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.

Comments
23 comments so far

Unfortunately, you’re making two major tax errors.

1. the proposal is not a cap on itemized deductions. If your tax bracket is above 28%, you can take as many deductions that you want, except that you would only save up to 28 cents of tax per dollar of deductions instead of 31 or 35 cents.

2. the tax exemption for interest on municipal bonds is not an itemized deduction, so it wouldn’t be affected by the proposal anyway.

Posted by LZed | Report as abusive

Given the fact that 5% of the population (based on income) pays well over 50% of the taxes, it is understandable that the individuals who are seeking tax deductions fall into the top two tax brackets. To take away any opportunity for these individuals and families to make deductions is just absurd. Maybe instead of drastic measures punishing the tax payers who pay approxametly 57% of the taxes, we can start with a more reasonable plan. It just doesn’t make any sense does it?

Posted by Anonymous | Report as abusive

Like LZed, I think there must be some misunderstanding of the proposal. People making 200K-500K routinely fall into the AMT and already have their deductions wiped out entirely, with the exception of charities and interest on first mortgages.

Posted by RZ0 | Report as abusive

So little time, so many misunderstandings:

Felix, municipal bonds already have higher interest rates than comparable Treasuries in many maturity brackets. The five-year UST yields about 0.85%, and a five-year Aaa muni yields yields about 1%. Go out further, and things are even more expensive.

The demand for munis is fragile now. There’s a lot of concern about credit quality (compare California or Illinois long-term debt to that of Maryland)and future tax rates. Meredith Whitney’s blabber didn’t help (though I’m still waiting for the ‘I was wrong’ moment…). But hurting demand, on the margin, *will* affect this market, which *will* affect local projects.

20 basis points is nothing? San Francisco Airport just floated a 500mm renovation deal. 20 basis points is 1mm–not trivial. The proposal, LZed and RZD, is to limit the tax-exempt status of *all* muni interest–not just that exempt from the AMT.

Once again, Felix, you display your lack of understanding of one of the most important financial markets out there. Take a Moody’s course or something, for goodness’ sake! Bond Girl knows what she’s writing about when it comes to munis (I suspect she was an underwriter or buy-side poo-bah some time)! If you want to preserve your (remaining) credibility, don’t take her on on her home turf!

Posted by Publius | Report as abusive

it’s a variant of the Law of One Price – Felix. If you take away $400B in incentives from the guys buying the bonds, the bonds will rise in yield to cost the issuers $400B more. That’s not 1 for 1, of course – it may be even worse, in fact. We’ll see. That was Bond Girl’s point.

Posted by KidDynamite | Report as abusive

Contrary to LZ’s 2nd comment, the proposal also limits the value of tax-exempt interest excluded under section 103.

Posted by comment1 | Report as abusive

Publius and comment1, could you point to the part of the proposal that has to do with municipal bond interest and section 103?

http://taxprof.typepad.com/files/explana tion.pdf

Here is the form (Schedule A) to itemize deductions.
http://www.irs.gov/pub/irs-pdf/f1040sa.p df
Note that the deduction for state and local _taxes_ paid is completely different from the municipal bond interest being exempt from tax, which is nowhere to be found on Schedule A.

Posted by LZed | Report as abusive

I think the impact will be more than $400 myn on state and local governments… prices in markets are set on the margin. the marginal buyers of munis are high income tax payers (and they are a large margin). If people think the muni market not economically efficient now, wait until they unload or even stop buying…. The entire market cheapens… it probably would need to cheapen a lot more than the increase in taxes (as many buy them to avoid taxes — that is why many specialty states can trade well thru national names on a tax adjusted basis).

Posted by cliburn | Report as abusive

@KidDynamite, this is not the law of one price, since the proposal applies to (a) much more than just muni-bond interest — for instance, it applies to the mortgage-interest deduction, too; and (b) non-infrastructure-related muni debt.

Posted by FelixSalmon | Report as abusive

As usual, Bond Girl is absolutely correct. Charles Samuels, a partner at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C., said it is ironic that Obama is trying to pay for his legislation, which focuses on providing federal assistance for infrastructure with a proposal that will hurt tax-exempt bonds, which states and local governments use to finance infrastructure projects.

“There’s going to be less value for tax-exempt bonds and more burden on states, local governments and charities even though they’re the ones we’re counting on to provide infrastructure and services,” he said.

http://www.bondbuyer.com/news/-1030977-1 .html?CMP=OTC-RSS

Posted by FPecar4525 | Report as abusive

As someone who gets most of his income from tax-free CA municipal and GO bonds, I would not buy them at their current interest rates if they weren’t tax free. They pay ~5%, and if I suddenly had to pay taxes on them, they might have to pay 6.5% to get me to buy them. That’s a 30% increase in interest expense for the governments, so I think it would impact infrastructure development.

Posted by KenG_CA | Report as abusive

@FelixSalmon – huh? Law of One Price for EACH of the items in the proposal!

simply: if you decrease the tax benefit of muni bonds, their yield increases to compensate. That’s what I meant of Law of One Price.

It’s basically what KenG_CA means in his comment from 11:57am

Posted by KidDynamite | Report as abusive

We don’t have to guess at the increase in muni financing costs. The Build America Bonds are fully taxable. Right now the yield on CA BABs is 1.3 times as much as on comparable GOs. If that 30% higher yield is all due to taxability (which seems reasonable), and the tax deductibility of muni interest drops from 35% to 28%, CA muni interest costs would rise by 6% of their current level – roughly 30 bp on a 30 year bond.

That’s not nothing, but it’s also not that much compared to the variation in yields over just the last year. CA tax exempt bond yields were 150 bp higher in January than they are now. This change would be a blip compared to the lowered cost of financing from the recession.

Posted by FosterBoondog | Report as abusive

I think BABs underestimate where the bulk of the issuers could issue. BABs issuers are generally larger, well known entities… The smaller issuers will get killed.

Posted by cliburn | Report as abusive

Amazing, 46 million Americans living below the Federally defined poverty line of $22,314 and people earning over $200,000 a year get tax deductible expenses?

Posted by FifthDecade | Report as abusive

@FifthDecade

A year before I married my wife, she lived in “poverty” earning about $16,000 with her 6 year old daughter. They lived in subsidized housing for $300/monthly which included heat in Maine. They had Cable tv, a cell phone, a 7 year old car paid in full, health & dental care provided by the state (albiet with a $20/co-payment), clean clothes, healthy fresh food…. and $2,000 in cash hidden under the bed in case the car broke down.

Fast forward 7 years, and my wife works 25% more hours and makes twice the money she use to. Include my salary and we make 5 times what she use to live on… with virtually no change whatsoever in her quality of life. I guess you could point out that our new 7 year old paid in full car has a DVD player in the back so the kids don’t whine when we go on trips.

The social safety net is what seperates first world nations from third world nations. I want a strong and effective safety net. Income inequality is dangerously high currently and steps should be taken to lower it…

…but PLEASE do not delude yourself or anyone else that there is poverty in the US or Western Europe. It is NOT amazing that 46 million Americans live on less than $22,314. SEVEN BILLION people live on this planet and FIVE BILLION live below that poverty line even accounting for differences in purchasing power parity.

We are so fortunate in this country that we no longer understand what poverty is. I fear we will soon remember if better decisions aren’t forthcomming.

Posted by y2kurtus | Report as abusive

@y2kurtus, I appreciated your heartfelt comment, and largely agree. But does it concern you that the safety net as it existed at the time result in an approximately equivalent lifestyle you have today at 5x income? That’s part of the backlash the safety net is experiencing today, that people have an adequate lifestyle under the safety net, thus reducing motivation to become more self-sufficient.

That may be the result of an overly generous safety net, or a seriously undercompensated employment picture (or more likely some combination of both). But as a working family, do you read what you just described with perhaps a touch of annoyance?

Posted by Curmudgeon | Report as abusive

@y2kurtus, from the quotation marks you put around poverty, I take it that you are saying that your wife and her daughter weren’t poor because their basic needs were met on a $16,000 salary and $2,000 in savings. It reminds me of the line from Dolly Parton’s song “Coat of Many Colors,” “One is only poor if they choose to be.”

It sounds to me, though, like they were living paycheck to paycheck, counting on the car not breaking down completely or being totaled and that they didn’t suddenly have health or dental emergencies that would involve more than a $20 co-pay. Did her job come with sick days or vacation days? Did this non-poverty situation allow her to save money that might have gone toward retirement or education, whether for herself or her child?
We are in complete agreement that a safety net is required and that income inequality exists and should be addressed. I would disagree, however, that there is no poverty in the U.S., but perhaps it is a matter of definition.

Posted by A.deWitt | Report as abusive

@A.deWitt, there may be poverty in the US, but what you describe (“living paycheck to paycheck, counting on the car not breaking down completely . . .”) is not poverty. Poverty is eating only a single meal a day (if that), and not having enough newspapers to stuff in your single pair of Salvation Army pants to ward off the cold at night. I do believe that’s the point y2kurtus is making (correct me if I’m mistaken, sir).

The safety net has largely been good enough to prevent that; I think y2kurtus is concerned about the possibility of our deciding that we can’t afford the level of services that made life tolerable for his wife and child in the past.

Posted by Curmudgeon | Report as abusive

deWitt, it is definitely a matter of definition. Poverty in the US means something very different from poverty in China or poverty in sub-Saharan Africa. Be grateful for that!

Posted by TFF | Report as abusive

@y2kurtus, the federal poverty line in 2004 for a family of 2 was $12,490.

Posted by FelixSalmon | Report as abusive

@Curmudgeon frankly it was shocking that my earnings power less taxes, insurance, school loans, and retirement savings approximated the various support programs that are available to someone ambitious enough to sign up for them.

While I am a vocal supporter of a strong safetynet every effort must be made to structure support and incentives to move to a higher level of self sufficency. Of all the major assistance programs I think the best is the earned income tax credit… but I do think collecting it should be contingent on the annual completion of some kind of personal finance course offered by some approved non-profit. Entry level retail or food service jobs will never pay much more than minimum wage. Every day I see bright people working at jobs clearly below their obvious potential. That’s better by far than not working, but society does need to guide those people towards increasing their value per labor hour rather than trying to moderate income inequality through assistance programs.

@Felix good point that the poverty line for a two person family 7 years ago was much lower than the current amount for 4. I got that $16,000 figure for 2004 off her annual social security statement so I know it’s accuarte. I will counter your very valid point that she was above the poverty line with the idea the safety net in my state is then infact so strong that minimal cost healthcare, dental care, and housing assistance were avalible to someone at 128% of the poverty line.

Posted by y2kurtus | Report as abusive

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