By Larry Jones
December 17, 2012

Next year, Congress and the President are expected to seriously turn their attention to tax reform. When they do, they will likely consider a number of proposals to offset a growing federal deficit estimated to be about a $1 trillion. The Simpson-Bowles Commission as a start has recommended lowering overall tax rates for everyone and eliminating most deductions, including tax-exempt municipal bonds. If the tax-exempt status is eliminated altogether, it would significantly drive up state and local borrowing costs. There are over $3.7 trillion in outstanding tax-exempt municipal bonds. A total loss of the exemption would mean local governments borrowing costs would increase on average by two percentage points.

While the President and Congressional leaders are not discussing totally eliminating the tax-exempt status of municipal bonds, both are seriously considering limiting the exemption. In a December 12 Wall Street Journal article, it was stated that both the White House and Republican leaders are willing to consider taxing a portion of municipal bond interest paid to high-income households. The article points out that in the Administration’s 2013 Budget, a proposal was included for capping the exemption on municipal bonds at 28 percent for households earning $250,000 or more annually. Conference of Mayors President Philadelphia Mayor Michael A. Nutter is cited in the article, commenting on the proposal by saying: “The bottom line is all it really does is drive up interest costs, which cities like Philadelphia and many others can’t afford.”

Under current law, a person in the 35 percent income tax bracket earning $100,000 in tax-exempt interest can effectively save $35,000 because the interest earned on municipal bonds is tax-exempt. Under the Administration’s proposal, the savings would be limited to 28 percent or $28,000. This means the same $100,000 in municipal interest would only be worth a $28,000 tax benefit and the investor would be responsible for paying the tax on the $7,000. An additional concern is that this proposal would apply to interest on bonds that have already been issued. In the 100-year history of tax-exempt bonds, Congress has never applied a retroactive tax to bonds already held by investors. This would represent a violation of the basic assumption by investors that Congress will not change the terms governing the taxability of interest for bonds already outstanding. It is estimated that state and local borrowing costs could increase between 60-75 basis points if this proposal is enacted.

l borrowing costs could increase between 60-75 basis points if this proposal is enacted.