US muni bond tax exemption is accident of history
By Agnes T. Crane
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.
U.S. lawmakers don’t like subsidizing municipal project financing. Last year they ended the Build America Bonds program that did just that. Yet the continuing federal tax break on state and local debt is a subsidy by another name. Getting rid of it could hit smaller borrowers — but would create a more efficient, transparent market.
No one starting afresh would design today’s municipal bond market. It was born of a 19th-century court ruling that made its way into the tax code and persists there, even though the courts have since changed their minds. Today, it’s a $2.9 trillion behemoth where an estimated 50,000 issuers finance things like schools, sewer treatment plants and public transport systems.
Large institutional investors tend to steer clear of munis because they’re after yield, not tax breaks. Municipal debt traditionally trades at lower yields than comparable U.S. Treasuries because individual investors pay less tax on the interest. But without the liquidity that comes with big players, even a smallish exodus by the sector’s mainly retail investors can trigger volatile swings.
Making munis taxable would bring in more of the big guns. The aborted BAB program, which subsidized borrowers rather than investors, proved that. Their firepower would help make the market more transparent as well as more liquid. After all, these investors aren’t likely to be satisfied with the thin disclosure that’s all too common. And the federal government would end up getting a bit more tax revenue.
Big and regular issuers like California wouldn’t have too much difficulty adjusting to a taxable market. Morgan Stanley estimates that a generic, A-rated state issuer could end up paying just 0.04 percentage point more of its budget on debt servicing over the next 10 years if it sold taxable debt.
Smaller borrowers — say in the $10 million range — would struggle more. They’ve traditionally relied on local bond buyers attracted by interest income that’s exempt from both state and federal taxes. With part of that benefit gone, borrowing won’t be so easy.
There could be other unintended consequences, too. For example, killing the federal tax exemption could lead to state government expansion as smaller communities turn to their respective state capitals, rather than residents, for funds. But the muni market is often dysfunctional in its current state. At the very least, major reforms deserve debate.