The Council Development Finance Agencies (CDFA) and Bloomberg News report that the tax exemption for investors in municipal bonds may be abolished as a part of the debt ceiling negotiations. Lawmakers agreed to preserve the exemption as a part of the fiscal cliff agreement, but it may only be short term.
What would happen to the municipal bond market if the investments became taxable? The cost of municipal government borrowing would almost certainly go up because investors would suddenly have to pay up to 39.6 percent of earnings on the bonds.
The exemption’s major benefit to municipalities is that it can help them borrow at a lower cost than if they had to borrow through the traditional, taxable market. The tax free bonds are more attractive to high wealth and high income individuals and entities because they pay higher tax rates.
The municipal bond market is an attractive target for tax increases because of its size at $3.7 trillion. I haven’t seen a detailed analysis of potential revenue from taxing the market, but it is important to remember that taxes would only come on the earnings in the bond market, not the whole market size. While borrowing rates are certain to rise in the future, current bond rates are quite low given the interest rate.
President Obama has suggested maintaining the exemption, but capping it at 28 percent – a lower tax bracket. This would mean that individuals in the highest tax bracket would pay an effective 12.6 percent tax on municipal bonds. This is not unlike the political strategy with the fiscal cliff. The increase would affect only the wealthiest investors (who for fairness make up the largest part of the muni bond market since they benefit the most).
A limited exemption for this group is a reasonable policy that might have less of an effect on the cost of borrowing for state and local governments. Unfortunately, there are only so many ways to raise revenue on the wealthiest Americans, and the increases on them will probably not solve the fiscal situation. As the federal government has to make more difficult decisions about revenue and spending, the exemption as a whole will probably remain up for discussion. If the exemption is eliminated, it could significantly dampen the potential for municipalities to renovate, build, and invest in the infrastructure that will help their local economies grow.
For more information on the benefits to state and local governments of the municipal bond exemption, take a look at Municipal Bonds for America. They are a pro-exemption advocacy group.