Municipal Bond Tax Exemption at Risk

There has been plenty of talk about “tax expenditures” at both the federal and state levels, with all tax breaks under heavy scrutiny. One that has received a little attention, but deserves some more discussion, is the municipal bond tax exemption. Investors, under current law, derive interest that is exempt from federal taxation when they invest in municipal bonds. That interest exemption is highly attractive to investors, especially those in the upper income tax brackets. It has helped to create a municipal bond market in the United States of about $2 plus trillion, and the “tax expenditure” will cost the U.S. Treasury about $230.4 billion in foregone revenue over the five fiscal years 2012-2016, according to the U.S. Office of Management and Budget.

For many years the relative efficiency of this tax break has been kicked around, with the general consensus appearing to be that the break is skewered in favor of those in the top marginal tax brackets. Without getting into the weeds it is sufficient to say that the theory is that the federal government gives up more via the “tax expenditure” than localities save in lower yields on their bonded debt. This relative “inefficiency” in the market, which in theory forces up the yields on municipal debt, is estimated to cost the U.S. Treasury about $6 billion per year. (Center for American Progress “Doing What Works- Bring Back Build America Bonds”)

Many have advocated for a system where localities would receive a direct subsidy from the federal government for a portion of the interest paid on bonded debt. The federal stimulus program contained such a program, called “Build America Bonds”, which paid 35% of the interest costs on eligible debt. (See the above link for such advocacy). (That two year program was not renewed by Congress)There is no question that such advocacy has plenty of merit, and does address some of the inequities that are involved in the current subsidy. I do not have an argument with the analysis. I do have an argument with the prospective viability of the proposed solution, which would replace “foregone revenue” with the need for an annual appropriation. Requiring Congress to appropriate annually is a recipe for disaster for municipalities, and could lead to cuts or outright elimination of the subsidy, leaving municipalities with substantially higher borrowing costs, or (even worse) being shut out of the credit markets.

Simpson-Bowles advocated elimination of the muni-bond exemption, and President Obama advocated capping it in his jobs bill that failed to pass the Congress last year. Both approaches, in my opinion, fail due to an emphasis on two things:

1) The cost to the U.S. Treasury.
2) The benefit to high tax bracket taxpayers.

1)The cost to the Treasury in foregone tax is real, and always needs to be considered. But an elimination of the tax break for municipal debt could collapse municipal access to credit markets, and would begin an inexorable rise in demand for other federal subsidies to assist localities with infrastructure projects. (see Build America Bonds). Some federal subsidy is a given, or else municipal access to credit markets will be further limited, or much more expensive.

2) As mentioned above I do agree that the data presented shows a larger benefit for upper income taxpayers. But that so called “inefficiency” (call it $6 billion) for top tier earners is a small price to pay for municipal access to inexpensive credit. That credit has proven to be less expensive over the years than the more credit worthy 20 year Treasury Bonds. (see above listed American Progress report). The goal of the subsidy has never been about providing tax shelter to upper income people, but rather about providing localities access to capital markets at affordable rates. When looked at from that perspective the current tax exemption, even if slightly inefficient, has worked for municipalities.

As the old saying goes if it ain’t broke, don’t fix it. Republican opposition to direct federal subsidies for municipal interest is clear, and not likely to change anytime soon. That is why the Build America Bond program was allowed to lapse, and why talk about ending or capping the tax exemption for municipal bond interest is a bad idea that will hurt municipalities and local taxpayers. Federal lawmakers should resist the temptation to grab this relatively small pool of money, and fight to ensure that municipal credit markets continue to provide localities with available and affordable capital. The best way to do that is to leave the tax exempt status of municipal bonds unchanged.

The Governing story on this issue is linked here.

Here is a second Governing article, sounding the alarm for municipalities.

Here is a CNN Money story on the issue.

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