Tax-exemption for bonds threatened by DC money grab

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From The Beacon, May 2013

As the Obama administration and Congress look for revenue to reduce the deficit and fund the federal budget, proposals have surfaced from the president and some legislators to restrict or strip cities and towns of their ability to issue tax-exempt municipal bonds.

Simply put, this is a terrible idea.

No matter how it is packaged, limiting or ending the tax exemption for interest on municipal bonds would impose a massive new cost on cities, towns and local taxpayers. Once fully implemented, these proposals could drive up the cost of vital local infrastructure projects in Massachusetts by as much as $525 million a year.

The tax-exemption for municipal bonds has been in place for 100 years, as long as the federal income tax. These instruments are the primary financing mechanism for state and local infrastructure projects. There are more than $3.7 trillion in outstanding tax-exempt bonds, issued by 30,000 separate governmental units at the local, county and state level.

Local governments save an average of 25 percent to 50 percent on interest costs by using tax-exempt municipal bonds, compared to what communities would have to pay if they sold taxable bonds. That’s because investors are willing to accept lower interest on tax-exempt bonds due to the tax benefit.

Proposals to end or undermine the use of tax-exempt bonds would shatter a system that is a spectacular success and would represent a money-grab by the federal government that would harm cities, towns and local taxpayers.

If the exemption is limited or eliminated, investors will demand higher interest payments to offset their new tax liabilities, forcing states and localities to pay more to finance projects. This federal cost shift would lead to less infrastructure investment, fewer jobs, and greater burdens on citizens who would then have to pay higher local taxes and utility fees.

This is why the MMA has joined the National League of Cities, the U.S. Conference of Mayors, the National Governors Association, and more than 50 major organizations to urge Congress and the president to respect the principles of fiscal federalism by maintaining the tax-exempt status of municipal bonds and providing stability and predictability to state and local governments and the investment community.

The need for infrastructure investment – and the jobs that come with it – is acute. Tax-exempt municipal bonds finance roads and bridges, schools, police stations, fire stations, libraries, town and city halls, senior centers, parks, drinking water treatment facilities, sewage treatment plants, and much more. Eliminating or limiting tax-exempt financing will drive up the cost of all of these infrastructure investments, which will reduce the scope of projects and impose a much higher burden on local taxpayers.

So far, several legislative proposals have been offered to curtail or eliminate the federal tax exemption for municipal bond interest. One proposal put forward in President Barack Obama’s budget would impose a tax-benefit cap of 28 percent for certain taxpayers on many itemized deductions and exclusions, including tax-exempt interest. The effect would be a partial tax on interest that would otherwise be exempt from the income tax. In effect, the tax-exempt bond market would no longer be entirely tax-exempt.

If this 28 percent benefit cap on tax-exempt interest had been in effect during the last decade, it would have cost states and localities an estimated $173 billion in added interest expenses for infrastructure projects, according to an analysis jointly published by the National League of Cities, the U.S. Conference of Mayors, and the National Association of Counties.

For an investor in the 39.6 percent federal tax bracket, the tax benefit cap proposal would equate to an 11.6 percent tax on municipal bond interest income (the difference between the tax rate and the benefit cap). While it may appear that this tax would fall on high-bracket taxpayers, in effect, it would be borne almost exclusively by state and local governments in the form of higher interest rates on their borrowing.

Market analysts have estimated that this proposed tax on municipal bond interest would raise state and local borrowing costs by up to 70 basis points (seven-tenths of a percentage point) or more. Because the tax would apply not only to new state and local borrowing but also to all outstanding bonds, investors would be taxed on investment that they reasonably expected would be tax-exempt as long as they are outstanding, an unprecedented form of retroactive taxation. As a result, investors would face the new risk that Congress could tax interest on outstanding bonds even more in the future, a risk that would raise state and local borrowing costs even more and create unprecedented uncertainty for investors in the municipal securities market.

Some have proposed an even more onerous full federal income tax on municipal bond interest. The Simpson-Bowles Commission, in its 2010 deficit-reduction recommendations, proposed full taxation for state and local interest for all newly issued bonds. If this proposal had been in place during the 2003–2012 period, it would have cost governments an additional $495 billion in interest expenses.

Partially or fully taxing the interest on municipal borrowing would have a direct effect on state and local budgets in the form of increased interest expenses. Taxing the interest on municipal borrowing for investors would have the same effect as taxing state and local governments directly, as these costs would be passed on from the bondholders to the bond issuers.

With the current tax exemption, cities, towns and states can issue bonds with interest payments that are 2 percentage points lower than on taxable bonds in normal market conditions. (The margin is likely about 80 basis points today in a suppressed interest environment, but that would end as the economy returns to typical conditions).

The MMA estimates that each year, cities and towns in Massachusetts issue $3 billion in tax-exempt bonds and notes. Under current interest rate conditions, repealing the tax-exempt debt authority of cities and towns would add approximately 80 basis points to an issuance, which would translate into $225 million in additional costs to local taxpayers in Massachusetts over the life of a 20-year bond. Under typical or normal market conditions, repealing the tax-exempt debt authority of cities and towns would add as much as 2 full percentage points to an issuance, leading to approximately $525 million or more in additional costs to local taxpayers in Massachusetts over the life of a 20-year bond.

At the end of 20 years, if tax-exempt financing is repealed, the annual burden on Massachusetts taxpayers would be $525 million, a massive cost-shift. Even a partial repeal, such as the president’s proposed 28 percent tax-benefit cap, would result in an annual burden on Massachusetts cities and towns of more than $200 million.

Massachusetts is fortunate to have a Congressional delegation that is fighting for cities and towns. Sens. Elizabeth Warren and Mo Cowan have pledged their opposition to any attack on tax-exempt financing, and Congressman Richard Neal is the primary sponsor of a resolution in the House that calls attention to the importance of tax-exempt bonds. When Sen. Cowan steps down in June, it will be imperative for his replacement to immediately stand with local government leaders on this matter.

Massachusetts is on the verge of enacting a sweeping new transportation tax package, and is planning to ramp up infrastructure investments by billions of dollars over the next several years. We applaud our partners on Beacon Hill for this commitment and this bold leadership. But we need Washington to recognize the attack on tax-exempt financing for what it is – a money grab that would hit local taxpayers, stop infrastructure investment in its tracks, and harm our economy now and for years to come.

Simply put, it’s a terrible idea.