Mandating Taxable Muni Bonds

Congress should not make all municipal debt taxable -- just provide the option.
by | April 14, 2011

There's an old saying that you'll catch more flies with honey than vinegar. As Congress considers a revenue-grubbing proposal to make municipal bonds taxable, legislators need to remember that adage.

The proposal by representatives Ron Wyden, a Democrat from Oregon, and Dan Coats, a Republican from Indiana, would make all new municipal bonds taxable, giving issuers instead a federal subsidy similar but smaller than the 2009-2010 Build America Bonds (BABs) subsidy -- 25 percent vs. 35 percent of the interest when paid.

The theory behind this mandatory taxable bond policy is that the federal government loses billions every year in income taxes evaded by super-rich investors and large insurance companies that invest in muni bonds. So, it would be better to subsidize states and localities directly as we did with BABs. Very few municipal bond issuers now sell their paper at an interest rate below the proposed subsidy level, so the economics could make sense on the surface if Uncle Sam could provide an irrevocable promise to pay its share -- which we all know it cannot.

Their bill is probably dead on arrival as it will invite the wrath of state and local governments. States and localities will oppose the idea that Congress should ever start taxing their bonds on a mandatory basis. Even though they lost the landmark court case on immunity from federal taxation in the 1988 South Carolina vs. Baker case, they still have a solid public-policy case for preserving their historical exemption from federal taxes on public-purpose infrastructure projects. Besides, BABs were unpopular with some members of Congress who saw them as a giveaway to underwriters.

Thoughtful municipal bond issuers and their professional associations have always been suspicious of proposals to authorize the taxable municipal bond option. They were afraid something like this new proposal would be the first step down a slippery slope that ends with Congress pulling the plug on all tax benefits now enjoyed by the sovereign states. They worry that if Uncle Sam eventually runs out of money to pay for anything besides the military ("the common defense"), debt and social entitlement programs, there won't be money to pay the promised subsidies on muni bonds. Current fiscal projections by the Government Accountability Office show that scenario by 2030 or sooner, before some of today's bonds would mature. Of course, that doomsday scenario offers little solace that Congress would not begin taxing muni bond interest anyway.

Taxable muni bonds have a worthwhile place in the public finance system. They permit issuers to tap investors and into markets that traditional tax-exempt bonds cannot reach, such as foreign investors who do not pay U.S. income taxes and pension funds. Those markets are too large to ignore, as long as the federal subsidy is reliable and calibrated properly.

I won't dwell on the history of the taxable bond option and the constitutional issues involved. My previous column on that topic is available for those interested. What's more important right now is for state and local leaders to unify on one theme: The proposal to make all municipal bonds taxable is a bad idea that smells like vinegar. Congress should instead provide honey to state and local issues, enabling them to make rational decisions that benefit both federal and municipal taxpayers. They could simply reduce the reimbursement rate previously paid to BABs to something that makes sense for the long run. The 25 percent reimbursement rate in the proposed bill is too stingy. An ideal subsidy rate would be the average marginal tax rate of muni bond investors. I've discussed the logic for this approach previously, for those interested in the math.

My advice to state and local leaders is that they should channel the energy behind the Wyden-Coats bill to promote a five- or ten-year extension of the taxable bond option at a lower reimbursement rate equal to the weighted average marginal tax rate of muni bond investors. In today's income tax schedules, that should be around 30 percent, which is still wider than the spread between muni bonds and taxable paper for many issuers. Every dollar borrowed by state and local governments under this approach will cost the federal government less, and municipalities will use the tool only when they know it works to their advantage. The subsidy level would be self-adjusting if taxable bonds begin to crowd out traditional tax exempt paper, which would receive lower interest rates. If Congress later raises the upper-income tax rates to Clinton-era levels, my formula would automatically raise the taxable bond subsidy rate commensurately.

If Congressional tax committees insist on a 25 percent reimbursement for voluntary taxable bonds, it should be an up-front payment upon completion of the project with progress payments allowable. That would eliminate the issuer's risk that Congress would later pull the rug out from under them on reimbursements of future interest payments, and the present value of the up-front payment would offset the lower subsidy rate.

Yields on traditional tax-exempt bonds will decline as some of the supply is channeled into markets that issuers cannot otherwise tap. It's a "win-win" if done properly.

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