Obama targets muni bond tax exemption for those earning over $200K

President Barack Obama’s plan to cut the budget deficit repeats his call for curbing the tax exemption on municipal bonds and would give states a break on unemployment debts owed the federal government.

The recommendation includes tax overhauls proposed last week that would limit exemptions for interest on state and local government bonds for those earning $200,000 or more. While that may push up municipal borrowing costs, Obama today proposed giving states that have run out of money for unemployment benefits two more years of interest-free loans.

The ideas are part of a package Obama submitted to a Congressional panel seeking to cut $1.5 trillion from the deficit in the next decade. By pressing for tax increases, mostly aimed at the wealthy, he places himself at odds with Republican leaders who want to focus on scaling back spending.

Any push to reduce the tax-exemption on municipal-bond interest may also face resistance from local government officials coping with fiscal pressure from the recession and a loss of federal stimulus money. California Treasury Bill Lockyer last week said losing part of the tax break might cost California as much as $7.7 billion.

Because the interest earnings are exempt from taxation, investors are willing to accept lower returns, driving down the cost of public projects. About $32 billion, or 47 percent, of the tax-exempt interest claimed in 2009 was paid to those earning more than $200,000, according to the Internal Revenue Service.

Tax Break Challenge

The tax break has withstood challenges in Congress amid a push to rein in the federal deficit. A presidential commission recommended scrapping it last year as part of an overhaul of the U.S. tax code, while Senator Ron Wyden, a Democrat from Oregon, proposed replacing the exemption with a credit. Neither plan advanced.

The Obama administration has proposed aiding state and local governments by providing $35 billion to prevent public employee layoffs, a plan that was reiterated today.

In addition, the president proposed providing assistance to states that have run out of money to pay for unemployment benefits because of persistently high joblessness. More than half of U.S. states have borrowed from the federal government to pay claims and now collectively owe more than $37 billion, according to the U.S. Labor Department.

The plan offered by Obama today called for forgiving interest payments on the debt for two years, as well as the automatic tax increases to be faced by businesses in indebted states. To shore up the trust funds later, it would increase wages subject to federal unemployment tax to $15,000 from $7,000.

–Bloomberg News–