The myths around the municipal bond tax exemption

March 6, 2013

The debate surrounding the sacred cow of municipal bond tax exemption is reaching new heights. In a recent report from the National League of Cities, estimates by SIFMA (the dealer trade group) show that municipal governments would have paid an additional $173 billion in interest over 10 years with a 28 percent cap on municipal bond tax exemption. And if Congress had fully repealed the municipal bond tax exemption, municipal issuers would have paid an additional $495 billion in interest costs over the last 10 years. These amounts would be on top of the $1.09 trillion in interest paid on municipal bonds in the last 10 years under the current law.

SIFMA/NCL arrived at these projections using this method (page 6-7) emphasis mine:

The information in Chart C was determined by taking the amount of interest paid by each jurisdiction in the last fiscal year, with a median interest average of 4.69 percent over the past 15 years (Thomson Reuters), and applying a 70 BPS increase for what the interest costs would have been if the bonds were issued with a cap in place, and applying a 200 BPS increase for what the interest costs would have been if the bonds were issued without the exemption in place.

The problem with this model is that we already have a market-based correlation to understand how much additional cost municipalities would face if the tax exemption were completely removed. All we need do is look at the taxable municipal bond market and compare those yields with tax-exempt yields.

Although taxable muniland only has about 8 percent of the trading activity of the tax-exempt market, there are still about 2,900 trades a day (page 77). This is enough for Thomson Reuters Municipal Market Data to evaluate yield levels for all maturities and credit levels. 72 percent of MSRB’s trades in 2012 were either AAA, AA or A, and across the 1-30 year yield table the average MMD spread for these ratings was 86 basis points. This is not far from SIFMA/NLC’s estimate of 70 basis points for capping the muni bond tax at 28 percent.

It is hard to believe that completely removing the muni tax exemption, which I don’t advocate, would have cost issuers an additional 200 basis points in borrowing costs or an additional $495 billion in interest costs over the last 10 years.

I don’t mean to make this a debate over models, and I easily could be wrong in my analysis, but so many numbers have been thrown around that rarely have any supporting methodology to back up their claims. As this debate moves forward it would be useful to have more transparency for the models. The federal government needs more tax revenue to pay for expanding Medicaid to 30 million additional people, among other social needs. State and local governments say they need the muni tax exemption in order to build infrastructure. Both of these purposes are essential. The debate needs to happen with more clarity and less rhetoric.


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