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<i>The Week in Public Finance</i>: Tax Reform Hits Muni Market, California Plays Tax Games and Local Pensions Do Better Than State

A roundup of money (and other) news governments can use.

California state Senate President Pro Tempore Kevin de Leon has proposed a workaround to changes in the new federal tax bill.
(TNS/Al Seib)

Corporate Tax Break Already Affecting Muni Market

Even though the federal tax overhaul has yet to go into effect, the cuts to the corporate tax rates are already impacting the municipal market. Preliminary data shows that banks have begun to reduce their muni bond buying. According to Municipal Market Analytics (MMA), banks' third quarter net buying fell to about $5.7 billion. That’s the lowest quarterly number since 2009, when banks collectively sold off a net $10.3 billion.

In addition to reducing how much they buy, MMA’s Matt Fabian says it’s “not unreasonable that at least some institutions will become net sellers” of tax-exempt municipal bonds in the early months of 2018. This, he says, could counteract what was expected to be an advantageous interest rate climate for governments.

The Takeaway: So why are banks reducing their municipal bond holdings? With the GOP tax bill, the corporate income tax rate was slashed from 35 percent to 21 percent. That means that banks and other corporations will start earning more money off other types of investments because their tax rate is a lot lower. It could even mean that, after taxes, those other investments are more lucrative than the low interest rate muni bonds. 

On the other hand, the muni market might see a counter development to this drop in demand. That's because the GOP tax bill also eliminated other types of tax-free municipal bonds, causing a mad rush to issue them before the end of the year. According to Bloomberg News, states and localities sold a record $55.6 billion of debt through Dec. 22, which could help to keep interest rates steady for governments.


Let the Tax Games Begin!

Now that tax reform is capping how much filers can deduct in state and local taxes, high-tax states are coming up with workarounds. This week, California’s Senate President Pro Tem Kevin de León began shopping a proposal that would allow taxpayers to pay part of their state tax bill as a tax-deductible charitable contribution to California’s general fund.

Here’s how it would work: The amount of state and local taxes people can deduct from their federal income is now capped at $10,000. However, taxpayers who pay more than that in California could make an additional “charitable” contribution -- up to $20,000 -- to the state’s general fund. The taxpayer would then receive a dollar-for-dollar tax credit against their state taxes owed.

The Takeaway: This is likely just the tip of the iceberg. California has the nation’s third-highest average itemized deduction amount behind New York and Connecticut.

For clues as to what’s next, a recent joint report by more than a dozen tax scholars and analysts may provide some answers. The authors suggest a few ways governments might try to shift toward other deductible taxes. The suggestions include converting taxes into a charitable contribution, instituting a state property tax and cutting back on income tax rates, and implementing a state payroll tax, which is deductible for employers, in place of an income tax.

De León is working with some of the professors who authored the report to craft his California plan. Lawmakers elsewhere may also look to do the same.


Local Pension Growth Outpacing States

Since the turn of the century, local pension plans have struggled more than state-level plans. New data, however, show that trend could be reversing. A research brief by the Center for Retirement Research reports that, since 2013, the gap between state and local pension funding has been shrinking. While the funded status of state plans has remained essentially level at a little more than 73 percent, the funded status of local plans has increased modestly from 67 to nearly 70 percent.

The Takeaway: The research brief sites a few reasons for this difference. The first is that local governments tend to make most -- if not all -- of their required contributions each year (often because they are required to by the state.) They are also more likely to use a lower investment return assumption, which impacts how much money they have to contribute each year.

Additionally, local plan investments as a whole have outperformed state plans by several percentage points. This difference could be due in part to local pension funds' lower allocation to alternative investments. But the authors of the brief say that more research is needed to determine why these investment preformances are so different.

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Liz Farmer is a former GOVERNING fiscal policy writer.
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