An Update on Two Endangered Tax Breaks

How likely is Congress to kill tax expenditures that favor states and localities?
November 27, 2013 AT 1:00 PM

With just over a month left in 2013 and Congress' already abysmal track record, it's a good bet that nothing will happen with tax reform this year. For states and localities, that's a huge relief. After all, two items on tax reformers' hit lists include the tax-free interest on municipal bonds and the ability of taxpayers to deduct state and local taxes from their federal income taxes.

But state and local officials shouldn't get too comfortable. The above two tax expenditures are still in peril: One or both of them could be pulled into other bills next year or even in 2015. (There is an assumption that, with midterm elections looming in 2014, Congress will shy away from a major tax reform deal that could prove unpopular with the public.)

Since both run up a sizable tab on the federal side of the budget ledger, they are an attractive target. If Congress acts, is one more likely to be phased out than the other? And is one loss more palatable to states and localities than the other? Let's get an update on the situation.

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The Tab

In 2013, the state and local tax deduction accounted for $77 billion in foregone revenue for the federal government, according to the Joint Committee on Taxation (JCT). It will cost the feds another $1.1 trillion over the next ten years, which makes it the seventh largest tax expenditure in the tax code. Meanwhile, the muni bond exemption accounted for $58 billion in 2013 in foregone federal income, according to the JCT. It will cost approximately $540 billion over the next ten years. The nonpartisan Committee for a Responsible Federal Budget ranks the tax treatment of municipal bonds as a "small but significant portion of federal aid to states."

But there is, of course, a counterargument to eliminating the deduction and exemption. The cost of eliminating both, according to a Moody's Analytics study, could result in a $71 billion hit to total gross domestic product (GDP) -- or 0.35 percent of GDP and 417,000 jobs or 0.28 percent of total employment over the next decade.

Who's Affected

If the state and local tax deduction was eliminated, it would only affect about 27 percent of taxpayers. It is an itemized deduction, with 80 percent of the value flowing to the top 20 percent of the income spectrum, according to the Congressional Budget Office (CBO). And not all states would be affected: More than 60 percent of the amount deducted comes from 10 states, with California and New York the two biggest claimants. Eight states have no state income tax, and get much more benefit from the sales tax deduction, which is scheduled to expire at the end of the year.

As for the muni bond exemption, its elimination would have a big impact. States and localities, of course, benefit from the exemption in that it affords them access to lower borrowing costs. According to the Conference of Mayors, between 2003 and 2012, 90 percent of the municipal bonds issued (worth about $1.65 trillion) was used to build infrastructure. The Moody's Analytics study found that its elimination would increase municipal borrowing costs by $33 billion over the next decade. Investors would also be affected. They benefit directly by receiving tax-free interest. Three-quarters of municipal bonds are held by individuals, either directly or indirectly through mutual funds. The tax break is split between individual and corporate bondholders at about a 4 to 1 ratio.

Elimination or Limitation Strategies

There is some discussion about limiting the deduction rather than eliminating it in its entirety. Some want only to discontinue portions of the deduction, like the property or income portion, while others have proposed converting the deduction into a credit, limiting it to a certain rate, capping it as a percentage of income or limiting it to a certain dollar amount.

There are a number of options to trim or reform the muni bond tax break without completely repealing it. Congress could, for instance, repeal certain elements of the tax exemption, such as disallowing private activity bonds. Or policymakers could, as a President Obama's proposal suggests, cap at 28 percent the amount of muni bond interest taxpayers may exempt from their incomes. The exemption could be replaced with a credit that could be set at a specific level or adjustable to achieve a certain interest rate. The credit could go to the owner of the bond or directly to the issuer. Those who back this approach argue that the credit would be more progressive than the current system and more efficient.

Chances of Reform Attempts

The state and local tax deduction has a long history of being on the chopping block. The 1984 Treasury paper that launched the 1986 tax reform effort called for its complete repeal. That effort failed but two decades later President Bush's tax reform panel called for complete elimination, and more recently, the Domenici-Rivlin tax reform plan called for repealing the deduction. The Center for American Progress, on the other hand, would replace it with an 18 percent credit. Meanwhile, an aide to House Ways and Means Chairmen Dave Camp has said that "the deduction will be significantly curtailed or axed in any proposal put forward by Camp."

The muni bond exemption is blessed with an active lobbying base: State associations such as the National Governors Association, the Council of State Governments, the American Public Transportation Association, the National Association of Treasurers and the League of Cities are on full alert to work to protect the main source of infrastructure financing. They are joined by deep-pocketed and savvy lobbyists from the private sector, such as Wall Street underwriters and all the other groups whose livelihoods are dependent on or deeply affected by the issuance of municipal bonds. The wide base of affected interests gives the exemption an edge in surviving, but it doesn't assure success.