Seeking Alpha

Warren Buffett published an Op-Ed piece in the New York Times entitled “Stop Coddling the Super Rich”. He says “my friends and I have been coddled long enough by a billionaire-friendly Congress". Buffett asks Congress to establish higher tax rates on the super rich.

Buffett’s plan is quite different from that of President Obama. President Obama wants to raise income taxes on all individuals earning over \$200,000 a year (\$250,000 for joint returns). But Buffett sets a much higher threshold for the definition of “rich”, and only wants to increase income taxes and investment tax rates for those making more than \$1,000,000 a year. In 2009, this was about 0.3% of tax returns filed. Obama’s proposal affects around 2.5% of tax returns.

Buffett is also recommending a higher tax bracket for those earning over \$10,000,000 a year. In 2009, there were only 8,274 returns filed in this category. Under Buffett’s tax proposal, 99.7% of the population would have their income tax rates unchanged, and the current two percent reduction in employee contribution to the payroll tax would be maintained.

One factor that was not mentioned in Buffett’s opinion piece was the beneficial effect on state and local municipalities. Higher marginal tax rates on the super wealthy are bullish for municipal bonds. Higher municipal bond prices imply lower municipal bond yields and lower borrowing costs for hard pressed state and local municipalities.

I did some calculations to see how much interest would be saved by a municipality if the top marginal tax rate was raised. Buffett did not mention specific tax rates in his proposal, but for illustration purposes, I have assumed new tax rates of 50% for those earning above \$1 million and 60% on income above \$10,000,000.

Municipal bonds generally trade on a “tax-equivalent” yield, which is the pretax yield that a taxable bond would need in order to compete with the municipal bond. This calculation can be used to fairly compare the yield of a tax-free bond to that of a taxable bond to see which bond earns more.

Tax Equivalent Yield = (Tax Free Muni Yield) / (1 – Tax Rate)

For example, the yield of 30-year municipal bond on Bloomberg is currently quoted at 3.862%. Using the current top marginal tax bracket of 35%, the tax equivalent yield of a 30 year muni bond is 3.862/ (1.0 – 0.35) = 5.94%.

Now consider what would happen if the top marginal tax rate was raised to 60% instead of 35%. The tax equivalent yield would be 3.862 / (1 – 0.6) = 9.65%! Of course, if the top marginal rate was raised to 60%, the prices of municipal bonds would be bid up by the super rich until the tax equivalent yield was closer to 5.94%. The yield of the 30 year muni yield has to drop to 2.38% in order to bring the tax equivalent yield down to 5.94%.

The bottom line is that a typical state or local municipality would save about 1.50% or 150 basis points per year in borrowing costs! Many hard pressed state governors and mayors will support the Warren Buffett tax proposal when they see how much they will save every year in interest payments.

Because municipal closed-end bond funds use leverage, the potential price gains from a Buffett-like tax proposal are even more dramatic. I recently wrote an article about PML which has a tax-free distribution yield of 7.5%. Using the current top tax bracket of 35% gives a tax equivalent yield of 7.5 / (1 - 0.35) = 11.54%. But if the top marginal tax rate went to 60%, the tax equivalent yield would be 7.5 / (1 – 0.60) = 18.75%.

You can be sure this yield would attract significant buying interest from the super rich driving up prices of muni bond CEFs!