Unlocking affordable infrastructure through tax-free municipal bonds

Canada’s local governments own and operate 60 per cent of Canada’s public infrastructure, despite having access to less than 10 cents out of every Canadian tax dollar. That imbalance has yielded a Canadian public infrastructure deficit estimated to be between $110-billion and $270-billion dollars. Tax-exempt municipal bonds—what the United States bond market calls “munis”—have long allowed American cities to reduce their cost of capital while encouraging investment in local and regional infrastructure projects. American investors purchasing “munis” typically pay no federal, state, or local income taxes, so they are willing to accept a lower interest rate on municipal bonds. The federal government has historically been reluctant to pledge long-term federal revenues to the municipal sector, whether through programs or directly. Unlike a program-expenditures regime, a federal treasury tax-expenditure provision would obviate the need for a bureaucratic delivery program and would be less vulnerable to changes in political winds and/or priorities. A study and podcast by the StrategyCorp Institute of Public Policy and Economy say “munis” may now have a place in Canada. Why is there an infrastructure deficit? By law, municipalities’ operating budgets must be balanced each year: they cannot run operating deficits, and debt-service payments have priority. As a result, municipalities often have better credit ratings than provincial governments and major Canadian corporations. Yet despite infrastructure’s long life, many municipalities are cautious about debt financing, even when offered attractive matching capital grants by other levels of government. Michael Fenn has been a city manager and a deputy minister under three Ontario premiers. Photograph courtesy of StrategyCorp When municipalities do borrow long-term, they generally issue debentures, a bond secured by the assets of the municipal corporation. In Canada, interest paid on those debentures is taxable income. Before the pandemic, historically low borrowing rates encouraged some municipalities to address more of the local infrastructure deficit. At the same time, both federal and provincial governments urged municipalities to cost-share with them on major capital projects in transportation, public transit, water and wastewater, “green initiatives,” and even broadband networks. Like homeowners facing mortgage renewals, however, municipalities will soon find that rising interest rates mean both existing and new debt will cost more, eating into their tax-supported operating budgets and causing good projects to be paused, scaled back, or abandoned. Can U.S.-style ‘munis’ work in Canada? The contrast between the Canadian and American municipal bond markets is striking. The US$3.8-trillion municipal bond market in the U.S. sees more than US$400-billion in municipal debt issued each year. Although Canada is 10 per cent of the size of the U.S., the Canadian municipal bond market is less than one per cent of the U.S. marketplace, or $35-billion, with only $5-billion in municipal debenture issued annually. Let’s take the case of a middle-income Canadian paying a marginal income tax rate of around 41 per cent, who buys a municipal bond paying an interest rate of 3.25 per cent (the rate paid on a 2022 City of Toronto debenture). If that same taxpayer could invest in a “muni,” they would only need to earn 1.9 per cent to achieve the same after-tax income. Allowing for markets, that means municipalities could theoretically pay an interest rate 30 to 40 per cent lower on their debentures. As interest rates rise from historically low levels, that differential becomes even more valuable. Past Canadian analyses of U.S.-style “munis” have raised three concerns, which today may be less relevant. The first concern is that municipalities prefer new revenue sources or transfer payment programs. The argument is that “munis” have been called an inefficient way for federal and provincial governments to fund municipal activities because lower borrowing costs may help municipalities, but they produce theoretical tax losses for other levels of government. But there is scant prospect of governments pledging significant long-term revenues to municipalities ahead of demands from healthcare and other priorities. Municipalities sharing significant taxes on income, goods and services, energy, or digital enterprises seems unlikely. The second concern is that despite having more than 3,500 municipal governments, there are only about 15 major issuers in a Canadian municipal bond market comprised mainly of financial institutions, pension funds, and registered savings plans (for example, RRSPs, TFSAs). For the “muni” concept to work in Canada, the municipal bond market would need to attract new (otherwise taxable) investors. But now it can. The Bank of Canada suggests $180-billion has been accumulated as savings during the pandemic by Canadians who are now understandably leery of investing in volatile stock markets and real estate. The third concern is that governments might not see ‘munis’ as a progressive tax measure since high-income taxpayers would benefit more. But there is a fiscal balance of benefit-and-loss favouring infrastructure investment. Canada has always used tax-expenditure programs to achieve public policy goals, like promoting business investment or encouraging retirement savings. “Munis” would be a tax-expenditure provision favouring investment in productivity-enhancing Canadian infrastructure. As studies demonstrate, public infrastructure investment generates a net fiscal benefit to the treasury. Eligibility criteria can plug any perceived shortcomings (e.g., only for “green” infrastructure or state-of-good-repair projects) and by minimum tax provisions for the very wealthy. The bottom line: “munis” can help make necessary infrastructure more affordable for Canadian municipalities. Michael Fenn is a senior adviser at StrategyCorp. He has been a city manager and a deputy minister under three Ontario premiers. In 2019, he was Special Advisor to the Minister of Municipal Affairs and Housing, on the review of regional municipal government in Ontario. The Hill Times