States fear tax hit on muni bonds could hit taxpayers
Exemption • Effort to put levy on the interest investors receive could have a domino effect.
Published: December 22, 2012 10:42PM
Updated: April 8, 2013 11:33PM
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(AP Photo/Jacquelyn Martin) Last week, House Speaker John Boehner accepted the Obama administration's proposal to limit various tax deductions and exemptions to the value now received by people in the 28 percent bracket. By implication, that includes municipal bonds.

Timothy Firestine, the top government administrator in Montgomery County, Md., is crunching numbers in his battle to preserve the hallowed tax exemption on municipal bonds.

The average annual property tax bill in his affluent suburban Washington county would ultimately rise by at least $100, he estimates, as a consequence of a proposal by the Obama administration to modestly tax the interest that wealthy investors receive from municipal bonds. That’s because, he says, if investors see less of a tax break, they will demand higher interest to make up the loss, and higher interest rates will mean higher borrowing costs for governments.

Firestine is on the front lines of a lobbying campaign by local and state governments, bond dealers, insurers and underwriters that is trying to pre-empt any attempt to limit or even kill the tax exemption. The administration has proposed capping the tax break that America’s highest earners now receive from municipal bonds, as part of its campaign to close loopholes and enlist more of the rich in fighting the federal deficit. Analysts expect such a cap to be part of a comprehensive tax overhaul package that Congress will take up next year, under a broad fiscal framework now being negotiated by President Barack Obama and House Speaker John Boehner.

“This is the most serious threat to tax-exempt bonds since Roosevelt, in the late 1930s, tried to repeal the exemption across the board,” said John Buckley, a professor of taxation at Georgetown University and former chief counsel to the House Ways and Means Committee.

At present, the federal government forgoes about $32 billion a year in taxes by exempting the interest that investors earn from municipal bonds.

A wealthy couple in the highest tax bracket who receive $100,000 a year in municipal bond interest currently pay tax on none of it, effectively lowering their total tax bill by $35,000 under the current rates. But under the administration proposal to limit tax breaks for households whose taxable income is more than $250,000, the same couple would see the savings on their tax bill reduced to $28,000, effectively resulting in a $7,000 tax payment. (People in lower tax brackets would not be affected by the change.)

There are other proposals for taxing muni interest. The National Commission on Fiscal Responsibility and Reform, known as the Simpson-Bowles commission, has suggested taxing all municipal bond interest, not just the interest paid to people in the top bracket. Other experts have suggested taking the exemption away from municipal bonds that raise money for business, while still allowing it for bonds that finance public works.

Firestine, the president-elect of the Government Finance Officers Association, has been following developments through conference calls arranged by the White House and calling members of Congress.

Officials of some other government groups, such as the New York City Housing Development Corp., have formed a coalition with Wall Street groups such as the Bond Dealers of America, to lobby on the issue. But there is the sense of an uphill battle. Last week, Boehner said he accepted Obama’s proposal to limit various tax deductions and exemptions to the value now received by people in the 28 percent bracket. By implication, that includes municipal bonds.

Obama’s proposal would not “grandfather” existing bonds, but would apply to all of the $3.7 trillion worth of municipal bonds now outstanding, most of them held by individual investors, directly or through mutual funds. High-bracket investors who hold them would have to start paying an effective tax of 7 percent of the interest — or even more if the highest tax bracket increases from the current 35 percent.

“This would be the first time that a tax law has affected existing debt,” said Chris Mauro, head of municipal-bond strategy at RBC Capital Markets.

Investors are anxious because they bought the bonds, often issued for 20 to 30 years, in the expectation that they would be tax exempt until maturity.

“The issue of grandfathering is really the big question,” said Mauro. “If it’s just new bonds, the municipal market can sort of deal with it. But if the entire market, on a retroactive basis, is affected, you’d have dislocations. Prices would have to adjust on all outstanding bonds to make up for the loss associated with the taxability.”

In other words, the value of the bonds now owned by investors would fall.

The tax exemption is thought to help states and local governments market their bonds, lowering their borrowing costs. But some fiscal analysts say that an undue share of the exemption’s value goes not to local governments, but to the wealthiest bond buyers instead.

There are not enough investors in the highest tax bracket to buy all the municipal bonds as they come to market, Buckley said. So underwriters price them at a deeper discount, to make them attractive to investors in the second-highest bracket, currently 28 percent. That enlarges the pool of buyers and gets all the bonds sold quickly, but for a lower price than people in the 35 percent bracket would probably have been willing to pay.

“That means the people in the 35 percent bracket are getting a big windfall,” in the form of an underpriced bond, “while the people in the 28 percent bracket are just getting a good deal,” Buckley said.

It is that advantage that the Obama administration now proposes to tax. Some muni experts say the administration’s pricing analysis is flawed, and that it overstates any windfall.

At the local level, where tax-exempt municipal bonds are the tool of choice for financing public works, officials are not generally focused on the intricacies of bond pricing. They are busy fighting their own budget deficits and view a potential fiscal gain for the federal government as a likely loss for them.

Firestine said that Montgomery County had about $2.1 billion of general-obligation bonds outstanding, on which it pays interest of $93 million a year. Capping the tax exemption would cause high-bracket taxpayers to look for higher-yielding investments, he said, and the county would have to offer more interest to lure them back. He says he thinks the county’s annual outlays for interest could rise to $135 million, which is why property taxes could rise by $100.

That may not sound like much in a prosperous county with an average property tax bill of $4,250. But Firestine said any property tax increase was a hard sell these days, when real-estate assessments have been declining and the county has had to lay off employees.

“The burden,” he said, “will be transferred to the property tax.”