Municipal market participants are breathing a sigh of relief that the recent fiscal cliff agreement did not include any changes to the tax-exempt status of interest on municipal bonds.
For months, the market had been concerned with proposals being floated that threatened to either eliminate or severely curtail the tax-exemption for municipal bonds. The President had proposed limiting the tax break to the value received by those in the 28% tax bracket, effectively eliminating any additional exemption for those in higher tax brackets. For example, under current law, a taxpayer in the 35% tax bracket that received $100,000 in municipal bond interest would not owe taxes on any of it, effectively lowering his tax bill by $35,000. But under the President’s proposal, the same taxpayer would only be allowed an exemption of $28,000 (28% x $100,000), resulting in an additional tax payment of $7,000. Market participants have estimated that the “28% cap” would result in municipal bond yields rising 40 to 60 basis points, and that complete elimination of the tax exemption would result in yields rising 200 basis points. Rising yields, of course, increase the borrowing costs for local governments.
The Bond Buyer is reporting in an article published today that the industry trade group, Municipal Market Advisors, has reduced its forecast that Congress will make serious changes to the tax-exemption for municipal bonds from “50% or higher” prior to the fiscal cliff deal to “30% to 40%.” One of the main reasons for the slightly diminished risk in the near term is that the fiscal cliff deal permanently fixed tax rates, thus taking away the immediate pressure to address comprehensive tax reform.
The article points out, however, that the upcoming negotiations over the debt ceiling, sequestration and the passage of a budget resolution will likely keep municipal bonds in the crosshairs, as discussions about cutting spending may also incorporate piecemeal revenue raisers, including limiting the tax-exemption of municipal bond interest. And, over the longer term, comprehensive tax reform is still a goal of many in Congress and the administration.
For those reasons, local governments are being urged to keep up the pressure on Washington to preserve the tax-exemption for municipal bond by contracting their Congressional representatives and joining in the lobbying efforts of industry participants.
Author(s): Jeffrey DeCarlo
