A Stimulus Plan Success Story

The impact of the much-maligned fiscal stimulus, now marking its first birthday, will fade over time.

Its tangible legacy, sure to be backdrops for Obama 2012 ads, will be infrastructure projects from the rehab of the Brooklyn Bridge to the new Russian River Bridge in Mendocino County, Calif.

Among the most durable changes, though, may be the way state and local governments borrow. Now, the municipal-bond market isn't on most Americans' list of top 10 things to think about. But it's big: About $400 billion in muni bonds were sold last year, roughly equal to Austria's entire annual economic output. The market undergirds schools, roads and sewer plants in every American town. And it collapsed at the end of 2008.

WSJ's Economic Editor David Wessel explains how the Build American Bond, by way of the Obama stimulus, could change the municipal market forever.

Because interest on muni bonds is exempt from federal taxes and interest on U.S. Treasury debt is taxed, muni borrowers usually pay 80% or 90% of the U.S. Treasury rate. In late 2008, those muni borrowers who could issue bonds had to pay twice the U.S. Treasury rate.

So in an obscure corner of the stimulus bill—where only city treasurers, bond dealers and big-time investors paid attention—a two-year experiment was launched. Cities and states could still offer traditional tax-exempt bonds, attractive only to high-tax-bracket investors.

To broaden the pool of potential investors to those who don't pay income taxes, including foreigners and pension funds, local governments also could offer bonds at higher, taxable interest rates—and the federal government would pick up 35% of the interest tab on borrowing done for building projects.

This was hardly a new idea. For decades, economists and tax experts had lectured Washington that what was justified as helping local governments borrow cheaply to finance projects with widespread public benefits was, in large measure, a windfall for rich investors seeking lower tax bills.

As a result, it cost the federal government more than $1 in forgone tax revenue to give $1 of help to state and local governments. Better, cheaper and fairer, they advised, would be for Washington to directly subsidize municipal borrowing.

Congress almost took the advice in 1969, but stiff opposition from mayors, governors and John Mitchell, the municipal-bond lawyer who was then attorney general, killed it.

In 2009, the driving force wasn't fairness or tax reform. It was an emergency. The bond market was closed to most cities and states. Many institutional investors weren't buying, and firms that had been insuring shaky municipal borrowers were imploding. An urgent need to draw new investors to buy muni bonds gave birth to the taxable, federally subsidized "Build America Bonds."

The experiment worked. It helped revive the muni-bond market, keeping local construction projects going. Last year, $64 billion in Build America Bonds were issued in 45 states, about 20% of all muni offerings; this year will be bigger.

Wall Street and U.S. Treasury estimates show that, after the federal subsidy, muni issuers of Build America Bonds save between one-quarter and one-half percentage point on borrowing costs versus issuing tax-exempts. That's $1.25 million and $2.5 million annually on a $500 million bond issue. New York's Metropolitan Transportation Authority figures it saved $46 million over the life of a $750 million Build America Bond issued last spring.

Bond dealers and investment bankers are happy, which, of course, makes everyone else suspicious. The more borrowing, the more money the bankers make, and new choices facing local governments means more demand for Wall Street advice. Investors are happy, too: Build America Bonds pay more than corporate bonds with similar ratings, even though municipalities rarely default. The big losers: High-end taxpayers who have fewer tax-exempt bonds to buy.

"It was right 40 years ago, and it's right today, and it's nice that something good comes out of the stimulus," says Michael Graetz, a Columbia Law School tax professor who did a stint at Treasury in the George H. W. Bush years.

Today, beneath partisan gunfire and ideological clashes in Washington, one of the few things on which Democrats and Republicans in the Senate agree is that Build America Bonds should be made permanent. It probably will be.

It succeeded in part because Washington was so generous, trying to stimulate local borrowing and building during the recession.

In making the program permanent, the president would broaden purposes for which the bonds can be issued and reduce the subsidy to 28% of the interest tab from 35%, mainly to reduce the cost to the Treasury.

The smaller subsidy would make issuing tax-exempt bonds attractive to local and state governments in some circumstances and make buying them attractive to upper-income investors, especially if President Barack Obama manages to raise their tax rates.

Keeping the traditional tax-exempt muni-bond market alive a while longer is prudent; the market could be an important safety valve if local and state governments meet stiff competition from corporate borrowers in the taxable-bond market when the economy revives.

Sometimes, the system works.

Write to David Wessel at capital@wsj.com