Municipal Leaders Fear Deficit Reduction Could Impact Bond Exemption

The federal tax code has, in effect, subsidized the cost of borrowing for state and local governments. Some say that could be poised to change.
by | November 26, 2012 AT 7:15 PM

Since the onset of the federal income tax in 1913, municipal bonds have had a special status. Since investors don’t pay federal income taxes on their muni bond earnings, governments can afford to pay them lower interest rates than other types of borrowers.

But as Washington seeks ways to reduce the deficit, and with tax reform set to be a hot topic in 2013, state and local leaders fear the exemption’s days could be numbered.

“If they want to tax our bonds, it (means) less we can build,” says Corneila Chebinou, head of the D.C. office of the National Association of State Auditors, Comptrollers and Treasurers. “Less schools. Less roads. At a time when we’re in a fiscal crunch, it’s a bad thing to do.”

While the administration and other federal lawmakers have touted the importance of investing in America’s infrastructure, state and local leaders are fighting to preserve a potential change in tax policy that would make it harder to just that.

“Everyone says that they want to get this country going again and put America back to work,” Jacksonville, Fla. Mayor Alvin Brown told Governing before meeting with federal lawmakers earlier this month. “The best to do that is to make sure we work together and create an environment so that we don't have impediments to moving our cities forward.”

Concerns over the exemption have been mounting for state and local leaders over several years. In 2011, the Simpson-Bowles commission proposed revoking the tax-exempt status of muni bond earnings. Last year, President Obama proposed capping it. Now there’s a fear in some circles that with Washington’s interest in deficit reduction, lawmakers are likely to tinker with the exemption. A recent report by Citi says that the exemption faces the biggest threat it’s faced since tax reform in the 1980s.

Just how much could a change cost state and local governments? It’s hard to say. Lawmakers might choose to cap the benefit so that it’s only fully enjoyed by those in the 28 percent tax bracket or below (investors in a higher bracket would be left paying the difference). Or the exemption could be capped at a certain dollar amount. The exemption could be eliminated altogether. Or Congress could do nothing to it.

As various proposals are floated, those discussions themselves could impact the municipal bond market, says Natalie Cohen, managing director of municipal securities research at Wells Fargo Securities. If investors are spooked and feel that munis have a target on their back, then issuing debt could be more difficult – and more expensive – for state and local governments, even before a change even occurs.

Some financial experts have said if the exemption is entirely eliminated, municipalities’ cost of borrowing would increase 2 percentage points. Compounded over time, that could increase borrowing costs by millions of dollars on a given project. But some observers view that estimate as too extreme. “We don’t think the sky is falling, but we are encouraging issuers to be vocal here,” said Matt Posner, director at the research firm Municipal Market Advisors. “Issuers are the most effective lobbying group when it comes to the muni market.”

To a degree, there’s an element of populism to the case against the municipal exemption. Even supporters of the exemption are aware that there’s a perception that wealthy investors unfairly benefit from the tax-free status of those investments. But they also say that argument misses the point: the exemption is more of a subsidy to municipalities than investors, since it allows them to borrow money at a lower cost than they’d ordinarily be able to.

“All this really does is shift who pays from the federal government to local governments,” said Timothy Firestine, chief administrative officer of Montgomery County, Md. “You look at who built most of the basic infrastructure in the country, and it happens at the local level.”