US muni bond tax exemption is accident of history

July 1, 2011

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.


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I think I know how Morgan Stanley got that number, and it’s not a wholly unreasonable take, but let me state it a different way: BABs typically traded 100 bps or more above tax-exempts (but the cost to issuers was offset by the Federal subsidy). That means public sector borrowers’ interest costs would be 20%+ higher in a strictly-taxable world. That’s a pretty severe penalty, and would lead to fewer public projects getting financed.

There’s also another way to approach efficiency. One of the strengths of the historic, market-access-on-demand model in the muni market is that it allows public sector issuers to keep their working capital balances and costs low. Those gains could well be fully offset by improved pricing in a more liquid taxable market, but it has not been proven.

Finally, I wonder what the hurdle is for declaring the market “often dysfunctional.” Is volatility really any higher than in the corporate bond markets? New-issue disruptions certainly haven’t come close to approaching the three-year-old “Closed” sign on hanging the door of most structured-finance markets.

Munis have to aim for perfection, because investors purchase them specifically to occupy a “riskless asset” position in their portfolios. The market’s current disclosure practices and secondary market liquidity, they fall short of that lofty goal. But historically, particularly thanks with their extremely low default rates, they’ve come much closer than most of their peer asset classes. Reform discussions have to begin with “first, do no harm.”

— Mike Stanton, Publisher
The Bond Buyer

Posted by MikeStanton1891 | Report as abusive

Your premise that making munis taxable would bring in more investors is absolutely ludicrous and wrong. First off, there is no problem finding investors, even in today’s stressed credit environment, for tax free munis. NONE.

For retail investors it has always been a scramble to get any bonds since institutions gobble them up so quickly. Ask any muni investor and they will verify.

The reason for tax exemption on muni bonds is that it lowers the cost of funding local governments. If you eliminate the tax exemption, you will again shift the burden of funding government away from the rich (who usually own munis) and back to the poor and middle class citizens through higher local taxes – most of which are very, very regressive (sales tax for one).

Your analysis reeks of conservative think tank jargon, with really no substance. It’s the same crap we hear about how high speed trading, hedge funds, prop trading desks and other speculators are providing LIQUIDITY to the markets. Actually it is just the opposite as soon as margin calls go out….

Go back and do your homework and analyze the effect higher interest rates on muni bonds would have on local cities, counties, and states. Instead of paying 3% for 15 years, they would end up paying nearly twice that amount – plus they would have to compete with other taxable bonds, so likely even have to pay higher and higher rates.

Posted by Acetracy | Report as abusive

Hi Agnes

Mike Stanton, as always, makes a good point… “first do no harm”.

-Big changes to the muni market would rattle all investors since prices would go on a rollar coaster ride causing massive fund redemptions which would in turn reset similarly priced muni bonds across the board. The bonds of 50,000 issuers would be underwater.

-Taxable BABs did a bring in more foreign buyers who in some cases scooped up picked close to 20% of the offering. But dont BABs get the same thin disclosure that tax exempts get?

-As for small issues, its interesting that in Europe most small issues are done with the help of Banks stepping in to do all of the issue.

Jim Walker

Posted by Jim_Walker | Report as abusive

“Large institutional investors tend to steer clear of munis because they’re after yield, not tax breaks.”
Does this belie the malfeasance of “large institutional investors” not looking out for net returns after taxes? Probably since most of their small and large clients reach for yield, aka the sticker price, rather than total cost of ownership.
Being right for the wrong reasons does not convince me here.

Posted by JP007 | Report as abusive

[…] That means public sector borrowers’ interest costs would be 20%+ higher in a strictly-Taxable world. That’s a pretty severe penalty, and would lead to fewer public projects getting […]

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