The problem with class warfare is that, like actual warfare, it can be hard to avoid the collateral damage.
The Obama administration is learning that in the wake of news that the Presidents American Jobs Act contains a proposal to limit the tax breaks on a host of itemized deductions and adjustments to income, including the interest on municipal bonds for high income households. Much like opponents of higher corporate taxes, who claim that workers and customers wind up paying for the corporate levy, opponents of the Presidents proposal on muni interest (including local politicians from both parties) are now arguing that the real losers would be cash-strapped local governments that would be forced to pay investors higher interest rates to offset the lower returns from a fed tax. These critics arent comforted by the knowledge that the Jobs Act in its present form stands little chance of passing. They worry that tax reform is coming sooner or later and that the presidents proposal has put the tax exemption for muni interest on the reform table, where it may stay.
The presidents bill would cap the tax benefit from itemized deductions and certain income inclusions at 28 percent. The administration has argued in the past that high-income earners gain more than other taxpayers from income adjustments and tax deductions like the ones on muni interest, charitable giving and mortgage interest. The Obama administration would like to keep upper income taxpayers paying higher rates on their income but limit the size of their deductions and exclusions. In the case of muni bond interest, the change would in effect install a 7 percent tax on municipal bond interest for households in the 35 percent tax bracket. If the Bush tax cuts were to expire and the top tax rate rise to the pre-Bush level of 39.6 percent, the tax on muni interest for those in the top bracket would increase to 11.6 percent.
The proposal has shocked the muni community, in part because in the days leading up to the release of the presidents proposal he assured local government officials that the Jobs Act would funnel more aid to cities and states for spending on infrastructure. They didnt realize that he intended to do that in part by taxing their muni customers more, potentially raising local borrowing costs in the process.
Theres more bad news for anyone who thought the administration might not be seriously pursuing this proposal. The Bond Buyer reported that the draft text of an administration deficit reduction package floating around Washington also establishes automatic continued cuts in tax deductions and income exclusions in the future if the federal budget doesnt hit deficit reduction targets. That could mean continually declining tax advantages for those owning munis and an overall climate of uncertainty for investors, who might not know the tax rate theyll be paying next year on the interest from a bond they bought this year. That would be unprecedented.
Those with a long memory know that the last time the feds stepped in to narrow the tax advantages of muni interest the move helped wreak havoc in the market. In the wake of the Tax Reform Act of 1986, which cut the deductibility of muni bond interest for banks and narrowed deductibility on some bonds, new issues dropped 50 percent. The decline was so great it drove a number of investment firms out of business and forced others out of the market, including Salomon Bros., which had dominated the market for years.
Its not clear just how profound an impact the new round of proposals might have on the market, but municipal officials arent eager to find out. Individual taxpayers own an estimated 35 percent of outstanding bonds, and about 60 percent of the interest that taxpayers claim on their individual forms comes from high-income earners who would lose part of their interest exemption.
Opponents of the presidents proposal can derive only small comfort from the fact that the jobs bill in its current format is not likely to pass. The bi-partisan Bowles-Simpson Commission on Fiscal Responsibility also recommended narrowing the exclusion on muni interest, and the new Congressional Joint Select Committee on Deficit Reduction is almost certain to look at the issue, too. While Republicans are unlikely to endorse any proposal to tax higher income investors more heavily, there are a number of Republicans in Washington whove expressed reservations about growing state and local debt, and they could well take the presidents proposal and use it to craft their own version of a narrower tax advantage for munis, in the process making them less attractive.
The history of the muni business is one of expansion, policy changes that narrow the market, contraction, and then another round of expansion as the issuers find new ways to make munis attractive again. Not all of the policies that have narrowed the market in the past have come from the feds, by any means. Reform at the state level, often initiated by voters, has also played a big role in taming the market through local legislation and constitutional amendments that cap debt or require voter approval of lending.
The muni market seems poised for another retrenchment. Outstanding municipal debt rose from $1.845 trillion in 2005 to $2.467 by the end of 2010, a one-third gain in just five years, according to the Federal Reserve. Overall, state and local liabilities in that period, including unpaid bills and loans, soared to $3.136 trillion from $2.336 trillion. And that doesnt include unfunded liabilities from pensions and other retiree obligations, which probably amount to another $1 trillion to $3 trillion, depending on whose accounting you use.
The presidents municipal interest proposal doesnt seem designed specifically to force a reduction in state and local borrowing. After all, it was the president who helped unlock municipal borrowing when the administration created Build America Bonds back in 2009. But in aiming now at high income earners, the president may help to produce one of those periodic retrenchments in the muni market. Call it collateral damage.
Original Source: http://www.realclearmarkets.com/articles/2011/10/05/collateral_demage_in_the_muni_market_99290.html