The unemployment rate remains stuck at more than 8 percent. More investment in roads, water systems, airports and other public infrastructure would bring both short- and long-term benefits. And state and local governments face ongoing deficits. So wouldn't it be great if we could design an efficient way to channel tax subsidies to state and local governments to invest in infrastructure?
Turns out we already have: the Build America Bonds program, which was a huge success in 2009 and 2010, but then expired. If you want an example of how political polarization is impeding sound economic policy, BABs would be hard to beat. Despite no credible argument against it, a divided Congress refuses to reinstate the program.
The traditional approach to subsidizing state and local bonds is to allow the interest to be excluded from federal taxation. The problem with that strategy for both efficiency and fairness is that the tax break varies with the bond purchaser's marginal tax rate.
Assume, for example, that the interest rate on a tax- subsidized bond is determined by equating the after-tax return of that bond with a taxable Treasury bond for someone in the 25 percent tax bracket. If the Treasury bond yield is 2 percent, the tax-subsidized bond would yield 1.5 percent. As a result, someone in the 35 percent tax bracket effectively would enjoy a windfall of 20 basis points (two-tenths of a percent) -- since that person would have been willing to buy the bond at a 1.3 percent yield.