Direct Versus Indirect Federal Bond Subsidies: New Evidence on Cost of Capital

The longstanding debate surrounding the most effective way for the U.S. federal government to subsidize state and local government capital‐raising received renewed attention in recent years due to the passage and subsequent expiration of the taxable Build America Bond (BAB) program. Recent academic studies, as well as reports from the U.S. Treasury Department, claim that the direct subsidy approach as evidenced by the BAB program provides greater bond borrowing cost benefits to state and local governments compared to traditional tax‐exempt bonds. This research investigates the extent to which such borrowing cost benefits may be overstated since it appears previous studies did not adequately account for the early call optionality of tax‐exempt bonds.