Lawmakers and the municipal bond tax exemption

October 16, 2012

The Joint Committee on Taxation is circulating an analysis of tax reform proposals, one of which includes removing the municipal bond tax exemption for all bonds issued after December 31, 2012. If the tax exemption is repealed or capped so that the federal government can collect more tax revenue, bond prices will fall. The higher yields would repay investors for their loss of tax exemption, nevertheless, groups are forming to oppose proposals to repeal the exemption.

Republican presidential candidate Mitt Romney has not indicated any specifics about how he would treat muniland in his tax reforms. President Obama has proposed changes. The Bond Buyer summed up the President’s position:

Some market participants contend that Obama’s plans to raise tax rates and permanently reinstate the Build America Bond program would help the muni market, despite his plan to cap the value of tax-exemption at 28% for higher income earners.

It would be good to know what the presidential candidates think about muni taxation, but the real players are the members of the Senate Finance Committee. Specifically, the members of the Subcommittee on Taxation and IRS Oversight, who have direct responsibility for crafting changes in the tax law. I wondered how heavily the committee members’ home states were loaded with municipal debt. It turns out that Democratic senators serving on the subcommittee come from states with very heavy debt loads. Republicans on the committee have much less debt on their states. The table below shows how much each state spends from its budget on debt.

The real issue here is that states with heavy debt burdens — Massachusetts and New York for example — would need to devote a lot more of their budgets to debt service if the muni tax exemption was removed and muni interest rates were to subsequently rise. For a state like New York, which pays an estimated 11.3% of its budget to debt principal and interest, increased rates would blow a hole in its budget plans.

All this would be compounded by a rise in interest rates that is bound to happen, since interest rates are so historically low now. It’s only a matter of when.

Moody’s did an excellent report in May that details state debt loads (the data in the table above is from this report). The median debt load for states was 4.9% (you can see the debt load for each state on page 11). A rise in interest rate costs would probably be manageable for half of the states with low debt burdens, but the other half above the median would likely find the eliminated tax exemption very painful.

There is, of course, the elephant in the room – Puerto Rico, which Moody’s estimated was paying 18.7% of it’s budget in debt service. Lawmakers should tread lightly, as Puerto Rico’s debt is held by many single-state mutual funds that have many retail investors.

There are very good arguments for capping the municipal bond tax exemption at 28%, as President Obama has proposed. Mitt Romney has floated the idea of exempting all investment income earned under $200,000 per year. Gaining prominence is the idea to entirely remove the muni bond tax exemption. In the end it’s likely to be a struggle between lawmakers whose states have different levels of municipal debt.

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