyst Tom Kozlik. The 2017 law already eliminated the federal tax-exempt status of advanced refunding bonds, which effectively killed them. Advanced refunding bonds allowed governments to refinance debt earlier and thus take advantage of lower interest rates years sooner.

Koxlik warns that Congress will be looking for more ways to save money this fall because it will likely face another debate about how to reduce the deficit. “Time could be running out on the municipal bond tax exemption,” he says, “and it’s possible that the advanced refunding repeal is just the beginning.”

That expectation is likely because federal government spending has boomed even as its tax revenues have been setting new records. Since the U.S. government’s spending is far higher than its revenues, it has been having to borrow more money to cover the gap.

That is not a fiscally sustainable situation, which is why the federal tax exemption that makes investing in state and local government-issued debt relatively attractive compared to other investment options may soon come to be abolished.

It is a situation that wouldn’t exist if politicians at all levels of government chose to more effectively restrain the growth of the spending they authorize. Unfortunately for us all, too many of these politicians would appear to have other priorities.

Craig Eyermann is a Research Fellow at the Independent Institute and the creator of the Government Cost Calculator at MyGovCost.org.
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