COPs, Cash Flows, and Taxes

We’ve pointed out some of the abuses of Certificates of Participation by the Denver and Jefferson County School Districts.  However, there are times when COPs are good.  One good use of COPs is as a cash management tool.  Municipal bonds are usually non-taxable, which means their yields are lower than Treasuries of an equal term, especially in longer-terms, say, 10 years and over.  Since a municipality doesn’t pay   income tax, it can lend at the higher Treasury rate, while borrowing at the lower municipal rate, assuming that its credit rating is good.  (I don’t care if Illinois has 30 years of gold stashed away, I’m not lending them a dollar for a hamburger to tide them over until next Tuesday.)  The municipality can make a little reliable money on the arbitrage.

In essence, this is a tax-shift.  The Treasury isn’t collecting income taxes that bond holders would normally pay, so that tax money is, in effect, shifted to the municipality.  It’s the reason that Treasury yields are higher in the first place.

Over the last couple of years, though, this hasn’t really been possible.  Municipal rates have stayed pretty steady, while long-term Treasuries have dropped precipitously as a result of all the various Quantitative Easings by the Fed.  This has deprived municipalities of a source of cash.  So while the stimulus was essentially a massive shift of debt from the states and municipalities to the Federal government, the feds are taking it back, inch by inch, by taking away this tax shift that had been available to the lower levels of government.

I don’t think it’s coincidence that one of the tax loopholes being mentioned for closure is the municipal bond interest.  The feds would like to make this tax shift permanent by pushing up municipal yields above Treasuries.  Most of the focus has been on the fact that this would make borrowing more difficult and expensive for municipalities.   But it would also close off this tax shift as well.  Both these facts will have the effect of making states and municipalities more dependent on federal funds.

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