In the span of a week, Americans witnessed two important days – Tax Day on April 15th, and Earth Day on April 22nd. While we saw many celebrations on Earth Day, on the infamous day that tax forms are due, moods were likely less cheerful as individuals throughout the country struggled to understand and complete a myriad of tax forms. However, perhaps the close proximity of these two important days is appropriate: taxes do play a crucial role in many environmental finance systems. For that reason, at this time of year I often try to relieve my form-fatigue with some reflection on the role taxes play in paying for environmental programs.
A long-time School of Government Faculty Member, Jake Wicker, used to say that governments never really pay for anything. Governments do the collecting – it’s the people who pay. I’ve always remembered this and try to keep it in mind as I work with communities to evaluate environmental financing options. Income tax and other government taxes and fees play a major role in how environmental services are funded throughout the country. These taxes and fees are direct examples of how governments decide to have people pay for services.
For example, the NC Department of State Treasurer recently released its annual financial analysis of municipally owned water and sewer utilities. It’s an excellent summary and highlights the financial significance of the local government water and wastewater industry. According to the report, city owned utilities collected just under two billion dollars in revenue during the 2012-2013 fiscal year. Water utilities are capital intensive and depend on a variety of direct and indirect public subsidized funding to support their operations. As such, all large water or sewer utilities are influenced by tax collection and tax policies.
A recent study by the Environmental Finance Center looked at where utilities across North Carolina get funds for capital projects. As of last year, local government utilities had over $8 billion in outstanding debt. This debt includes federal and state tax programs such as the United States Department of Agricultural Water and Waste Loan and Grant Program and the United States Environmental Protection State Revolving Loan Program. (To learn more how the management of these programs have been consolidated in North Carolina, see a series of presentations by staff from the State Water Infrastructure Authority).
Interestingly, the biggest impact taxes have on how public environmental infrastructure is paid for relates to what is not collected, rather than what is collected. Large utilities that never look to federally subsidized loan or grant programs still are impacted by tax policy through their reliance on tax exempt bond financing. The system of tax exemption is the foundation behind the low interest rates (relative to corporate bonds) that supports public infrastructure investment. Tax payers must pay tax on the interest they earn on investments, with some notable exceptions such as the interest they receive for municipal bonds. Some studies have estimated that the federal government forgoes as much as $35 to $40 billion dollars a year in revenue by not taxing municipal bond interest. To put the size of this benefit in context, the total appropriation for this year’s largest water and sewer direct funding program, the federal government’s Drinking Water and Clean Water State Revolving Fund Capitalization Grants, was under $2.5 billion.
Policies that drive down interest rates on water and sewer loans are a cornerstone of supporting infrastructure investment and have an enormous impact on local utility finances. This tool developed by the Environmental Finance Center allows utilities to see the financial impact of below market rates (whether driven by tax exempt bond financing or a tax funded federal program). For a $10 million dollar loan with a 20 year term, a utility able to borrow at 3% instead of 5% would see their spending power go up approximately 15%. In other words, without the advantage offered by taxes, they would have only been able to borrow $8.4 million dollars for the same debt service payments.
It is true that there is relatively little pure grant money available to pay for many environmental projects. However, that does not mean the government is not involved. It is difficult to think about environmental infrastructure without thinking about taxes.
Jeff Hughes is Director of the UNC Environmental Finance Center. This post also appears in the UNC School of Government’s Community and Economic Development Blog.
This is a thoughtful analysis of how government allocates taxes (and foregone taxes) to subsidize municipal water operations, particularly in NC. However, it would be useful to look at the efficiency of the alternatives to provide such subsidies. First,as the Build America Bond program demonstrated during the financial crisis aftermath, it is more efficient to provide a direct interest subsidy than the indirect subsidy of foregoing interest on municipal debt. Second, the inefficient benefit goes disproportionately to the wealthy, so it exacerbates the tax code’s bias in that regard. Third, the labrynth of rules associated with IRC Section 103 significantly impedes financing for water and other public infrasturcture by making it difficult to combine bonds with private financing. Finaly, the transaction costs associated with Section 103-compliance are significant, requiring larger borrowing to absorb the unit cost of raising bond financing.
It is difficult, of course, for the capital intensive water/wastewater industry to “give up” the benefits of even inefficient federal support through tax exemption without assurance that a more efficient subsidy would be provided and maintained as a substitute. Indeed, proposals to narrow or eliminate the exemption (see Congressman Camp’s February tax reform program or provisions in the Obama administration’s FY2015 budget)provide little comfort of a reliable substitute subsidy. That is why the Association of California Water Agencies (as an example) has made preserving the municipal debt exemption a high lobbying priority.
Nonetheless, as you point out, the vast majority of capital available to the water industry comes from service rates and charges, not from federal or state subventions. It is worth studying whether our public infrastructure (at least those parts of the infrastructure related to direct service revenues) would be better off without federal tax exemption on revenue supported debt. Among other things, elimination of federal tax exemption on municipal debt would allow this essential infrastructure to be financed in the far more liquid and efficient global debt markets, without the distortions associated with Section 103.
Given the public good nature of water and waste water services and other environmental services, it seems likely that there will continue to be some role for state and federal governments to play but it is interesting to ask what the best form that role should take. We are watching the space closely and I think its too early to predict what the governmental funding framework will look like in five to ten years, but it probably will be different than what it is today. We’ve asked a group of environmental finance professionals to address these and other questions at a special forum we’ve organized. Maybe they will have the answers?