Obama Proposals Would Hit Municipal Bonds With A Tax Double Whammy

by: Richard Shaw

When Obama released the broad goals of the "American Jobs Act of 2011" proposal, we published an article (click here to read) discussing how the limitation of tax exempt income for the wealthy would reduce the appeal of municipal bonds, thus raising the rates states and local governments would have to pay.

That proposal would be retroactive in that it would apply to outstanding as well as new issue bonds. That would cause the price of outstanding bonds to decline, and the coupon rate on new issues to rise. In the end those most hurt would, once again, be the middle class, not the rich.

The rich would adjust what they buy, or what they pay for what they buy, to get to after-tax equivalent returns acceptable to them. States and municipalities, however, would have higher costs and that means higher property taxes and higher state and local income taxes --- and that is mostly a middle class burden.

Additionally, the inevitable result would be more federal financial assistance, which would advance the consolidation of power in Washington at the expense of self-determination by the States.

As we have already seen with Build America Bonds, which are taxable municipal bonds where the federal government pays part of the interest to keep the cost to the issuers down, the federal government picks and chooses which projects it will assist. That in effect gives the federal government the power to make what have historically been local decisions.

Now, another Obama proposal which is meant to be implemented alongside the American Jobs Act, would slap a second whammy on municipal bonds.

The additional proposal was reported on today by "The Bond Buyer" in an article titled "Debt Bill Could Hurt Munis" (click here to read).

Here are some excerpts:

"President Obama has sent draft legislation to the congressional deficit reduction committee that would have the potential to further limit the value of tax-exempt interest for higher-income taxpayers below the 28% level proposed in his jobs bill.

... the Debt Reduction Act of 2011 … would require the Office of Management and Budget to establish steadily declining annual ratios for debt as a percentage of gross domestic product beginning with fiscal 2013. … If the ratios were not met in any given year, automatic cuts in spending and tax preferences, such as tax-exempt interest, would be triggered.

“It would introduce a tremendous amount of uncertainty in the municipal market,” said Bill Daly, senior vice president for government relations at Bond Dealers of America. “Investors would exact a premium on state and local governments because of the uncertainty. ...

“It would make tax planning almost impossible,” said Michael Decker, managing director at the Securities Industry and Financial Markets Association and co-head of its municipal securities division. “If you were buying a long-term bond you’d have no idea over the life of the investment how much would be taxed. It would create a big new element of risk that would be difficult to price.” ...

Edward Kleinbard, a law professor at University of Southern California Gould School of Law and former chief of staff for the Joint Tax Committee, agreed. “It’s one thing to say that the tax benefits of muni bond interest will be capped at a 28% rate from now on,” he said. “It’s another to say the tax benefit will never be more than that available to a 28% taxpayer, but can fluctuate all the way down to zero, depending on unrelated budget disagreements.”

The 28% limit in the jobs bill is viewed by most market participants as a 7% tax on muni bond interest because the highest income tax rate is currently 35%. If the Bush tax cuts expire at the end of 2012, 39.6% becomes the highest income tax rate and the 28% limit would equate to an 11.6% tax on muni bond interest.

For those market participants who thought the job’s bill provision on tax-exempt interest was an aberration because it had never been included in previous proposals to limit tax deductions, Obama’s debt reduction bill continues the theme …"

Who knows what of all this may or may not get through Congress, but if the markets get too much of a whiff of this sort of thing, the current enthusiasm for muni-bonds could be dampened, and existing holders could see some losses or profits erosion before 2013.

Of course, opposing upward forces are the current fear factor reallocating out of stocks, and the long lasting and demographically driven reach for cash yield by an ever burgeoning retiree population.

If muni-bond holders have capital gains and might wish to reallocate as a result of such tax changes, they should consider doing so before 2013, because in that year universal healthcare laws recently put on the books impose a 3.8% Medicare surcharge tax on capital gains after 2012. That would include capital gains on the sale of muni-bonds (as well as other investments, including real estate).

Disclosure: QVM does not have positions in any mentioned securities as of the creation date of this article (09/30/2011).

Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here