Cutting municipal tax deductibility won’t hurt infrastructure investment

By Felix Salmon
September 13, 2011
Bond Girl, but today is obviously the official day when bankers talk their book with no particular logic.

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I’m normally a big fan of Bond Girl, but today is obviously the official day when bankers talk their book with no particular logic. In this case, the proposal which has attracted her ire is the idea that part of the jobs bill will be paid for by capping itemized deductions for individuals earning more than $200,000 a year and married couples earning more than $250,000. Basically, you can deduct away to your heart’s content — until your tax rate reaches 28%. At that point, you can’t deduct any more.

Amazingly, this simple and pretty modest proposal would raise a whopping $400 billion — pretty much the entire cost of the jobs bill, right there. And it doesn’t go nearly as far as I would: I’d abolish all deductions altogether, in an attempt to radically simplify the tax code.

But Bond Girl finds a lot to hate, all the same.

This would likely reduce demand for municipal bonds substantially – you know, the primary vehicle for infrastructure investment in this country. According to the Bond Buyer, “Internal Revenue Service data from 2009 shows that 58% of all of the tax-exempt interest reported to the IRS was from individuals with incomes of $200,000 or higher.” Prices for outstanding municipal bonds will decline and borrowing costs for state and local governments will increase going forward. This means state and local governments will have to levy more taxes to construct projects as planned, postpone projects, or cut spending elsewhere.

I’m happy to grant, here, that demand for munis might well decline if this proposal goes through. But would that really hurt infrastructure investment, or mean higher local taxes? Unless and until I see some hard numbers, I’m going to be very skeptical, given the existing ultra-low interest-rate environment. Sure, it’s nice for individual muni investors right now that they don’t need to pay income tax on the puny interest payments they’re getting. But the reason those interest payments are so puny is mostly a function of interest rates, rather than tax-deductibility.

In the absolute worst-case scenario here, all individual investors would shun the muni market entirely, and municipals would have to fund themselves in the institutional market, with taxable bonds. What’s the difference in yield between taxable and tax-free bonds? Right now, it’s not very much.

Realistically, then, how much would municipalities’ cost of funds rise if tax-deductibility were curbed in this way? 20 basis points? 30? 40? We’re not talking, here, about the kind of numbers which change the economics of an infrastructure project. And we’re certainly not talking about the kind of numbers which would necessitate local tax hikes to pay for suddenly-higher construction costs.

Whenever you close a tax loophole, you’ll have a series of consequences. Some will be intended, and some will be unintended. Some will be positive, and some will be negative. But closing loopholes in and of itself is a good thing — and when doing so gets you an extra $400 billion, it’s a no-brainer. If necessary, calculate the added interest expense that municipalities will have to pay, take it out of the $400 billion saved, and just give it to those municipalities as an outright grant. I doubt it would amount to very much money.

And it’s certainly no reason not to go along with this very welcome idea to start cracking down on deductions in the tax code.

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