by Aaron Klein
By increasing the cost to finance infrastructure for states and local governments, the recently enacted Tax Cuts and Jobs Act (TCJA) will lower investment in our nation’s infrastructure. This runs counter to President Trump’s repeated desire to tackle the major problems associated with America’s crumbling infrastructure through increased investment. The impact may be large and immediate enough to swamp the short-term impact of any infrastructure package Congress can put together in the immediate future.
In America, most investment in infrastructure—about 3 out of every 4 dollars for operating, maintaining, and improving infrastructure—occurs at the state and local level. States, local governments, and infrastructure providers (port authorities, transit agencies, etc…) own over 90% of non-defense public infrastructure assets. They fund and finance infrastructure through a combination of taxes, borrowing, and user and beneficiary charges.
Big picture: The tax cuts will make infrastructure financing more expensive for states and local governments and increase the costs to local voters of funding infrastructure through property taxes. Here’s how that will happen:
The largest immediate impact on the cost of financing infrastructure will come from increasing the cost for states to borrow through municipal debt. On a basic level, states and local governments borrow by issuing municipal debt “munis” that enjoy special status of paying interest that is not subject to federal taxes (and often not subject to the state’s income tax, as well). The muni debt market is huge—about $3.8 trillion. Most infrastructure projects, particularly significant ones, involve issuing muni-debt to finance the costs. After all, a bridge needs to be built before it can collect any tolls.
The tax cuts will cause muni debt to be more expensive for states and local governments through several mechanisms. Many muni buyers are wealthy individuals, particular retirees. When the top marginal tax rate is cut, the value of debt being tax-free falls. This decline in value from cutting taxes for the top marginal rates will ripple through and make the bonds worth less. This means that new tax-free municipal debt will have to pay higher interest rates to attract capital. Higher interest costs for infrastructure agencies means less money available to build, repair, and upgrade infrastructure.
A second whammy for the muni-market will come from the corporate rate cut. Many muni debt buyers are corporations, particularly banks and insurance companies. The Federal Reserve estimates that banks and insurance companies together own almost 30 percent of all municipal debt. The same principle that applies to retail investors applies to corporate owners: When the marginal tax rate falls, the value of being ‘tax-exempt’ falls. With larger cuts on the corporate side from 35 to 21 percent, demand for munis from businesses, particularly banks and insurance companies, should fall even sharper.
Another negative impact from the tax bill on infrastructure funding comes from its treatment of local property taxes. Smart infrastructure projects increase property value. Basic and more innovative approaches to fund infrastructure have tried to capture that increase in value as a source of to pay for infrastructure. This can take the form of broad increases in property taxes or special property tax rate districts, but the principal is the same: property taxes are increased to pay for infrastructure.
The tax bill limits the amount of property taxes that can be deducted against federal income tax through what is often called the SALT deduction. This deduction is particularly binding on states with higher income taxes (often states in the northeast), which have some of the oldest and most decaying infrastructure. SALT deductions are also more likely to hit cities that have their own local income and property taxes and larger infrastructure needs. Limiting the SALT deduction will increase the cost of property taxes to voters, who ultimately have control over whether state and local governments go forward with new infrastructure projects.
To be fair, some of this impact will be mitigated by the various carve-outs in the legislation for businesses, particularly real estate businesses that allow them to continue to deduct state and local taxes. But the overall impact of limiting SALT deductions will be to increase costs to citizens who fund infrastructure through property taxes.
The tax bill will serve to increase the cost of infrastructure projects, slowing down the investments that President Trump says he wants more of. It will have the opposite impact of the Build America Bond program, enacted in the first year of the Obama Administration, which lowered the cost of municipal debt and helped stimulate greater investment in infrastructure.
Decreasing investment in infrastructure is the wrong way to try to increase our nation’s long-term economic growth. Perhaps future infrastructure policy will counteract some of these impacts, but financial markets work quickly and the impact of the tax bill, at least in the short run, will be to make infrastructure more expensive again.
Aaron Klein is a fellow in Economic Studies and serves as policy director of the Center on Regulation and Markets at Brookings Institute.