If you see something big and round hanging over our nation’s capital, it’s likely you’ve spotted the trial balloon being floated by two senators who, in their bill attempting to make the tax code more “simple and fair”, would eliminate tax-free municipal bonds.
While the proposal hasn’t yet garnered the massive attention it likely will, we have been contacted by a few investors concerned over the possible implications.
Our response is simple: It’s unlikely to happen. But in the slim chance that such a bill does become law and tax-free municipal bonds are no longer issued, current investors will yet have reason to smile because the value of their tax-free munis will skyrocket.
Remaking the tax code
The provision regarding muni bonds is part of a blockbuster bill introduced by Sens. Ron Wyden (D-Ore.) and Judd Gregg (R-N.H.) that would, in the words of one writer, fundamentally remake the tax code. Under the proposal, the number of tax brackets for individuals would be cut from six to three, with a top rate of 35%; the U.S. corporate tax rate would be reduced from 35% to 24%, while special tax breaks would be eliminated; the alternative minimum tax would be repealed; and the first 35% of capital gains and dividends would be tax exempt.
The bill would also remake how the federal government subsidizes debt issued by state and local governments. Under the new proposal, all municipal debt would be taxable and tax-exempt bonds would cease to be issued beginning in 2011. There would be a shift to tax-credit bonds, in which investors would be issued a tax credit equal to 25% of interest costs. Additionally, the bill would prohibit any advance refundings of municipal bonds.
Market participants strongly oppose the measure. Issuers weighing in say the move from tax-exempt bonds to tax-credit bonds would amount to unwanted federal interference in states’ ability to raise capital. A securities industry spokesman says that in order to attract the likeliest investors – those in higher tax brackets – interest rates would need to be higher, thereby increasing borrowing costs. The National Association of Bond Lawyers says tax-exempt bonds and tax-credit bonds complement one another and should remain intact.
Dismal history of tax-credit bonds
Resistance to a shift away from tax-free munis is understandable. The $2.8 trillion tax-free municipal bond market has a track record of more than 80 years. The market is straightforward and liquid, and tax-free munis enjoy a strong following among investors and public finance officials.
Tax-credit bonds, on the other hand, have existed for about 10 years and haven’t fared well. Of the more than $22 billion in tax-credit bonds that have been authorized through the end of this year, only a small fraction has been used, according to Dow Jones.
In the unlikely event that Wyden and Gregg’s trial balloon doesn’t pop and the shift is on from tax-exempt to tax-credit munis, how would current investors fare? Since there is no chance tax-frees would be eliminated retroactively, the immediate effect would be a spike in value.
Though the Wyden/Gregg proposal is silent on Build America Bonds, some argue they may one day replace tax-exempt bonds. Created last year as part of the economic stimulus package, Build America Bonds have proved to be extremely popular. Issuance of the bonds, which pay issuers a subsidy equal to 35% of their interest costs, has grown to about $80 billion and accounts for almost 20% of new issuance in the muni market.
Even so, Treasury officials say it’s too early to determine whether Build America Bonds would be a worthwhile substitute for tax-frees. And if they do ultimately prevail, the yield would have to be attractive enough to provide a reasonable after-tax return to satisfy their primary market – high net worth investors.
Despite the various possible scenarios, one thing remains certain: There will always be demand for fixed-income investments. We will continue to monitor developments as they occur.