February 1, 2023

Rise To Thrive

Investing guide, latest news & videos!

Inflation Reduction Act’s tax incentives may reshape muni market

3 min read
Inflation Reduction Act's tax incentives may reshape muni market

Tax incentives in the Inflation Reduction Act have the potential to reshape the municipal bond market by undermining its reliance on the tax-exemption.

That’s the thesis from Justin Marlowe, a research professor at the University of Chicago’s Harris School of Public Policy, author of a paper on the topic that will be published this month in the Government Finance Officers Association’s bimonthly magazine, Government Finance Review, which he previewed Thursday during a Volcker Alliance briefing on the Inflation Reduction Act.

Justin Marlowe, a professor at the University of Chicago, Harris School of Public Policy, says tax credits available to public entities in the Inflation Reduction Act could prompt a shift away from tax exempt bonds.

Signed into law by President Biden on August 16, the IRA features a lengthy list of tax incentives for public and private entities to finance clean energy projects. Among the incentives are direct-pay tax credits and the ability to transfer tax credits, both of which benefit public entities that have no tax liability.

The products are not new to muni participants, but a significant increase in their supply may affect the market, Marlowe said.

“It raises the question of what happens if we see a whole range of successful new assets built using this creative new financing? What if we expand this beyond clean energy, into transportation infrastructure or basic infrastructure like buildings?” Marlowe asked. “The success of a lot of high-profile projects [could create] momentum to think about the municipal bond market as a direct-pay tax credit market,” with less emphasis on the tax-exemption.

That’s something some Congressional lawmakers have been advocating for, Marlowe added.

The IRA features two types of direct-pay tax credits: an investment tax credit, based on a percentage of a project’s cost, and a production tax credit, which is an annual payment based on the amount of energy produced and sold by a project over 10 years.

“The direct pay plus the transferability of the credits has even more significant implications for where the municipal financing industry goes from here,” he said. The combination of the two creates “a variety of interesting scenarios.”

Renewable energy developers and public entities — like cities, states or public pension funds — could work together to leverage the IRA’s tax credits, he said.

For instance, a developer could tap the tax credits to build a solar farm, then sell the project to a public entity, which can convert the tax credits into direct-pay credits. Then the entity could “turn around and lease that same asset back to the developer, and the developer could sell the power” using different tax credits back to a public entity.

Past direct-pay bond programs, like Build America Bonds, have run into criticism because Congress has been willing to halt appropriations for deficit-reduction purposes. That political risk may be mitigated if the tools reach “a critical mass,” Marlowe said.

“There’s a very good chance with the IRA that we could reach that critical mass, and that would mean some big shifts in how we think about the municipal finance market and how we finance infrastructure,” he said.