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Federal Tax Reform May Be Saving Money for States, Even High-Tax Ones

The part of the 2017 law that high-tax states are battling in court is likely helping them lower their debt -- at least in the short-term.

Connecticut State Capitol
The Connecticut State Capitol
(David Kidd)
Many states that lobbied against federal tax reform’s limit on a certain tax deduction are now benefiting from a potential effect of that 2017 policy change.

Tax reform capped the state and local taxes (SALT) that filers can deduct from their federally declared income at $10,000. High-tax states like California, New Jersey and New York have sued to block that change because their state and local taxes can be twice that amount for residents.

But as more people turn to municipal bonds, seemingly as a way to lower their federal tax burden, the result is lower borrowing rates for state governments, which saves money for them.

Case in point: Connecticut recently planned on selling $850 million in bonds to investors, but the demand was so great that the state upsized its sale to $1 billion for the same cost of borrowing. California, New Jersey and New York are seeing similar demand for their bonds, according to financial analysts.

Federal tax reform, however, likely isn't the only factor playing a role in the better borrowing costs for governments. The muni bond supply this year has been below the five-year average. The increased demand, combined with the low-supply environment, means that most states coming to the market are getting favorable rates on their bonds because it's a sellers market.

Still, analysts see at least one sign that tax reform is driving this increased demand: In high-tax states, local governments are receiving more favorable rates when compared with local governments in low-tax states.

Analysts are watching to see what happens to demand when tax season wraps up next week.

“A lot of the push [in buying muni bonds] so far has been on the presumption that there is more [demand] in these states with the SALT effect,” says Kimberly Olsan, senior vice president of FTN Financial. “I’m not really going to be able to quantify that until next week passes.”

The SALT cap means that many people in higher-tax states can't deduct all their state and local taxes from their income on their federal tax returns. The expected result is that their income will increase and therefore so will their federal taxes owed. Reports so far have indicated that thousands of tax filers either owe taxes this year or are receiving smaller refunds.

That's where municipal bonds come in.

They act as a tax shelter for income and can lower a person's federal tax burden. The increase in demand for them is outpacing the supply and that is generating a lower cost of borrowing for governments. The result is that governments are either paying less than they expected on the bond debt or they are borrowing more for the same initial cost. Either way, taxpayers get an indirect benefit because their government is getting more bang for its buck.

Still, there are big questions looming about federal tax reform's long-term impact on government debt.

Rudy Salo, a public finance attorney at Nixon Peabody, notes that the bonds being issued now were long ago approved by voters. If voters in higher-tax states are feeling the pinch from federal tax reform, they may be less likely to approve future bonds that would raise their taxes.

“There’s a possibility the next time a school bond goes up in a high-tax state, voters will be thinking twice,” Salo says. “They may not be as willing anymore because they may not get to deduct that [tax hike] anymore.”


In Other Public Finance News This Week


 Kentucky Governor Vetoes Pension Bill

Gov. Matt Bevin vetoed a bill in Kentucky that opponents warned could have ultimately bankrupted the state employees’ pension fund.

The controversial bill allowed regional colleges, universities and other quasi-government institutions to leave the state's troubled pension system without immediately paying off their debt. Instead, they could pay it off over 25 years. Employers leaving the fund would be required to provide other retirement options for their employees, such as a 401(k). 

Regional college presidents and other proponents of the legislation said it would have given them much-needed budget relief from an upcoming spike in their annual pension bill.

In his veto message, Bevin said the measure violated the “moral and legal obligation” the state has to the affected retirees and that he would call for a special session to address the issue.


Newsom’s Idea to Avoid More Bankrupt Utilities

When California’s largest utility filed for bankruptcy earlier this year, many warned that it could be the first domino to fall as deadly wildfires and ensuing liability lawsuits have become more frequent in the West. Now, Gov. Gavin Newsom is expected to pitch his solution that could help investor-owned utilities like the bankrupt PG&E stay solvent while also making fire victims financially whole.

At issue is a California law known as inverse condemnation, which essentially holds utilities responsible for wildfire damage caused by their equipment -- whether the companies acted negligently or not. PG&E is facing $30 billion in potential wildfire liabilities and filed for bankruptcy in January.

According to NPR affiliate KQED, Newsom’s proposal to be released Friday will include establishing a state reinsurance fund to act as a financial backstop for utilities. And he’s proposing streamlining the California Public Utilities Commission so that the regulatory agency can deal more quickly with issues of safety and liability.

This appears in "The Week in Public Finance" newsletter. Subscribe for free.

Liz Farmer is a former GOVERNING fiscal policy writer.
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