State and local governments have enjoyed hundreds of billions of dollars in interest cost savings by refinancing their debt, but that all changed in 2018, costing taxpayers billions.
Iowa’s state and local governments have almost $21 billion in outstanding debt obligations, with two-thirds of that total borne by local property taxpayers. The combined debt of Iowa’s cities, counties, and schools exceeds $14 billion, meaning taxpayers are ultimately on the hook for the principal and interest payments of those bonds. Depending on changes in interest rates over the life of a bond, state and local governments can sometimes utilize tools like refinancing to lower the cost to taxpayers. Unfortunately, a little known aspect of the federal Tax Cuts and Jobs Acts (TCJA) has made that savings less likely to be achieved.
State and local governments use the municipal bond market to borrow funds much as homeowners use mortgage loans to finance their home purchases. Like homeowners, state and local governments can also refinance their debt when interest rates fall to reduce their debt-service payments and, in turn, save taxpayers money. Most of us clearly remember the falling interest rate environment of 2020 when many homeowners refinanced their mortgages to take advantage of lower interest rates.
One important aspect of investing in government debt is that it is commonly tax-exempt, meaning investors don’t pay tax on the interest they receive from the bonds. Therefore, they are willing to accept lower interest rates than they would otherwise demand from taxable investments in the private sector. Clearly the favorable tax treatment of government bonds adds up to substantial taxpayer savings.
If interest rates drop dramatically over the lifetime of a given bond, the government entity may attempt to refinance or “re-fund” that bond. If a government issuer refinances its debt within 90 days of the call date (the predetermined optional redemption date), it is considered “current refunding”. And if the issuer refinances before the 90-day call date window, it is considered “advance refunding”. Historically, the federal government has allowed both types of re-financed bonds to retain their tax-exempt status. State and local governments of all types have thereby realized hundreds of billions of dollars in savings from interest costs.
That all changed when TCJA was passed in 2017. Since that legislation was enacted, if a government entity proceeds with advance refunding, the bonds lose their tax-exempt status. Unfortunately, this change is permanent and not among the provisions of TCJA set to expire in 2025.
Dr. Andrew Kalotay has evaluated the effects of this change in our present high-interest-rate environment. Kalotay’s analysis finds that taxable advance refunding has cost taxpayers billions of dollars since the TCJA change. For example, the Massachusetts School Building Authority (MSBA) saved $104.32 million by advance refunding its 2011B bonds with taxable 2019 bonds. However, if the authority had waited until the call date in 2021, refinancing with tax-exempt bonds through a current refunding, it would have saved $245.97 million. In other words, MSBA lost out on roughly $142 million, or 137%, in additional savings. The result was more debt payments borne by Massachusetts taxpayers.
Iowa’s high municipal debt burden makes tax-exempt advance refunding especially beneficial for property taxpayers. Many bills have been filed in Congress to reinstitute this policy, but none have gained traction. Much of the TCJA is set to expire at the end of 2025, which will force lawmakers to consider the issue of debt re-funding alongside the multitude of other TCJA facets before that deadline.
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