Time to ride the muniland tax exemption pony

By Cate Long
November 9, 2012

At the Bloomberg Link conference on Thursday, Matt Posner, of Municipal Market Advisors, said that discussion of the municipal bond tax exemption would likely be rolled over to the next session of congress, which begins January 3. Yes, the long awaited muniland battle is upon us. Strap on your armor.

Ever since President Obama created the National Commission on Fiscal Responsibility and Reform (Simpson Bowles) in 2010, the subject of reducing or eliminating the federal tax exemption for muni bonds has been kicked around. The administration proposed, in 2011, to “reduce the value of itemized deductions and other tax preferences to 28% for families with incomes over $250,000.” Muniland’s tax exemption has a big fat target on its back.

Many in Congress believe that the muni tax exemption benefits the wealthiest households in the U.S. In fact, IRS (2009) data shows that 151,098 households with annual incomes over $1 million get almost $16 billion of non-taxed interest from municipal bonds:

Another approach would be to make munis taxable and attract other classes of investors, especially 401(k) and IRA account holders, as I wrote in September of 2011:

The effect of various tax proposals on municipal borrowing rates, including full removal of any tax-exempt status, should be analyzed against the various classes of muni bond ownership. U.S. tax-exempt organizations, for instance, control $8.2 trillion in assets; if municipal bonds became taxable they could prove to be a great asset class for pension funds and other organizations which do not pay taxes on interest income. This is also true for personal retirement accounts like 401(k)s, which are not taxed until savings are withdrawn.

There are other solutions for restructuring the muni exemption. Peter Coffin, thePresident of Breckinridge Capital Advisors, had an excellent suggestion at the Bloomberg conference:

But Congress is generally not amenable to last-minute changes in policy direction unless there are some strong interest groups pushing well-thought out alternative proposals. The 28% cap on municipal interest exemption has been on the table for two years, and it neatly solves a complex issue for an already strained congress.

It will be a big effort for muniland to implement the operational changes needed to accommodate the 28% cap. Tax, accounting, investment advisor and broker systems would require reprogramming. Robert E. Amodeo, head of municipal investments at Western Asset Management Company, brought up the potential effect on mutual funds at the Bloomberg conference:

Do you hear the trumpet call muniland?

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