The big muniland tax exemption dud

January 10, 2013

Alarm bells are ringing across muniland because the discussion about capping the municipal bond tax exemption at 28 percent has surfaced again. Bloomberg reports:

“If and when there is a serious attempt to make substantial reforms to the tax code, I think that there’s a risk that the [municipal bond] tax exemption could be curtailed or eliminated,” said Decker, the co-head of SIFMA’s municipal securities activities.

The possibility of municipal-bond income losing its exemption from tax is as great as any time since 1986, when major tax reform was ushered into law during the Reagan administration, said George Friedlander, Citigroup Inc. senior municipal strategist.

Municipal bonds losing their tax favored treatment “is a very real threat,” said Mike Nicholas, chief executive officer of the Bond Dealers of America.

These industry leaders are echoing concerns that have been bouncing around muniland for a year and half. But the only specific proposal made by a government official came in President Obama’s 2013 budget proposal. Reuters reported in February, 2012:

President Barack Obama on Monday proposed limiting tax breaks given to high-income earners on the interest paid by municipal bonds, a change that could rock the $3.7 trillion market if approved.

In his fiscal 2013 budget, Obama reiterated his desire to cut tax breaks for families with incomes over $250,000, saying they should only be allowed to reduce their tax liabilities to 28 percent of income from the current 35 percent.

What exactly would Obama’s proposal to cap deductions look like for high earners and their municipal bond tax exemptions? I dug out the most recent IRS data (2009) that showed the total amount of tax-exempt interest and the number of filers by income category. I averaged the amount of tax-exempt interest by income bracket and compared that to a possible 28 percent cap.

Generally, households averaged between 14.8 percent to 25.6 percent of the proposed 28 percent deduction cap on municipal bond interest. These taxpayers would likely have other deductions, such as mortgage interest payments and state and local taxes, to put against the 28 percent cap as well. But the dire warnings of catastrophic sell-offs from rich people being crushed under fewer deductions just don’t seem evident in the data.

Governors and mayors have been flocking to Congress to protect their Medicaid, education and other grants from being slashed the federal government. It would seem wise, if they haven’t already, to drop their arguments for protecting the municipal bond tax deduction for the wealthiest Americans. Local and state officials have a lot more at stake with their Medicaid and education funding to be protecting wealthy bondholders.


Wells Fargo: Municipal Market Outlook, 2013

GFOA: Concerns with Capping the Exemption of Muni Bond Interest

Mintz Levin: “28% Cap” Unlikely To Trigger Wave Of Municipal Bond Tax Calls

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