This post was originally published in the the July 2024 edition of our monthly Capacity Factor newsletter.

For the public sector to access all of the Inflation Reduction Act’s investment facilities, states and municipalities must develop or augment their legal and financial capabilities, including: filling out IRS tax forms, underwriting, project development, and strategic planning. Fortunately, there exist numerous models and existing capacity from which states can draw inspiration. One example is the state bond bank. These are state-level public finance instrumentalities that issue bonds on behalf of municipalities, schools, or other local institutions to finance capital development projects.

The Vermont Bond Bank (VBB), which has existed since 1969, is a quintessential example. In a recent report for the Brookings Institute, VBB Executive Director Michael Gaughan and Brookings Metro Senior Fellow Adie Tomer described its capabilities. VBB issues bonds to capital markets backed by repayments of its loans to individual municipalities, school districts, etc., which repay through their normal fiscal frameworks. In the event of nonpayment, it draws on state funds allocated to municipal or district borrowers (a form of derisking called an intercept mechanism).

This structure has numerous advantages. Consider it a pooled borrowing authority. The VBB can issue large bonds to finance a number of smaller-ticket municipal projects, standardizing their terms through aggregation and thereby lowering those projects’ capital costs. It leverages the fiscal capacity and credibility of the state through intercept mechanisms to further reduce its borrowing costs.

Existing and new bond banks can take on the role of intermediaries for channeling federal funds to municipal projects, and work with other state lending facilities to fill project capital stacks where private lenders may treat those projects as unbankable. Crucially, bond banks already have in-house administrative capacity that can be shared with small, under-resourced, or otherwise cash-strapped municipalities. For example, state bond banks could help municipalities to manage and apply for elective pay. Another example is meeting regulatory requirements for participants in municipal bond markets, a hurdle that smaller municipalities in most states may not be able to clear.

There are currently 13 bond banks nationwide. Gaughan and Tomer argue for a federal capitalization of existing and new bond banks. Their proposed structure is similar to the Greenhouse Gas Reduction Fund: Treasury would be given $25 billion to allocate to bond banks; states would have two years to establish a bond bank and to develop an intercept mechanism, or other credit enhancements, for its borrowing. The authors note that this would represent an opportunity for states either to pitch analogous institutions for capitalizations (state infrastructure banks, for instance) or to augment existing institutions such that their capabilities match those of bond banks, rendering them eligible to receive federal capitalization.

Finally, Gaughan and Tomer argue for increasing the tax incentives for banks purchasing municipal bonds. They also suggest states should expand existing intercept mechanisms beyond school financing to include other units of government. I will add another policy proposal. Bond banks are designed to tap into municipal bond markets and therefore rely, as Gaughan and Tomer note, on tax-exempt financing. IRA tax credits offering elective pay to state and local entities currently penalize using the proceeds of tax exempt debt to finance projects by reducing the elective pay disbursement by up to 15 percent. This penalty should be removed.

Resources

• Report published June 20, 2024 by VBB Executive Director, Michael Gaughan and Brookings Metro Senior Fellow, Adie Tomer [LINK]
• Charlotte, VT elective pay case study [LINK]
• VBB Annual Report 2023 [LINK]
• Fidelity report on state school district credit enhancement programs (including examples of intercept mechanisms) [LINK]