Beginning the day after the election, Republicans in Congress knew they would have to agree to increases in revenue to have Democrats reciprocate on spending cuts. While Democrats appear to be holding firm that the increase must come from higher tax rates, ending some deductions and closing loopholes will still be part of any long-term tax code revisions.
Now, the exemption on municipal bond interest, which is not only part of the president’s proposal but also on the list of tax code revisions proposed by the Simpson-Bowles commission, is getting serious consideration.
States, counties, cities, school boards, and independent utility districts rely on bonds to finance many projects and services. The market for these bonds is currently valued at $3.7 trillion. According to Loop Capital Markets LLC, new issuance in 2013 is expected to be around $400 billion, up from $370 billion this year. Interest exempted from taxes for those earning more than $200,000 per year is estimated to be $10 billion annually. The total cost to taxpayers in 2011 was approximately $26.2 billion.
Whether issuing entities would be seriously impacted by any changes to the exemption is a matter for discussion. Under the president's proposal, which now appears to be gaining GOP support, exempted interest would be capped at 28% for those making over $200,000 per year. While that could raise borrowing costs for municipalities, it may not drive many investors from the municipal bond market. Simpson-Bowles ends the deduction in total.
States, counties, cities, and other agencies that depend on tax-exempt bonds for funding, unlike the federal government, cannot just create money. Since 2008, they have seen their federal funds cut along with their shrinking tax base. Of course, local government employees took the largest hit. However, municipal bonds still perform well. If the proposed cap is implemented, I don't believe bond buyers will leave in droves if projects are well defined and carefully planned. Creativity may very well be the key.
While it looks like Democrats will get a Republican concession on tax rates to avoid them being blamed for raising taxes on the middle class, the tax exempt status of municipal bonds may be an area of agreement once Congress starts to discuss deficit reduction in earnest.