During the presidential election campaign, Donald Trump’s probable pick for Commerce Secretary, Wilbur Ross, and economist Peter Navarro, wrote a comparison of Trump’s infrastructure plan to Hillary Clinton’s. In the report they wrote that America faces a huge infrastructure gap and attributed that gap to a lack of adequate financing options. President-elect Trump has said he will focus on rebuilding America’s infrastructure, and The Wall Street Journal reports that he will rely on private capital to reduce the cost of his plan.
The Trump plan will offer some discipline because it is designed to move private capital off the sidelines, and investors, unlike politicians, expect a decent return. In an October white paper, Trump economist Peter Navarro and investor Wilbur Ross detail what they call “a huge infrastructure gap,” which they attribute to a lack of “innovative financing options.” They think they can unleash about $1 trillion in the capital markets with a tax credit equal to 82% of private equity investment, much as states and cities encourage real-estate development.
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That should help avoid the crushing debt normally associated with infrastructure stimulus programs. Ross and Navarro explain further Trump’s private sector financing plan here:
The Trump infrastructure plan features a major private sector, revenue neutral option to help finance a significant share of the nation’s infrastructure needs. For infrastructure construction to be financeable privately, it needs a revenue stream from which to pay operating costs, the interest and principal on the debt, and the dividends on the equity. The difficulty with forecasting that revenue stream arises from trying to determine what the pricing, utilization rates, and operating costs will be over the decades. Therefore, an equity cushion to absorb such risk is required by lenders.
The size of the required equity cushion will of course vary with the riskiness of the project. However, we are assuming that, on average, prudent leverage will be about five times equity. Therefore, financing a trillion dollars of infrastructure would necessitate an equity investment of $167 billion, obviously a daunting sum.
We also assume that the interest rate in today’s markets will be 4.5% to 5.0% with constant total monthly payments of principal and interest over a 20- to 30-year period. The equity will require a payment stream equivalent to as much as a 9% to 10% rate of return over the same time periods.
To encourage investors to commit such large amounts, and to reduce the cost of the financing, government would provide a tax credit equal to 82% of the equity amount. This would lower the cost of financing the project by 18% to 20% for two reasons.
First, the tax credit reduces the total amount of investor financing by 13.7%, that is, by 82% of 16.7%. The elegance of the tax credit is that the full amount of the equity investment remains as a cushion beneath the debt, but from the investor point of view, 82 percent of the commitment has been returned. This means that the investor will not require a rate of return on the tax credited capital.
Equity is the most expensive part of the financing; it requires twice as high a return as the debt portion, 9 to 10% as compared to 4.5 to 5.0%. Therefore, the 13 percent effective reduction in the amount of financing actually reduces the total cost of financing by 18 to 20 percent. By effectively reducing the equity component through the tax credit, this similarly reduces the revenues needed to service the financing and thereby improves the project’s feasibility.
These tax credits offered by the government would be repaid from the incremental tax revenues that result from project construction in a design that results in revenue neutrality. Two identifiable revenue streams for repayment are critical here: (1) the tax revenues from additional wage income, and (2) the tax revenues from additional contractor profits. 5
For example, labor’s compensation from the projects will be at least 44 percent. At a 28 percent tax rate, this would yield 12.32% of the project cost in new revenues. Second, assuming contractors earn a fairly typical 10 percent average profit margin, this would yield 1.5% more in new tax revenues based on the Trump business tax rate of 15 percent. Combining these two revenue streams does indeed make the Trump plan fully revenue neutral with 13.82 percent of project cost recovered via income taxes versus 13.7 percent in tax credits.
An Example
To look at this at a more granular level, conventional financing would require total payments of $1,625 per thousand dollars of project cost if the final maturity were twenty years at 4.5% and the equity got a 9% rate of return over the same period. However, with an 82% tax credit, the payments would be reduced to $1,330, an 18.1% reduction. If the respective rates instead were 5% and 10% and the final maturity 30 years, the respective payments would be $2,138 and $1,705, a savings of 20.2%.
Note that this tax credit reduces the risk of loss to the equity yet it still leaves investors with skin in the game. In effect, this tax credit approach means that major revenue shortfalls could occur without impinging on either the debt or the equity.
The tax arithmetic is likewise straightforward. 16.67% of project cost is the equity component, so the 82% tax credit equals 13.69% of project cost. The labor content of construction would be at least the 44% share the Congressional Budget Office attributes to the GDP. Taxing it at the 28% rate (21% plus 7% for the trust) yields 12.32% of tax revenues.
There also would be a 10% pretax profit margin for the contractor. Taxing that at the 15% business rate yields 1.5% of project cost. Adding that to the taxes on wages yields 13.82%, slightly above the 13.69% tax credit.
Note that the risk of a major shortfall is limited because contractors operate on a cost-plus basis. Alternatively, if they commit to a fixed price, they build in a large margin for error. Importantly for the government budget, there will not be much of a time gap between the granting of the credit and receipt of the tax payments under the Trump plan.
