Feds Move to Tax Muni Bond Earnings

A proposal by the president's fiscal commission could dramatically increase the cost of borrowing for cities.

A new proposal by the National Commission on Fiscal Responsibility and Reform seeks to revoke the tax-exempt status of earnings from state and municipal bonds. The move could drastically raise the cost of borrowing money for local governments.

The interest earned by municipal bonds is exempt from federal income taxes; in some cases it's exempt from state and local taxes too.

Since the investor doesn't have to pay taxes on income earned from the bonds, he may be willing to accept a lower interest payment from the issuer. That reduces the cost of borrowing for the state or local government issuing bond. And that's the way it's been since 1913, when the federal income tax code was adopted.

The bipartisan National Commission on Fiscal Responsibility and Reform, created by President Obama earlier this year, is tasked with developing recommendations on how to improve the federal government's fiscal situation and balance the budget by 2015.

Their report, released earlier this month, includes a measure to render interest on newly-issued state and municipal bonds as taxable. There is no elaboration on that plan within the report.

Here's an example of how the tax-exempt status benefits local governments, courtesy of Morgan Stanley:

The following example illustrates: If a New York state resident were to purchase $10,000 worth of a 7% corporate bond and was in the 6% state tax bracket and the 28% Federal tax bracket, he would have to pay 32.93% (the Combined Effective Rate), or $238, to state and federal tax authorities. This would leave him with an after-tax yield of 4.62%. Thus, a 5% New York municipal bond that is both free of federal and state taxes and yielding more than 4.62% would be an attractive alternative.

Thus, in some cases, a state or local government can charge a lower interest rate than a corporation yet still be more profitable to investors.

Revoke that tax-exempt status, and the equation changes. Since the investor pays taxes regardless, he should put his money in the corporate bond that pays a higher interest rate. New York would have to pay a better interest rate than the corporation to be attractive to investors, and borrowing money for projects becomes more expensive for the state.

"Very simply stated, this would have a huge impact on state and local governments' ability to raise capital," R. Kinney Poynter, executive director of the National Association of State Auditors, Comptrollers and Treasurers, told Governing
. "The idea of these being taxable goes against the whole history of giving state and local governments a break."

A senior commission staffer with the fiscal commission explained to Governing that the plan relied on "zero-based budgeting" to come up with a personal tax plan. The commission eliminated all deductions, then built them back only with what was viewed as necessary. The tax-exempt status was among the deductions that were axed.

"Our view was that the tax code doesn't need to be permanently subsidizing everything just because it's historically been subsidizing things," the staffer said.

One could argue that the tax-exempt status for municipal bonds is a subsidy for the wealthy. Their status primarily benefits individuals in the highest tax brackets. Other investors in municipal bonds include mutual and money market funds, insurance companies and commercial banks.

"Tax reform must continue to protect those who are most vulnerable, and eliminate tax loopholes favoring those who need help least," the commission wrote in its report.

Still, eliminating the tax-exempt status would raise borrowing costs at a time when state and local governments are struggling financially. Furthermore, it would make it more costly to build infrastructure even when leaders across the country are emphasizing that need.

For cities and states, the idea of losing tax-exempt status for their bonds is so unpalatable that it's actually used as a compliance mechanism in a bill introduced by House Republicans that would require public pension plans to report data to the Treasury Department. Those that didn't would see their locality lose the ability to issue tax-exempt bonds.

The Securities Industry and Financial Markets Association, a trade group, estimates that municipal bonds' tax-exempt status allows state and local governments to borrow at interest rates that are 25 to 30 percent lower than they would be otherwise.

Meanwhile, investors hold $2.8 billion worth of municipal debt. Thus, one could surmise that that the tax-exempt status has helped state and local governments across the country save $700 billion on their existing debt.

Poynter conceded that the commission's proposal is not likely to pass. But municipal bonds are still coming under fire.

Earlier this year, Sens. Ron Wyden and Judd Gregg introduced a bill that would have eliminated the bonds' tax-exempt status and instead offered a smaller tax credit for a portion of their interest.

The popular Build America Bonds program was not extended in tax legislation passed by the Senate this week.

And the Securities and Exchange Commission is in the midst of holding hearings on the municipal securities market. According to an SEC press release, issues to be examined include investor protection, financial reporting, transparency and market stability and liquidity, among other subjects.

At the conclusion of the hearings next year, the SEC will release a report making recommendations for regulatory changes and industry "best practices."

Zach Patton -- Executive Editor. Zach joined GOVERNING as a staff writer in 2004. He received the 2011 Jesse H. Neal Award for Outstanding Journalism