If Uncle Sam taxes munis, munis could tax Uncle Sam

Is it really possible that the federal government will use the threat of the fiscal cliff to take away the tax exemption from municipal bond income? Not if the states have anything to say about it – and it appears they might. According to feedback from some astute readers, individual states have a certain degree of negotiating leverage in the form of the doctrine of reciprocal immunity. Established by the Supreme Court, and introduced along with the first federal income tax in 1913, the doctrine essentially states that as long as the federal government does not tax municipal debt, the local municipalities will reciprocate by not taxing federal debt securities. In other words, if lawmakers decide to try and balance the federal budget by taxing muni bond income, the individual states will have the green light to start taxing the income from Treasury bonds owned by state residents. Of course, as we all know, the individual bond investors won't really be paying the taxes because the elimination of the tax exemption will force the bond issuers at all levels to pay higher yields. That, in turn, would create the unintended consequences of more expensive debt for every bond issuer, from local municipalities all the way up to the federal government. Not even congress could think that's a good idea.