Should Congress Curb Tax-Exempt Municipal Bonds?

By :: August 28th, 2012

As politicians and their allies look for ways to finance tax rate cuts, a surprising option is getting a great deal of attention among conservatives: The tax exemption for municipal bonds.

Mitt Romney’s economic adviser Glenn Hubbard, The Wall Street Journal editorial page, and the American Enterprise Institute’s Matt Jensen are among those who in recent weeks suggested limits on tax-exempt bonds. On Aug. 13, Journal editorial writers quoted Hubbard as saying the tax benefit of munis is “on the table” as Romney searches for ways to slash tax preferences.  

And the idea is not new. For instance, the tax reform plan offered by the chairs of President Obama’s fiscal commission, Erskine Bowles and Alan Simpson, would also limit the exemption.

Tax-exempt bonds are certainly worthy of discussion. Should the federal government subsidize state and local borrowing? Should it limit the subsidy to general obligation bonds only? If federal subsidies are appropriate, are tax preferences the most efficient way to deliver them?

The answers are not simple. Here are just a few issues worth thinking about:

The effect of lower rates on munis:  The very act of lowering tax rates may reduce the attractiveness of tax-exempt debt.  To the degree any reform cuts rates, state and local governments may have to pay more to borrow.

To see how it works, think about an investor who can buy either a taxable bond yielding 3 percent or a tax-exempt muni with the same risk and maturity.

In theory, if she's in the 35 percent bracket a tax-free yield of 1.95 percent would be equal to a 3 percent taxable return. But if Congress cuts her tax rate by 20 percent, her after-tax return on the taxable corporate bond would rise. And to get an equivalent return, she’d demand a 2.16 percent yield on her tax-exempt muni bond, thus raising borrowing costs for the issuer. (In recent years the spread between taxable corporate bonds and tax-free munis has narrowed considerably, but the general rule still applies).

New bonds versus old: Policymakers have two choices here—curbing the tax-exemption for all bonds or for new bonds only.  But it is a vexing choice.

First the money: Remember, a goal is to find revenue to help pay for rate reductions. The Tax Policy Center figures that repealing the tax-exemption for high-income investors would generate about $25 billion. But that’s if Congress eliminates the preference for all munis, including existing bonds.  If lawmakers cut the exclusion for only new bonds, they’d have only a fraction of the money to play with, at least until all that existing debt matures or is refinanced. There are about $2.7 trillion in outstanding municipal bonds, but on average state and local governments issued only about $380 billion-a-year over the past decade.    

Then, there is the politics. Is Congress really going to tell bondholders that those tax-exempts they bought in good faith (and at relatively low yields) are now going to become taxable? Imagine seniors with pitchforks.

On the other hand, if Congress limits the exemption for new bonds but lets old paper remain tax-free, states trying to borrow will be forced to compete for buyers with their own old (tax-free) debt. Imagine state and local finance officers with pitchforks.

Taxable bonds. In 2009, the Obama Administration created taxable Build America Bonds that provided state and local government a direct federal subsidy in lieu of the tax exemption. Investors liked them, but some local governments and many members of Congress did not, and the idea quietly died in 2010.

We may not have heard the last of these, however. If lower tax rates or curbs on the exemption make tax-exempt bonds less attractive, state and local issuers may find themselves rethinking their opposition to federally-subsidized taxable debt.

The fate of munis could be a key issue in any tax reform debate. If you’d like to learn more, check out an upcoming Sept. 21 panel discussion co-sponsored by The Tax Policy Center and George Mason University.    





  1. Ralph H  ::  5:21 pm on August 28th, 2012:

    I vote for ending (or phasing out) the exemption. I assume there will be some discussion of limiting mortgage interest deduction, and there already is substantial limits on tax payments (in AMT), so this benefit (going to so few) should be on the table. A side benefit may be to “save” municipalities from over borrowing in the quest for “cheap” money. This will make the tax code more “progressive” and is a reasonable trade off for lowering rates. It also makes taxable income more representative of real income. I do not consider this to impact savings, as new bonds would increase their yield.

  2. Vivian Darkbloom  ::  5:44 pm on August 28th, 2012:

    The tax exemption for municipal bonds should be eliminated. Historically, there was a constitutional issue as to whether the federal government could tax interest on state and local obligations. While the Supreme Court has not ruled on the issue directly, it appears based on related precedent that those prior constitutional concerns are no longer an obstacle to taxing them.

    Readers may recall that one of the many unreasonable assumptions the TPC made in evaluating the Romney fiscal proposal was that he would retain the tax break on muni bonds. Not only did Hubbard seem to dispel that notion, but the original idea that the tax benefit goes (solely) to rich investors was wrong, as Gleckman now (much too late) points out:

    “Should the federal government subsidize state and local borrowing?…The very act of lowering tax rates may reduce the attractiveness of tax-exempt debt. To the degree any reform cuts rates, state and local governments may have to pay more to borrow.”

    Hmmm. So not only was it unreasonable to simply assume this tax break would be maintained, but TPC also assumed in that original analysis that the benefit of not taxing muni bonds goes not solely to rich investors, but is at least equally a subsidy to state and local governments.

    What were the authors of that original TPC analysis of Romney’s “plan” thinking? How can we make the data in our analysis fit our thesis? There are many more assumptions in that analysis that need to be re-visited and changed. Let’s hope that the TPC is willing to admit that.

  3. ekiM  ::  7:17 pm on August 28th, 2012:

    Yet you fail to state the obvious–a vote to phase out the exemption is a vote to increase state and local taxes. Who do you think will pay the additional debt service costs (especially of GO bonds)? Taxpayers. Taxpayers in every jurisdiction that issues tax-exempt bonds (that would be nearly every sizable, full-service jurisdiction in the USA).

  4. Vivian Darkbloom  ::  4:55 am on August 29th, 2012:

    Martin Feldstein has an interesting Op-Ed in today’s Wall Street Journal entitled “Romney’s Tax Plan Can Raise Revenue”. I’ll link to the URL in a follow-up comment. The Op-Ed specifically mentions—and disagrees with—the TPC “analysis” of the Romney proposal. Specifically, Feldstein takes the IRS data from 2009 tax returns filed and shows, in fairly simple arithmetic, that is possible for tax rates to be cut 20 percent across the board and not increase taxes on the “non-rich”. And, Feldstein’s math only involves eliminating *itemized deductions* on those earning more than $100,000 (Attentive readers will note that this may be a clever sleight of hand in that it uses a different definition of “non-rich” than the TPC study, but at the same time Feldstein’s analysis does not involve cutting *any* itemized deductions for those earning less than that amount. Also, Feldstein personally favors keeping all deductions but capping the benefit of those deductions for high income taxpayers. The latter approach appears to differ from the Romney proposal). But, Feldstein’s analysis does not touch refundable credits, above-the-line deductions or “tax expenditures” that entail exclusions from income, such as cafeteria plans and health benefit exclusions, which the TPC analysis apparently did. Not touching refundable credits has a huge effect on the distributional analysis. Feldstein was not speaking for the Romney campaign, but his disclosure indicates that he is a campaign advisor. Therefore, it it tempting to assume that his thinking in the Op-Ed reflects the thinking behind the Romney claim.

    While Feldstein’s analysis is alluringly simple, it has the advantage of being totally transparent. His math is there to see and easy to check. The same cannot be done with respect to TPC’s analysis.

    It would be interesting to hear what TPC’s response to this is. What causes such a huge difference between their numbers and Feldstein’s? Is it merely Feldstein’s use of $100,000 as a threshold? His dynamic scoring? There is one item that is not explicit in Feldstein’s story—does the 20 percent tax reduction for those earning between $100,000 and $200,000 adequately offset the loss of their itemized deductions? Aside from this, Feldstein’s analysis is much more transparent than that of the TPC’s analysis, the inputs and many of the assumptions of which have not been disclosed.

  5. Vivian Darkbloom  ::  4:56 am on August 29th, 2012:

    Here is the link to that Feldstein Op-Ed:

  6. Michael Bindner  ::  9:06 am on August 29th, 2012:

    The answer to this question has to be basic tax reform, with a mix of consumer and employer paid consumption taxes (the differences being receipt visibility, border adjustment and the ability to take deductions – which negates border adjustablity) and a residual graduated simplified income surtax on income from all sources, including cash disbursements from inheritances) above a high floor ($75,000 single/$150,000 joint current income or $50,000/$100,000 after gross pay cuts). Such a reform will also impact state finance, especially if senior Medicaid is federalized as an incentive for states. If the remaining income tax is dedicated to military and sea deployments and redeeming principal and interest on federal bonds and sunsets when all bonds are paid off, then the Fed will be looking for some other investment and Munis may be the key.

    Of course, if personal accounts in Social Security holding employer voting stock is part of the reform, then eventually employee-owned firms will either buy the bonds in the cities where they are located or will simply provide some of the infrastructure these bonds now finance. Of course, if we get all libertarian in public finance, what will TPC do? (or who will fund it?)

    It seems that the fate of Municipal Bonds is tied to the fate of charitable contributions as well. This may present a quandary for the entire non-profit sector.

  7. Tax Roundup, 8/29/2012: Envision an IRS exam. « Roth & Company, P.C  ::  9:39 am on August 29th, 2012:

    […] Gleckman,  Should Congress Curb Tax-Exempt Municipal Bonds?  […]

  8. Ralph H  ::  12:01 pm on August 29th, 2012:

    And this is bad???? The true interest cost should be transparent and be charged. It is dishonest to hide this cost rather tack it on to our national debt for payment in the future by our grandkids.

  9. AMTbuff  ::  1:08 pm on August 29th, 2012:

    I favor ending the exemption. If we’re going to subsidize states, then we should do so directly. That’s more efficient.

    Ending the exemption will also make visible the tax burden on these securities. Currently they appear to be tax-free, but that’s an illusion. An income tax is implicit in the lower yield for tax-exempt bonds.

    Income inequality obsessives have consistently ignored the implicit tax on tax-exempt bonds. They will not be able to ignore this income tax paid by the rich when it becomes explicit upon revocation of the tax exemption.

    I predict that the income inequality obsessives will attempt a baseline game, creating a baseline that includes the implicit tax, then measuring the increase in taxes paid by the rich against that baseline. Even though these same “economists” never used that baseline when it was reality. This trick will be too complex for the layman to follow and too obviously political to fool anyone who understands the authors’ argument.

    I’m in favor of truth in taxation. Unlike many other deductions and exemptions, this one is unrelated to accurate measurement of disposable income. Replacing this exemption with direct subsidies would be a win for everyone. Existing debt should be grandfathered, but new obligations should be fully taxable.

  10. A. Caruso  ::  10:40 pm on September 13th, 2012:

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  11. jason g  ::  12:15 pm on September 27th, 2012:

    Do you have any idea how many or “few” (in your words) receive the benefit of the muni income exemption? Likely you have no idea, and the actual answer will surprise you. As the article states, think seniors with pitchforks.

  12. Letisha Monaham  ::  12:01 pm on January 12th, 2013:

  13. jerry  ::  2:12 pm on May 22nd, 2013:

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