Consequences of Increased Federal Support
for Infrastructure Investment

(click for report with supporting data)

Federal support for water-system investment can have unintended consequences. For example, an analysis of the federal wastewater construction grants program under the Clean Water Act concluded that it reduced other contributions to wastewater capital spending by 67 cents on the dollar. Thus, federal support does not necessarily increase investment in water infrastructure but may prompt cuts in state and local spending or its diversion to other uses.

Federal support for investment projects also undermines the cost-effective provision of water services by distorting the price signals that systems face and thus affecting managers' choices in many areas, such as preventive maintenance, construction methods, treatment technology, pipe materials, and excess capacity. The resulting losses can be significant, particularly if subsidies are large. For example, a statistical analysis done for a 1985 CBO study of the wastewater construction grants program indicated that the original federal cost share of 75 percent led to higher costs for plant construction. In particular, the study projected that a cut in the federal share of investment funding from 75 percent to 55 percent (which occurred later under the program) would reduce average capital costs by 30 percent. (Costs would be reduced, assuming that the states did not replace the lowered federal funding with their own subsidies, because system managers would exercise more care in choosing treatment technologies and reserve capacity and in monitoring the pace of construction.)

One way to reduce the distorting effects of federal subsidies might be to target increased aid to fewer systems--those judged most deserving, whether because of high costs associated with declining customer bases, federal regulations, or simply high levels of anticipated investment (or investment and O&M) in general. It may be difficult, however, to define the target group in a way that does not reward systems for poor management and past underinvestment. Targeting could even undermine cost-effective action if it encouraged system managers to let infrastructure deteriorate in hopes of qualifying for aid in the future.

A variety of spending mechanisms--grants, loan subsidies, and credit assistance--are available to deliver and annually readjust a desired level and pattern of aid for water systems, but the design of such programs would strongly influence total costs. For example, federal support such as partial grants, partial loans, or credit assistance would leave investment projects relying on private funds as well, and thus could help keep costs down by subjecting water systems to more market discipline from lenders and ratepayers. Another approach to help system and state authorities make cost-effective choices would be to allow them more flexibility in using the SRFs. That strategy might include eliminating floors and ceilings on funding for eligible activities in the drinking water program, easing restrictions on transferring federal money between drinking water and wastewater revolving funds, and broadening the funds' range of uses to address issues such as nonpoint source pollution.

The federal government can also use tax preferences to aid water systems, but doing so limits its discretion in delivering certain levels and patterns of aid. Public water systems and the interest paid on municipal bonds issued on their behalf are generally exempt from federal taxes. Options for enhancing the tax preferences already accorded to municipal bonds include relaxing the requirement that issuers rebate arbitrage profits (earned by investing the proceeds from a bond at a rate above the bond's own yield) to the Treasury and eliminating the partial taxation of interest earned on municipal bonds held by corporations that pay the alternative minimum tax. Such enhancements would aid medium-sized and large water systems but would be less helpful to small systems, many of which do not have access to the municipal bond market. The Congress's ability to review and adjust tax preferences is limited in comparison with its ability to adjust spending programs through the annual appropriation process, but the greater year-to-year stability of the preferences would make planning easier for water-system managers.

Implications of Direct Federal Support for Ratepayers

An alternative to subsidizing investment by water systems would be to assist low-income households facing high or greatly increased water bills. No federal program exists for transferring income to help households with their water bills, but there are precedents for that type of federal aid.

A well-designed program to support households might address distributional objectives more precisely and at the same time avoid price distortions that would undermine incentives for cost-effective action by water systems and their customers. Unlike programs to subsidize investment, a program to subsidize households would not affect the choices confronting water-system managers; nor would it reduce the water prices faced by households that were not receiving the direct subsidies. Even for subsidized households, the program could limit the costs associated with distorting water prices by defraying the expense of their basic water use (for example, by paying a fixed amount per month based on household size) instead of paying benefits as a percentage of each household's water bill (which would effectively lower the price per gallon used). Such a program would provide support without encouraging overuse of water services.