Association for Public Policy Analysis & Management

Recent federal proposals to boost infrastructure investment aim to stimulate capital spending by lowering the cost of tax-exempt borrowing. The efficacy of these proposals depends on the responsiveness of state and local borrowing to the cost of capital as well as the extent to which changes in borrowing translate into changes in capital spending. I study the supply elasticity of municipal debt by exploiting a debt notch created by the Tax Reform Act (TRA) of 1986. In order to issue "bank-qualified bonds'', which confer considerable interest rate savings, a significant number of governments issue exactly $10 million in debt per year. Moreover, there is considerable heterogeneity, with school districts much more likely to bunch in response to the notch than general purpose governments. Drawing from the recent bunching literature, I use this result to 1) infer elasticities of borrowing and 2) quantify the extent to which reduced borrowing in response to the notch translates into lower capital spending.