For all of the consternation around the "fiscal cliff" and the sequestration, the path remains unclear for an agreeable way to address the federal budget deficit with additional revenue, further spending cuts, or both. And part of this uncertainty extends to the proposals to cap the tax exemption on municipal bonds as a method of generating additional revenue from the highest income brackets without further burdening people in the lower income brackets.
Yet, the proposed cap of 28% may be a zero-sum game at best because it could increase costs for nearly all taxpayers. While there are additional arguments against adjusting the municipal tax exemption—such as whether it infringes on states' rights—the culmination of these factors indicates that such a significant change could alter what has served as one of the most efficient forms of government and infrastructure financing for more than a century.
By limiting the exemption on municipal bond income, investors in the higher tax brackets would likely require higher yields to purchase bonds, prompting an increase in yields throughout the municipal market. While many people believe that municipal bond financing pertains only to state and local governments, the majority of the municipal market consists of revenue bonds that support projects in the education, healthcare, transportation, utility, and housing sectors.
Many of these infrastructure or public purpose projects would have been unaffordable without the tax-exempt borrowing rates available on municipal bonds or without significantly higher costs paid by customers and taxpayers. The necessity for most municipal issuers to pass along higher borrowing costs stems from standard covenants in most revenue bond offerings. These covenants have been created to provide investors with the confidence to make loans and finance projects. For example, the language in a water revenue bond offering might stipulate that the issuer's revenues must be at least 1.2 times greater than its annual debt service.
With this mandated relationship between debt service and revenue, an increase in the issuer's borrowing costs would require a corresponding increase in revenue or fees from its customers. Indeed, if an exemption cap had been in place over the past decade, it would have amounted to an estimated $173 billion in taxes or fees to cover the increased borrowing costs.1 And a potential increase in taxes or fees on most income levels runs contrary to the stated intent of capping the exemption.
Although the latest suggestions to cap the municipal exemption have emerged over the past few years, these proposals are not specific to the current fiscal situation. Challenges to the exemption have emerged throughout the past century at times of high fiscal deficits, such as those that were proposed as ways to pay for both World War I and II. These efforts, and others, were rejected when state and local officials emphasized the increase in borrowing costs that could occur with an adjustment to the exemption.2 One notable aspect in the recent proposal that differs from past ones is that the exemption cap would extend to all existing tax-exempt bonds, not just newly issued securities. This exclusion of a “grandfather” clause is considered to be unprecedented because it alters the treatment of securities that were issued according to the existing legal guidelines at the time of an offering.
At this point, the market has yet to react to any of the recent proposals. Similar to other broad issues that could affect municipal securities, such as the implementation of the Patient Protection and Affordable Care Act, we frequently analyze the possible ramifications from an exemption limit. And one takeaway is that even though the 28% cap may not be as beneficial to high-income investors, the municipal bond market would continue to provide an attractive source of tax-efficient income for investors, particularly considering the changes to personal exemptions and itemized deductions that were part of the tax package that passed in early 2013. Additional suggestions to adjust deductions and exemptions could emerge as more sources of revenue are explored during attempts to reconcile the recently released budget proposals from the two chambers of Congress. The Obama administration is expected to release its 2014 budget in the coming weeks.
The market's unresponsiveness to the capping proposal reflects a lack of consensus in the market regarding what may emerge from Washington. And the same could be said for suggestions about alternative financing options, such as renewal of some form of taxable bond offerings with interest payments that are partially reimbursed by the federal government. Yet, both issues warrant further observation when considering the midterm elections in 2014 and the repeated proposals for the cap, which was first included in President Obama's Jobs Act in 2011 and has appeared in each of the administration's budgets since then. Therefore, the chances for an exemption cap in the future could increase if there is a change in the House majority in 2014, which would require an increase of only 20 seats by the Democrats.
Another tactic state and local officials previously have used to defend the exemption is the concept of preserving states' rights. After an amendment to the U.S. Constitution in the early 1900s allowed the federal government to tax income from any source, New York's governor argued that this would subvert states' borrowing abilities to the federal government, which "would be an impairment of the essential rights of the State."3
The topic of state versus federal rights is one that has been debated throughout U.S. history with significant implications. Yet, this debate may also pertain to the efficiency of the municipal bond market. At its fundamental level, the market allows state and local governments to establish their own financing requirements. And these determinations can be validated by investors' willingness—or lack thereof—to purchase specific bond offerings. This could be viewed as a necessary component of a free market system that would be unlikely to be replicated with such a sweeping adjustment to the market as an exemption cap. Another consequence of introducing an alternative system could be that state and local government relax their strong financial standards because they would not need to be concerned about a market reception for their debt offerings.
The debate about the best methods to reduce the federal deficit will likely continue to include contrasting suggestions for additional revenues and further spending cuts. While each path may have its merits, it is unlikely that a zero-sum policy of capping municipal bond interest can deliver a tangible reduction in the federal deficit by passing along more taxes and fees to all income brackets. And with the increased costs to taxpayers and customers, the greatest effect from capping the exemption on municipal bonds may be a disruption in a market that historically has been efficiently distributing capital to municipalities and infrastructure projects for more than 100 years.
Daniel S. Solender is a partner and director of municipal bonds at Lord Abbett & Co. LLC.
