P3 Projects and

Tax-Exempt
Bond Financing:
How Does the
Puzzle Work?
Vicky Tsilas and Edith Brashares*

This article discusses tax-exempt bond financings of infrastructure projects and the
value and challenges associated with using public-private partnerships. The article ex-
plores the types of projects that have been financed to date as well as the administra-
tion’s proposals to encourage public-private partnerships.

INTRODUCTION

R
eports of our nation’s aging infrastructure and our need to pro-
vide additional investment to support its modernization have
revived discussions in Washington about what the best source
of financing is and which parties are most suitably equipped to pay for
it. The talk about infrastructure is not just limited to Washington; even
comedian John Oliver did a segment on financing infrastructure on his
HBO show (John Oliver, 2014). The federal government’s contribu-
tion to infrastructure investment comes in the form of grant and loan
programs as well as federal subsidies provided through the tax system.
Increasingly, the debate has focused on the role of the private sector and
whether federal government initiatives should encourage more private
sector funding.
This paper describes infrastructure spending by state and local govern-
ments and the traditional methods for funding these assets. Investment in

*Vicky Tsilas is a partner at Ballard Spahr LLP in Washington, DC. Edith Brashares is
director of the Business and International Taxation Division at the Office of Tax Analysis, U.S.
Treasury, Washington, DC. The views expressed in this paper are those of the authors and
do not necessarily reflect those of their employers. Vicky Tsilas can be reached by email at
tsilas@ballardspahr.com.
51
52 MUNICIPAL FINANCE JOURNAL

our bridges, highways, utility systems, and water and sewage facilities has
come from both the public and the private sectors. Given the importance
of transportation investment, we first discuss the experience with high-
way projects. Highway projects have been one of the main areas where
the public-private partnership (P3) structure has been used. We describe,
first, the traditional approach for building highways and the use of gov-
ernmental tax-exempt bonds for financing. We then use the Transporta-
tion Infrastructure Finance and Innovation Act (TIFIA) program as a way
to examine increased private sector participation. We also examine P3s
and how private activity tax-exempt bonds are used by P3s for highway
construction. Finally, we discuss the arguments and experience with P3s
and describe some initiatives and proposals to expand P3 structures for
infrastructure.

WHAT IS INFRASTRUCTURE AND HOW IS IT

BEING FINANCED?
The term “infrastructure” is defined by the Congressional Budget Office
(CBO) as including transportation systems (23%; roads, highways, air, water,
and rail), utilities (30%; water, gas, electricity, and telecommunications)
and other public facilities, such as schools and universities. In 2013, capital
spending on infrastructure was estimated to be more than $508 billion per
year, of which about $81 billion was financed by the federal government,
primarily for highways and other transportation. Most federal investment in
infrastructure is in transportation, drinking water, and wastewater systems.
By contrast, private sector investment in infrastructure focuses on energy
utilities and telecommunications systems. Figure 1 applies the methodology
of the Congressional Budget Office and U.S. Congress Joint Committee on
Taxation to estimate capital spending on the types of infrastructure financed
(CBO/JCT, 2009).
Given the importance of highways and the federal government’s funding
of them, our discussion will focus on public spending on highways. This
type of infrastructure has also seen much experimentation over the last
decades with including the private sector as a partner. As is summarized in
Table 1, state and local government spending accounts for approximately
70% of highway spending, including almost all operation and maintenance
spending and approximately 50% of capital spending. This split highlights
the importance of costs not only for building and renovating infrastructure
but also for ongoing operating expenses. Both costs are important to the
public sector. Although there is variation across jurisdictions, most states
rely on vehicle fuel taxes. Federal spending includes grants as well as
borrowing subsidies and generally flows from the Highway Trust Fund to
state and local governments. Federal spending accounts for roughly half
 P3 PROJECTS AND TAX-EXEMPT BOND FINANCING 53

Figure 1: Total Estimated Public and Private Capital Spending on

Infrastructure in 2013 by Type
Health Care
Health Care Private
Public 17% Transport Public
2% 21%
Transport
Education
Private
Private
2%
4%
Education Utilities Public
Public 9%
16%
Environment Utilities Private
Private Environment
21%
1% Public
7%
Sources: Updated methodology of Table 1-1 from Congressional Budget Office and Joint Committee on Taxation
(2009) using Office of Management and Budget, Budget of the U.S. Government, Fiscal Years 2014 and 2015
and Analytical Perspectives, Tables 20-2 and 18-2; U.S. Census Bureau, State and Local Government Finances,
2012 and 2013, and 2012 and 2013 Annual Capital Expenditure Survey, Table 4a; and U.S. Department of Com-
merce, Bureau of Economic Analysis, National Economic Accounts, Fixed Asset Tables, Tables 3.7S and 3.7ES.

Table 1: Highway Public Infrastructure Spending 2014 (2014 $ billions)

Federal State and Local Total
Grants State &
Net of
& Other Total Total Amount Local
Federal
Loans Percentage
Total 44,851 1,467 46,318 118,345 163,197 164,664 72%
Capital 43,583 0 43,583 48,324 91,908 91,908 53%
Operation &
1,268 1,467 2,735 70,021 71,289 72,756 96%
Maintenance
Sources: Table W-7 from Congressional Budget Office (2015) and supplemental Tables W-7 through W-12 for 2014.

of the capital spending for highways.1 Because many projects can take a
number of years to build and are longer-lived assets, bond financing is
frequently used to enable closer matching of payment for the asset with
its use (Kile, 2014). In general terms, borrowing enables the project to be

1
In 2014, revenues from excise taxes, primarily fuel taxes, credited to the Highway
Trust Fund were approximately $38 billion, and federal spending was closer to $45 billion.
The difference was that some general funds have been shifted to the Highway Trust Fund.
See http://www.cbo.gov/sites/default/files/45416-TransportationScoring.pdf.
54 MUNICIPAL FINANCE JOURNAL

done sooner than if the funds must be saved before work can begin. How-
ever, there may be state limits on the amount of tax-exempt borrowing
for a particular project, and this can result in projects being delayed when
relying on tax-exempt financing.
This public spending is seen as raising overall economic output and is
done by governments for reasons related to economic efficiency. For exam-
ple, it may be difficult or economically inefficient to charge consumers for
use of infrastructure because infrastructure may have some public-good
characteristics. In this case, the services provided by the infrastructure
may be provided to an additional consumer at little or no extra cost. In
addition, some infrastructure services may be provided in the long run at
lowest cost by one provider, a “natural monopoly.” For example, instead
of having multiple sets of pipes, water is supplied by one facility in a given
area. Finally, the benefits of investing in infrastructure may extend beyond
where the specific infrastructure is built, so that private-sector provision
would be too low (CBO, 2015).
Tightly wrapped up with public spending on infrastructure is how these
assets are managed. The choice of public or private management can affect
financing choices. With regard to highway projects, we describe, first, the “tra-
ditional” approach for managing and financing these ventures because this is
still the primary way highways are maintained and built in the United States.

FINANCING HIGHWAY PROJECTS USING THE

TRADITIONAL APPROACH
Traditionally, state and local governments have assumed most of the
responsibility for financing infrastructure, with the federal government pro-
viding subsidies primarily for capital. State and local governments sepa-
rately contract to design, build, and maintain a highway. For example, under
the design-bid-build approach, the government may separately contract for
a bridge design, get another contract for the bridge to be built, and then per-
haps contract for some operation and maintenance to be done on the bridge.2
Each stage is administered with a separate contract, with the lowest-cost
bidder usually being chosen. The state or local government combines some
of its own funds with those of the federal government and also borrows
money that is repaid by taxes or tolls. The government may also contract for
operation of the highway or may maintain and operate it using government
employees. Except for very large projects, financing is generally from tax
revenues or tolls or, if borrowing is used, from tax-exempt bonds. Often the
tax-exempt bonds are supported or paid off using either tax revenues or tolls.

2
In general, the government contracts with private companies to perform the work, with
government employees, or their proxies, administering the contract.
 P3 PROJECTS AND TAX-EXEMPT BOND FINANCING 55

Under the traditional approach, the public agency retains a high degree
of control over the project during its useful life, but governments tend to
bear all of the risks, too. If the design must be modified while it is being
built, the government bears the cost for changing the design as well as for
project delays that may result because often these contracts are not a fixed
price, but pass on cost overruns. Similarly, the design and the quality of the
structure can lower maintenance costs, but it is difficult for the contract to
ensure that these maintenance costs are accounted for in the design stages
because they are not paid by the private contractors. Finally, by financing
the project, government and the state and local taxpayers bear the risk that
tolls or related tax revenues will be inadequate to pay for the project.

Tax-Exempt Bond Financing: The Use of

Governmental Bonds
In addition to grants from the federal government, the most common
means of providing a federal subsidy for infrastructure investment is by
permitting the tax exemption for interest on state and local bonds.3 Tax-
exempt bonds pay interest to the bondholder that is not subject to federal
income tax. This reduces the issuer’s borrowing costs because purchasers
of the debt are willing to accept a lower rate of interest than that for taxable
debt.4 If tax-exempt bond financing is used, part of the costs and risks are
shifted to all federal taxpayers because the exclusion of tax-exempt inter-
est from federal taxable income is borne by all taxpayers (U.S. Treasury,
2011). Although there is no specific estimate of the subsidy for highway
projects for governmental bonds, the tax expenditure for public purpose
bonds was $29 billion for 2014. Because approximately 20% of govern-
mental bonds issued in 2012 were for transportation, $6 billion of the tax
expenditure can be assumed to have been for transportation, of which the
lion’s share would be for highways.
Tax-exempt bonds may be classified as either governmental bonds or
private activity bonds. Interest paid on governmental bonds is excluded
from gross income for federal income tax purposes, but the interest paid
on private activity bonds is not excluded unless they are “qualified pri-
vate activity bonds,” which are certain permitted categories of tax-exempt
bonds for projects involving private sector parties. The tax rules do not
limit the types of facilities that can be financed with governmental bonds.

3
According to the Joint Committee on Taxation (2015), the exclusion of interest on
general purpose state and local government debt has consistently been one of the biggest
corporate tax expenditures since 1975.
4
Generally, tax-exempt bonds are viewed as a costly mechanism for delivering a federal
subsidy to the issuer of the bonds, because the revenue foregone by the federal government
in connection with the exemption is greater than the subsidy received by the issuer.
56 MUNICIPAL FINANCE JOURNAL

As a result, governmental bonds can be used to finance a wide range of

infrastructure projects, including highways.
Traditional highway project financing has used governmental bonds that
require the proceeds to be primarily used to finance governmental func-
tions or to be repaid from governmental sources. Although there is no vol-
ume cap on how much can be borrowed, the tax rules impose limits on the
parties that may benefit from tax-exempt bond-financed facilities. Projects
can qualify for tax-exempt financing if the bonds exceed either the 10%
private business use test or the 10% private payment test, but not both. In
general terms, this means the bonds finance publicly owned projects or are
paid off with public funds. Bonds that do not satisfy these criteria would
pay taxable interest that is not subsidized.
Under the tax rules, private business use is limited. In particular, private
business use includes use of bond-financed property by a nongovernmen-
tal person as a result of ownership, a lease, or actual or beneficial use of
the bond-financed property under a management or output contract.5 A
contract between a private entity and a governmental entity to manage or
provide other services for a bond-financed facility may result in private
business use, depending on the length of the contract and the compensa-
tion structure.6
The longest permitted term under the existing IRS safe harbors before
private business use occurs is a 15-year management contract (20 years for
public utility property). During the term, periodic fixed fees must make up
at least 95% of the service compensation for each year. The compensation
for the services rendered must not be based on a share of the net profits
from operation of the financed property in order for there not to be private
business use.
In practice, governmental bonds can be used to finance projects that may
be built by the private sector as well as managed by that sector. Bonds can
qualify as tax-exempt governmental bonds despite significant private busi-
ness use if the bonds are paid back using public revenues such as taxes. In
instances where a private party manages a tax-exempt bond-financed gov-
ernmental facility, such as a toll road, the private manager often receives
availability payments and not payments based on the net profits of the
project. In addition, the management contract will generally be no longer
than 15 years in order to prevent private business use and result in the
bond interest becoming taxable.
The advantage of this private sector involvement is that private busi-
nesses that specialize and are more efficient in building roads and bridges

5
Treas. Reg. 1.141-3(b).
6
Rev. Proc. 97-13, 1997-1 C.B. 632 as supplemented and modified by Notice 2014-67.
 P3 PROJECTS AND TAX-EXEMPT BOND FINANCING 57

and managing them take up these tasks. Local governments, for example,
may plow the snow and repave roads because these activities occur con-
tinually. The key to engaging the private sector is that governments must
be able to write contracts that account for contingencies for road design,
build, and maintenance issues. Ideally, governments could use incentive
payments, penalties, and milestones in contracts to align the private con-
tractors’ and the government’s incentives. Some argue that these results
are more easily achieved with P3s.

New Impetus for Private Sector Involvement: The

Transportation Infrastructure Finance Innovation Act
With traditional sources of highway funding, particularly motor fuels
taxes, not keeping up with spending needs, tolls have been growing as a
funding source. Because tolls and other user financing can be uncertain,
project borrowing costs have risen. To fill this financing gap, the federal
government started providing direct loans, loan guarantees, and lines of
credit to finance larger projects in 1998 under the Transportation Infra-
structure Finance and Innovation Act (TIFIA). State and local governments
have to repay the TIFIA loans within 35 years of substantial completion of
the project. This assistance is allocated by the Department of Transporta-
tion based on specific criteria.7 Table 2 summarizes the TIFIA highway
projects as well as P3 projects described in work by the CBO on highway
funding (Kile, 2014). The table lists specific projects, the phases the private
party was involved in that were included in one contract, an estimate of the
value of the contract, the estimated opening date, and the general financing.
Some projects, such as the State Highway 45 North in Texas, continue to
use the traditional approach, with the design contract being bid separately
from the building contract and financing with tax-exempt governmental
bonds and public funds (taxes and tolls) and TIFIA. However, over time,
there have been an increasing number of projects that have combined the
design and build stages into one contract. For example, the I83-A Turnpike
project in Texas was a similarly financed project that combined the design
and build stages with the government acting as the contractor. Similarly, the
I-15 Reconstruction project in Utah was another design and build project
financed with public funds and tax-exempt bonds. Although these projects
do not run afoul of the tax-exempt bond restrictions on private participa-
tion, the type of private involvement in the project is limited. Projects that
combine design and build stages set up a mechanism whereby designs that
lower building costs are encouraged. This internalization of the costs from
poor designs better aligns the government’s and the builder’s interests.

7
See DOT: http://www.fhwa.dot.gov/safetealu/factsheets/tifia.htm.
58 MUNICIPAL FINANCE JOURNAL

Table 2: Characteristics of Specific P3 Highway Projects in the

United States

Private Activity

Taxes and Tolls

Private Equity
Private Debt

Tax-exempt
Value of

Maintain
Project

Operate
Contract ($

Finance
Design

TIFIA

Bonds

Bonds
Build
billions Date
2013) Opening

1 Central Texas Turnpike System (TX) X X 4.1 2006 X X X

State Highway 45 North X bid X 2007 X X X
Loop 1 (Mopac Expressway) X bid X 2006 X X X
State Highway 130, Segments 1 to 4 (TX) X X 1.7 2007 X
2 LA 1 Improvements - Phase 1 (LA) X bid X 0.4 2009 X X X
3 Riverwalk Expansion (IL) X bid X 0.4 2016 X X
4 Wekiva Parkway (FA) X bid X 0.5 2018 X X
5 I-15 Reconstruction (UT) X X 2.1 2001 X X
6 Cooper River Bridge Replacement (SC) X X 8.8 2005 X X
7 183-A Turnpike (TX) X X 0.4 2007 X X X
8 North Texas Tollway Authority (TX) X X 0.7 2009 X X X X
9 Intercounty Connector (MD) X X 5.6 2011 X X X
10 Triangle Expressway (NC) X X 1.3 2012 X X X
11 US 36 Managed Lanes (CO) X X 0.3 2015 X X X
12 Grand Parkway Segments D-G (TX) X X 2.9 2016 X X X
13 SR 520 Floating Bridge (WA) X X 2.9 2016 X X
14 SR 91 Corridor Improvement (CA) X X 1.3 2017 X X X
15 Gerald Desmond Bridge Replacement (CA) X X 1.3 2017 X X
16 Tappan Zee Bridge (NY) X X 3.1 2018 X X X

17 Route 3 North (MA) X X X 0.5 2005 X X

18 Southern Connector (SC) X X X 0.3 2001 X X
19 Atlantic City-Brigantine Tunnel (NJ) X X X 0.5 2001 X X
20 Northwest Corridor (GA) X X X 0.8 2018 X
21 I-75 Collier/Lee County (FL) X X X 0.5 2010 X X

22 Chicago Skyway (IL) X X 2.1 2005 X X X

23 Indiana Toll Road (IN) X X 4.3 2006 X X X
24 Bayonne Municipal Utilities Authority (NJ) X X X 0.2 2013 X X X

25 Dulles Greenway (VA) X X X X 0.5 1995 X X X

26 SR-91 Express Lanes (CA) X X X X 0.2 1995 X X X
27 Camino Colombia Bypass (TX) X X X X 0.1 2000 X X X
28 Pocahontas Parkway (VA) X X X X 0.7 2002 X X
29 South Bay Expressway (CA) X X X X 0.8 2007 X X X X
30 State Highway 130, Segments 5 to 6 (TX) X X X X 1.4 2012 X X X X

31 I-495 HOT Lanes (VA) X X X X X 2.1 2012 X X X

32 I-595 Corridor Readway Improvements (FA) X X X X X 2.0 2014 X X X X
33 Port of Miami Tunnel (FL) X X X X X 1.1 2014 X X X X
34 I-595 Managed Lanes (FL) X X X X X 1.9 2014 X X X X
35 Presidio Parkway (CA) X X X X X 0.4 2015 X X X X
36 N. Tarrant Express, Segments 1 & 2 (TX) X X X X X 2.2 2015 X X X X
37 I-95 HOV/HOT Lanes (VA) X X X X X 0.9 2015 X X X X
38 I-635 LBJ Freeway (TX) X X X X X 2.8 2016 X X X X
39 Ohio River Bridges E. End Crossing (IN) X X X X X 1.2 2016 X X X
40 Midtown Tunnels (VA) X X X X X 2.1 2017 X X X X
41 Goethals Bridge Replacement (NY, NJ) X X X X 1.4 2017 X X X X
42 N. Tarrant Express, Segment 3A (TX) X X X X X 1.4 2018 X X X X
43 Portsmouth Bypass (OH) X X X X X 0.6 2018 X X X
44 I-4 Ultimate Project (FA) X X X X X 2.8 2021 X X X X

Sources: TIFIA website, active and retired projects: http://www.transportation.gov/tifia/projects-financed; Kile

(2014), Tables 3 and 4; Department of Transportation website: www.fhwa.dot.gov.
 P3 PROJECTS AND TAX-EXEMPT BOND FINANCING 59

Given that governments are also concerned with operation and mainte-
nance, it is natural to consider including these activities as well into one
contract. Doing this, however, can raise issues with financing with respect
to governmental tax-exempt bond rules.

PUBLIC-PRIVATE PARTNERSHIPS
The term “Public-Private Partnership” (P3) is broadly used to refer to
an arrangement between a private entity and a public agency—typically a
state government—for a project in which the private entity assumes some
level of risk beyond that typically associated with providing its services
to the public entity. The Department of Transportation defines “public-pri-
vate partnerships as contractual agreements between a public agency and a
private entity that allow for greater private participation in the delivery of
[a] transportation project.”8 There are a number of ways to structure a P3,
as suggested in Table 2. A private party may agree to a model that involves:
design-build, operate and maintain, design-build-operate-maintain, and
design-build-finance-operate-maintain. In each of these models, the level
of investment, control, and risk the private party assumes over the project
can vary. In addition to providing needed funds, private financing may
encourage more efficient management of costs and risks because this gives
private partners incentives to finish projects on time and under budget. As
with the design-build projects, this shift is designed to more closely align
the private contractor’s interests with those of the government.
Although the P3 approach varies as to the extent of private involvement,
in its purest form, the private sector takes over all aspects of operation. For
“greenfield” projects, this can include design, build, operate, and main-
tain as well as finance. The Dulles Greenway in Virginia is an example
in which all stages were run by a private partnership and depended upon
tolls to pay for the private debt financing as well as a return to the private
equity invested. In this case, the private sector designed, built, and oper-
ated the road and could potentially reap any efficiencies from combining
these operations. In addition, the private sector took the financing risks
that tolls collected from users would be adequate to finance the highway,
with the public sector bearing little risk. Similarly, for highways already
built, such as the Indiana Toll Road, under the pure approach, the private
sector acts as a concessionaire operating and maintaining the roadway for
a long period in exchange for collecting the tolls to pay off private debt
and provide a return to private equity. In cases such as the Indiana Toll
Road, the private sector may make an upfront payment to the govern-

8
See DOT: http://www.fhwa.dot.gov/ipd/p3/defined/.
60 MUNICIPAL FINANCE JOURNAL

ment for the right to operate the road ($3.8 billion for 75 years),9 which
is similar to selling the public asset, with the private sector bearing all the
risk. These two examples point to the difficulties with having the private
sector bear all the risk. In both cases, the toll revenue projections were too
optimistic and both projects have run into financial difficulties. Although
these may be a modern-day lesson in why the government is involved in
highways, they are also part of the reason for TIFIA.
Using a P3 structure can mean that it will be faster to build the project.
One contract covering multiple phases may take less time to negotiate and
enables intermingling of cost overruns with excess profits across phases.
Moreover, projects may obtain financing faster because they can work
around states’ self-imposed limits on borrowing and tap private funds.
However, the risk that tolls will be inadequate has resulted in a broadening
over time of financing arrangements, with the private sector willing to bear
less of the project risk. In response over time, instead of receiving uncer-
tain tolls, the private sector receives more fixed availability payments.
This has the effect of transferring from the private contractor to the public
the risk that the tolls will not provide adequate financing.10
There has also been a move to use subsidized borrowing to replace pri-
vate borrowing using taxable bonds. In particular, TIFIA and the quali-
fied private activity bonds described below are being used more as time
goes on to finance P3 projects. This move lowers the private partners’
costs at the expense of federal taxpayers and can increase the state and
local government’s share of risk if they are ultimately liable. As a result,
these newer P3 projects have diminished incentives associated with pri-
vate financing to control costs and be completed quickly. To ensure that
the private contractor has “skin in the game” and has aligned interests with
those of the government, most P3s continue to require equity investments
by the private parties.

Qualified Private Activity Bonds: A Tool in the P3 Toolkit.

The tax rules define a “private activity bond” as any bond that satisfies
(1) the private business use test and the private security or payment test
(the private business test) or (2) the private loan financing test. Under the
private business test, a bond is a private activity bond if (1) more than 10%
of the proceeds are used in a trade or business of a private business (pri-
vate business use test) and (2) more than 10% of the payment of principal
or interest on the issue is (a) secured by property used for a private busi-
ness or (b) to be derived from payments in respect of property or borrowed

9
See Schmitt and Chung (2014).
10
This may be a desirable outcome in encouraging more vehicles on toll roads and off
smaller local roads that are not subject to tolls.
 P3 PROJECTS AND TAX-EXEMPT BOND FINANCING 61

money used or to be used for a private business (private payment test).11

If a tax-exempt bond meets the private business tests, it will be treated as
a taxable private activity bond, and the interest paid will not be excluded
from gross income for federal income tax purposes. A bond issue satisfies
the private loan test if bond proceeds exceeding the lesser of $5 million or
5% of the borrowings finance loans to the private sector. A bond will be a
private activity bond if both the private business use test and the private
payment test are met.
However, the tax rules permit certain specified categories of private
activity bonds (referred to as “qualified private activity bonds”) to be
tax-exempt bonds even though they provide financing for the private sec-
tor. These categories of qualified private activity bonds were created by
Congress as a way to recognize that certain facilities and activities, even
though privately owned/operated, serve the general public and therefore
should be encouraged and subsidized. The tax rules define “qualified pri-
vate activity bonds” to include, among others, exempt facility bonds.12
Exempt facility bonds finance most infrastructure projects. In order to
qualify as an exempt facility bond, 95% or more of the proceeds of the
tax-exempt bonds must be used to finance certain permitted facilities.13
Transportation facilities that can be financed with exempt facility bonds
include qualified highway or surface freight transfer facilities.
Unlike governmental tax-exempt bonds, the tax rules impose a number
of limitations on qualified private activity bonds. In most cases, the vol-
ume of the bonds that can be issued is limited every year by annual state
volume limitations (volume cap).14 In the case of qualified highway or sur-
face freight transfer facilities, the tax rules provide a national limitations
amount of $15 billion over multiple years that is allocated by the Secretary
of Transportation.15
Qualified private activity bonds have been part of the financing mix,
particularly of more recent P3 projects that cover all project stages listed
at the bottom of Table 2. Although the main revenue source continues to
be tolls from the project, and the private partners are required to put up
some equity, financing often includes a mix of TIFIA loans and guaran-
tees, qualified private activity bonds, and government funds. For example,

11
U.S. Code Section 141(b).
12
Section 141(e).
13
Section 142(a).
14
For calendar year 2015, the amount used under U.S. Code Section 146(d)(1) to calcu-
late the state ceiling for the volume cap for private activity bonds is the greater of (1) $100
multiplied by the state population, or (2) $301,515,000. See IRS Rev. Proc. 2014-61. In ad-
dition, states may carry forward unused amounts during the three calendar years following
the calendar year in which carry-forward amounts arose. Section 146(f)(3)(A).
15
Section 142(m)(2)(A).
62 MUNICIPAL FINANCE JOURNAL

the I-635 LBJ Freeway in Texas includes private activity bonds as well as
other funding sources, with the private developer setting and receiving toll
revenues for 52 years as compensation.16

Two Sides to Every Story:The Value of P3s

The value of engaging in P3 arrangements has been strenuously debated
over the years, with proponents advocating for legislative and regulatory
changes to make it easier for state and local governments to use them.
P3s are argued to enable efficiencies to be realized by combining all the
design, build, operate, and maintain stages so that the roadway is designed
to be less expensive to build, operate, and maintain instead of the tradi-
tional approach in which each stage is decided separately without account-
ing for the interactions. With tight budgets, P3s have also been promoted
as a way to access private funds for public projects, typically enabling a
project to be started sooner. Although projects that are totally self-financed
are likely to be rare, P3 financing has evolved over time to enable more
private involvement. Key to the success of a P3 is that the government can
write and administer a contract that accounts for the future.
Critics of P3s often note the risks to state and local governments. Con-
tracts may not be able to perfectly align the public and private interests
in that the private sector in the pursuit of profit may restrict competition
and earn monopoly profits. Moreover, private parties require a return on
their investment, which is not necessary for a public participant. Although
initially P3s shifted more risk to the private sector, more recent projects
do less shifting. This may be more efficient, in that the public sector can
better bear the risks, but it can set up a situation where the private sector
bears little downside risk but continues to enjoy the upside.
Evidence of whether P3s are helping or hindering infrastructure invest-
ment is not plentiful because there have been few P3s used in the United
States compared to the numbers used in other countries. A 2014 Treasury
Report notes that: “International experience demonstrates that many kinds
of infrastructure that are publicly provided in the United States can be pri-
vately owned or managed. . . . For example, privately managed highways
are common in Canada and Europe, and Hong Kong’s transit system is
likewise privately managed” (U.S. Treasury Department, 2014, p. 5). How-
ever, in comparing the U.S. system with infrastructure financing abroad,
overseas experience may not be as helpful, given the relative autonomy of
state and local governments in the United States and significantly differ-
ent tax rules and subsidies provided in other international countries. For
example, giving tax-exempt bond subsidies to state and local infrastruc-
ture is unique to the United States.

16
See DOT: http://www.dot.gov/policy-initiatives.
 P3 PROJECTS AND TAX-EXEMPT BOND FINANCING 63

The Treasury Report notes that P3 investment remains a small part of total
U.S. infrastructure investment and that between 2007 and 2013, the $22.7
billion of public and private funds invested in P3 transportation projects
represented only 2% of overall capital investment in the nation’s highways
during that same period. The Report concludes that although public invest-
ment is a critical part of infrastructure funding, P3s should be embraced
because they “can infuse projects with private capital, management, and
expertise to bolster total infrastructure investment while also exploiting
untapped efficiencies in infrastructure provision” (U.S. Treasury Depart-
ment, 2014, p. 17). Thus, the main advantage of P3s is in providing road-
ways more efficiently. Kile (2014), however, focusing on financing, argues,
after examining a limited number of P3 projects, that while including a
private partner does not result in additional money for roads, in some cases
it does appear to speed up financing so that the highways are built sooner.
All-in capital costs are similar whether financed by the government or a P3.
Critics of P3s point out that there are many inherent limitations with
P3 arrangements. One of the limitations listed for P3s is that not all states
have passed legislation authorizing P3s. In fact, in 2015, about 34 states
and Puerto Rico had passed laws authorizing P3s for highway and bridge
projects.17 Moreover, even in states where P3 legislation has been enacted,
the degree of support for P3s varies depending on what types of P3 arrange-
ments the legislation permits.
There are also a number of financing risks cited for why public entities
should not enter into P3s for financing infrastructure projects. Some oppo-
nents argue that while private financing could allow certain states to cir-
cumvent budgetary or legal constraints regarding how much debt the state
can borrow, it does not expand the resources available to the state to repay
the debt, potentially creating implications for a state’s finances. Another
argument made against P3s is that a long-term arrangement between a
public entity and a private party for assets can ultimately turn out to be a
bad policy decision for the public entity. For example, the SR-91 Express
Lanes in California were eventually purchased back by a California trans-
portation authority because the private operator had a non-compete clause
inhibiting the government from expanding alternative roadways despite
the need. Moreover, critics of P3 models state that the public entity must
ensure that it has a clear understanding of the value of the assets it will
contribute to the partnership. Otherwise, inaccurate modeling of costs
could result in the P3 model incorrectly appearing to be less costly than
anticipated. Finally, negotiating P3 arrangements may result in consider-
able legal and administrative costs and time that may outweigh the cost

17
See Association for the Improvement of American Infrastructure: www.aiai-infra.
com, and also www.fhwa.dot.gov.
64 MUNICIPAL FINANCE JOURNAL

savings that could result from the P3 deals. Indeed, the recent canceling of
the Route 460 P3 project in Virginia highlights one of the hazards, where
public contract negotiations appear to have resulted in payments of up to
$250 million without any roadway being built.

CONCLUSIONS
In some respect, the discussion about P3s is one of degree. Even under
the “traditional” financing approach for highways, governments contract
with the private sector to do much of the construction, if not maintenance.
P3s bundle together more of these activities to encourage internalizing
costs and realizing savings. However, P3s also require modifications of
financing tools as well as sophisticated contracting. Although the jury is
still out on many of the P3 highway projects, given the long life of high-
way assets, the approach is being expanded into other infrastructure areas.
For its part, the Obama administration has launched the Build America
Investment Initiative to encourage P3s. The initiative includes a 2016 budget
proposal for a new category of tax-exempt qualified private activity bonds
called Qualified Public Infrastructure Bonds (QPIBs) that are eligible to
finance specific categories of facilities financed with exempt facility bonds
under current law. A significant aspect of this proposal is that, unlike other
categories of qualified private activity bonds, QPIBs are not subject to the
bond volume cap requirement and the alternative minimum tax (AMT) pref-
erence for interest on qualified private activity bonds. Exclusion from the
volume cap requirement is designed to facilitate use of these bonds for larger
projects, such as sewage and water facilities. This exclusion from the AMT
preference puts the QPIBs on the same footing as governmental bonds.
Facilities eligible for QPIB financing include most categories of infra-
structure eligible for private activity bonds, including highways. However,
there are two core eligibility requirements for QPIBs: a governmental
ownership requirement and a public use requirement.18 Existing categories
of exempt facilities that overlap with QPIBs could be accommodated.19

18
The ownership requirement can be met even if the property is leased to the private
sector, provided that certain conditions are met. The proposal provides a safe harbor for
establishing governmental ownership of financed projects so that property leased by a gov-
ernmental unit is treated as owned by the governmental unit if (1) the lessee makes an irre-
vocable election (binding on the lessee and all successors in interest under the lease) not to
claim depreciation or an investment credit related to such property, (2) the lease term is not
more than 80% of the reasonably expected economic life, and (3) the lessee has no option
to purchase the property other than at fair market value (at the time the option is exercised).
19
Existing categories would be removed on the effective date of the proposal (which ap-
plies to bonds issued starting January 1, 2016), subject to a transitional exception for quali-
fied highway or surface freight transfer facilities. Alternatively, the proposal provides that
Congress consider continuing the existing categories of exempt facilities that overlap with
QPIBs for privately owned projects, subject to the unified annual state bond volume cap.
 P3 PROJECTS AND TAX-EXEMPT BOND FINANCING 65

Even without expansion of private activity bonds, the American Bar

Association Tax Section (ABA, 2015) submitted comments suggesting
that the IRS and Treasury set forth safe harbors under the tax-exempt bond
rules for certain P3 arrangements. The ABA has requested that the cur-
rent rules governing contractual arrangements between users as owners of
capital projects and for-profit contracts/service providers be clarified and
amplified to allow long-term arrangements to exist in the context of capital
projects. The ABA recommends a safe harbor of at least 30 years but not
longer than 80% of the useful life of the applicable facility, with a flexible
compensation structure. The new safe harbor would include safeguards
to assure that the benefits of tax-exempt financing are not shifted to the
private operator. These expansions in the availability of new subsidized
financing for P3 projects make their use in the future more likely for infra-
structure projects in general.

References
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