Threat of tax cap freaking out muni market

The municipal bond market is circling the wagons once again following the latest suggestion that the Obama administration wants to reduce the 100-year-old tax exemption on muni bond income.
Even though most muni market experts see a slim chance of Mr. Obama’s succeeding in capping the exemption at 28%, as is proposed in his current budget, the $4 trillion market is leaving nothing to chance.
“For state and local governments, the use of the tax-exempt status is so important to us that we take any threat seriously,” said Joe Costello, executive director of the Regional Transportation Authority of Northeastern Illinois.
“We’re looking at a 10-year need of about $31 billion and growing rapidly — just to be in a state of good repair,” he added. “Don’t do this to us; don’t create the additional burden on us by eliminating the well-worn and well-established approach to financing that we’ve taken for decades.”
The latest dust-up started earlier this week when a Treasury Department official indicated her support for a 28% cap on the muni bond exemption during a forum in Philadelphia sponsored by the State Budget Crisis Task Force.
According to reports, Mary John Miller, the Treasury Department’s undersecretary of domestic finance, referred to the muni tax exemption as part of a “broader group of sacred cows.”
Ms. Miller, who did not respond to requests for comment, was quoted at the forum as saying, “As the private sector has recovered, we need to begin pulling back the federal safety net so that we can restore our fiscal situation.”
While it should not be news to anyone in the muni bond space that the Obama administration supports capping the muni exemption, along with most other exemptions, at 28%, the public comments by Ms. Miller were seen by some as a direct and immediate threat.
“In the context of tax reform, the [proposed 28% cap] has a lot of legs, and I think it will be seriously considered,” said Mike Nicholas, chief executive of Bond Dealers of America.
“This is clearly something that is on the table and it will be discussed,” he added. “Now that we’re past the eleventh-hour rush from sequestration and the fiscal cliff, there will be a more thorough discussion about capping the exemption on municipal bonds.”
From the muni bond market perspective, any reduction in the tax-free income exemption adds up to a new set of fiscal challenges at the state and local levels because those jurisdictions rely on the tax-exempt status to help the lower-yielding muni bonds stay competitive in the overall bond market.
If the exemption is cut or even reduced, logic dictates that muni bonds will have to offer higher yields to attract investors, effectively increasing borrowing costs at the local and state levels.
According to Philadelphia Mayor Michael Nutter, who was on the same panel as Ms. Miller at the forum, a 28% cap on muni tax exemptions would increase Philadelphia’s borrowing costs by more than $5 million a year.
On a broader scale, according to the National Association of Counties, a 28% exemption cap would cost municipalities $9 billion a year in additional borrowing costs.
With more than 50,000 local muni bond issuers across the country, the dollars add up quickly when calculating the impact of capping the tax exemption, which has been around for as long as there has been a federal income tax in the U.S.
But it isn’t the heavy impact on state and local governments, but the polarized state in Washington that will prevent the 28% cap from succeeding, most market watchers say.
“Even though this administration keeps putting it in the budget, tax reform is an extremely difficult thing to get done, and I don’t think it has legs,” said Tom Dalpiaz, senior vice president at Advisors Asset Management Inc.
“The president campaigned on asking the wealthy to pay more because he wants to take more from that group of people,” he added. “But in this politically charged environment, where it is difficult to get anything done, it’s hard for me to believe something like this gets done.”
Even as representatives from the muni market have expressed vocal opposition to any change in the current income exemption status, the municipal bond market, as measured by prices and yields, so far has shrugged off the threat.
“This kind of thing does get the muni market to pay attention, but from our perspective, it’s very unlikely President Obama gets this done,” said Adam Buchanan, vice president at Ziegler Capital Markets. “The president can’t even get his own party behind it.”