Federal tax and infrastructure plans will impact cities, towns and states

From The Beacon, January 2017
 
Much of President-elect Trump’s domestic agenda is still unclear and subject to change, which makes it difficult to predict how cities and towns will fare when he takes office later this month. However, two of his priorities, tax reform and infrastructure investment, are worth exploring because of their potential impact. Tax reform is a major concern, and infrastructure investment is a major question mark.
 
First, the incoming president has pledged to slash federal tax rates on individuals and businesses, reducing the tax rate for top earners from 40 to 33 percent, and slashing corporate taxes in half. These tax changes could add $6 trillion to the federal debt over the next 10 years, according to estimates. Given Congressional budget rules and practices, this would force significant reductions in federal spending, which could cut funding for everything from education to environmental protection to human service programs. Depending on the programs that are cut, this could be quite damaging to state and local budgets.
 
But massive tax cuts may not be funded exclusively through budget reductions. Republican leaders in the House and Senate have stated their preference that tax code changes be “revenue-neutral,” which is another way of saying that any tax rate reductions would have to be offset by the elimination of allowable tax deductions and credits. This could be very bad news for states like Massachusetts if Congress decides to eliminate three key deductions: mortgage interest, state and local taxes, and interest earned on municipal bonds. In the eyes of the House Freedom Caucus (a major force driving GOP fiscal policy) these three deductions disproportionately benefit “blue” states that have higher incomes and higher levels of taxation.
 
The elimination of the mortgage interest and state/local tax deductions would significantly increase federal tax payments by Massachusetts residents, which, in turn, would impact the local economy by decreasing disposable income and reducing consumer spending. One likely byproduct would be a commensurate decrease in willingness of voters to support higher tax rates here at home, including Proposition 2½ overrides and debt exclusions.
 
Eliminating the tax-exempt status of municipal bonds would have a dramatically negative impact, driving up the cost of local and state infrastructure investments, because localities and state agencies would be forced to increase interest rates in order to provide bond purchasers with the same net income. This means that the cost of building schools, repairing roads, upgrading water and sewer systems, and every other important capital improvement would increase substantially.
 
Public entities in Massachusetts issue approximately $3 billion in tax-exempt bonds every year. In the current interest rate environment, with extremely low rates, ending the tax-exempt status for municipal bonds could add $225 million to borrowing costs over a 20-year period. Under normal interest rates, the cost would be more than $500 million.
 
Because debt is issued every year, the initial impact would be low, but the cost would compound and would soon add hundreds of millions of dollars to the cost of infrastructure projects. The only options would be to increase property taxes to cover this increase, scale back projects, or take the funds from other government services. All are bad choices.
 
President-elect Trump has said that his preference is to retain the tax-exempt nature of municipal bonds, which is good news, but he has no commitment or agreement with Congressional leaders that this will be the outcome.
 
But even if Congress approves the tax rate changes that the president-elect has proposed and leaves municipal bonds untouched, local borrowing costs would still increase substantially. This is because the primary purchasers of municipal bonds are high-income households and large institutional investors. If these investors have obtained federal tax relief (a 20 percent tax cut for those with incomes above $400,000, and a 50 percent tax cut for businesses), their need for tax avoidance will decrease. Municipalities would be forced to offer higher interest rate payments to attract buyers. Thus, municipal borrowing costs are likely to increase if federal tax policy eases the burden on high-end investors. The impact would not be as great as an all-out elimination of the tax-exempt status of municipal bonds, but local taxpayers and infrastructure projects would take a negative hit.
 
This leads to the second major issue – an examination of the Trump administration’s goal of investing $1 trillion for infrastructure over the next 10 years. Based on the headlines, this sounds very promising. But reading the details, the plan would provide only a very limited benefit to local and state governments, and would lead to investment in a very narrow range of capital projects.
 
The president-elect’s plan would direct 80 percent of the $1 trillion to private businesses as tax credits to offset their investments in public capital needs. In other words, almost all of the funds would go to private industry, not public entities. There are a number of obvious shortcomings to this policy.
 
First, private businesses would only be attracted to projects that would provide a return on their capital investment. While the net return needed would be smaller (due to the federal tax credit), the only feasible projects would be those that could be “monetized,” such as toll roads and bridges, public transportation, water and sewer treatment plants, electric utilities, and airports. Without a revenue stream to generate income, there would be no private investment.
 
It is hard to imagine how private tax credits would help to build schools, police and fire stations, town and city halls, non-toll roads, sidewalks, bike paths, or open-use parks. Thus the new administration’s plan would leave behind vast swaths of infrastructure needs.
 
The second question is, who would own these public assets? Transferring ownership of public assets to private firms would require a major shift in our sense of what is appropriate. The alternative is to embark on long-term lease or management contracts, which would raise substantial questions of accountability and transparency. Current public-private partnership arrangements may be a model, but it is unlikely that taxpayers will want their public safety or school operations privatized.
 
Another question is whether states, cities or towns have the resources to monitor and audit these new privately operated public facilities. We’ve seen the problems that state government had with the technology contracts to run websites for the health insurance exchange and the unemployment benefits system. Communities would certainly need to increase their operating budgets to add staff and consultants to oversee privately managed infrastructure systems.
 
The point of these tax and infrastructure examples is that making policy is a very complex process, with many unintended consequences that need to be fully understood before action is taken. While tax cuts and infrastructure proposals may seem attractive at first blush, the details matter, and they should be adjusted to prevent negative impacts at other levels of government. Otherwise the policies will fall short or fail or counteract each other.
 
The United States is heading into uncharted territory, as a new president with no background in government takes office. The success of his administration and his policy proposals will depend on a clear and full understanding that our government is based on a system of federalism. Our federal, state and local governments are interdependent, and federal policy must respect the needs of local and state leaders. Unilateral action that undercuts states and localities will make it impossible to deliver for our communities and the American people.
 
Sensible tax and infrastructure reform must take that into account.