Tax Law Complicates ‘Smart City’ Financing Plans

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By Tara Jeffries

U.S. cities’ technology ambitions may get pricier under the new tax law changes.

Cities with ambitious “smart city” tech projects face contorted public finance decisions after President Donald Trump signed the tax law in December. Municipal bonds, which are federal-tax-free, fixed-income securities that cities often issue to finance infrastructure projects, could be less attractive because corporate and institutional investors, now facing lower corporate tax rates, have less incentive to look for tax-free investments. Cities also could face revenue slumps as the tax law’s limits on local tax deductions may hamper their ability to raise taxes.

“Demand will go down,” particularly from corporate investors, Matt Fabian, a partner at Municipal Market Analytics, told Bloomberg Law. “Infrastructure is something that will be squeezed out in that equation.”

Some tech-focused infrastructure projects nationwide, such as Atlanta’s project to install road sensors to manage traffic and Cincinnati’s app-based parking system, have been financed with muni bonds. But cities that face shrinking demand from muni investors may have to raise interest rates they pay to attract bond investors, muni analysts told Bloomberg Law. That could slow the progress of urban technology development that companies like Cisco Systems Inc. and Verizon Communications Inc. see as emerging business opportunities, infrastructure and public finance experts say.

The tax law “raises borrowing costs for state and local governments in a couple ways,” Fabian said. For one, the overhaul “undermines the demand from corporations” for tax-exempt income. “By capping the deduction for state and local taxes, it makes it more difficult for state and local governments to raise taxes to pay for infrastructure.”

These new calculations come as President Trump’s infrastructure plan proposes to spend about $200 billion in federal funds over the next decade in a bid to spur billions of dollars in spending by states, cities, and the private sector, with a goal of about $1.5 trillion in total infrastructure investment. The incentives and subsidies in Trump’s plan could drive state and local governments—which supplied about 76 percent of infrastructure funding in 2014, according to Bloomberg Government analysis—to spend more than they otherwise might have planned.

Infrastructure is expensive and already hard to finance. And these tax wrinkles will make it harder, bond analysts say. More than half of city finance officers—55 percent—named infrastructure as the leading drain on their budgets in 2017, according to data from the National League of Cities.

Waning Demand for Munis

Municipal bonds, which pay fixed incomes to investors over long stretches of time, have been cities’ favored financial tool for long-term projects. Investors, from retirees to large banks and insurance companies, often flock to them because they’re safe, stable, and free of federal taxes.

Trump’s tax overhaul cut the corporate income tax rate to 21 percent from 35 percent. With less income taxes to pay, corporate investors’ urgency to target tax-free investments has waned, analysts say. Banks and insurance companies hold nearly 29 percent of municipal bonds, according to Bloomberg Intelligence.

“The fact that municipal bonds are generally tax-exempt in the United States is pretty relevant for the decisions that state and local governments make, with respect to infrastructure spending,” Scott Greenberg, a senior analyst at the Washington-based Tax Foundation, told Bloomberg Law.

The lightened tax burden may also make corporate bonds, which are generally riskier but carry higher coupon rates, more attractive to investors than munis even though incomes on them are taxed. The difference between yields on taxable securities and tax-exempt ones like muni bonds has narrowed, making munis a relatively less appealing choice to corporate investors, Don McDonald, CEO of Prime Advisors Inc., told Bloomberg Law.

Still, demand from foreign buyers and individuals for munis likely will keep the market stable, McDonald said.

Lower Revenue

The tax law also could darken cities’ revenue outlook. The law capped the amount of state and local taxes (SALT) that taxpayers can write off their federal tax bills.

State governments may find it more politically perilous to raise taxes now that voters have less room to write them off in federal returns. The SALT deduction cap doesn’t have an impact on local coffers directly, Greenberg of the Tax Foundation said. And many policymakers decried the write-off as bad policy that needed fixing—akin to a federal handout to high-tax states.

However, in the long term, the deduction cap could drive people away from high-tax cities and states, Sumit Agarwal, a finance professor at Georgetown University’s McDonough School of Business, told Bloomberg Law.

Meanwhile, local property tax revenue growth may also slow down if cities are reluctant to raise taxes, according to Moody’s Investors Service. Its research shows local property tax revenue is anticipated to grow 2 to 4 percent in 2018, compared to 3 to 5 percent projected last year.

Those cities, in the long run, “will have a harder time raising capital because now they don’t have as much revenue generation. They will have to issue bonds,” Agarwal said. “That will impact the ability of these cities to kind of become more modernized, become more tech-savvy.”

To contact the reporter on this story: Tara Jeffries in Washington at tjeffries@bloomberglaw.com

To contact the editor responsible for this story: Roger Yu at ryu@bloomberglaw.com

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