Buried in a House committee’s 51-page report on ways to raise tax revenue, 13 words are being scrutinized by innumerable investors and municipal market professionals.

“This option would end the exclusion, making income from municipal bond interest taxable.”

How those words are interpreted and whether they’re acted upon will decide the fate of a successful, historic method of financing public assets and a secure, steady source of tax-free income for investors.

Impact of removing the exemption

As we’ve noted (“Muni Yields Soar as Exemption Threat Looms”), the new Congress and president are looking to raise money to pay for trillions of dollars in tax cuts.

Among the scores of revenue-generating ideas included in a House Ways and Means Committee report are taxing worker benefits, ending the tax deduction for mortgage interest, eliminating Health Savings Accounts – and wiping out the tax exemption for interest earned from municipal bonds.

Although it’s hard to fathom why a key component in building and maintaining the nation’s infrastructure would be jettisoned, the idea has been floated for years. The difference now is the seriousness in which it is being pursued.

The pushback has begun.

The Government Finance Officers Association, for example, sent a letter to House and Senate leaders of both parties noting, “In the last decade alone, $2.7 trillion in municipal bonds have been used to finance more than 80,000 new projects nationwide.”

The group cautioned: “Elimination of the tax-exemption would correspondingly raise borrowing costs $823.92 billion, a cost that would be passed onto American residents and amount to a $6,554.67 tax and rate increase for each American household over the next decade.”

May be a constitutional question

While efforts are underway to maintain the exemption, there is also the task of divining the meaning of the actual text. Specifically, if lawmakers removed the exemption, would investors have to pay taxes on the interest they earn from bonds they already own?

A public finance attorney, Johnny Hutchinson, told The Bond Buyer that is unlikely.

When Congress has attempted to limit tax-exempt financing in the past, “it typically has done so prospectively,” he said.

“In addition, although the Supreme Court has typically been rather lenient in favor of Congress on the question of retroactive tax legislation (and in particular whether it violates the Due Process provisions of the U.S. Constitution), it is at least questionable whether retroactive limits on the tax exemption would be constitutional,” he said. “And that is to say nothing of the political blowback Congress would face if it attempted to retroactively tax interest on outstanding bonds.”

Others put the odds of taxing existing tax-exempt debt “as close to zero as you can get without being zero.”

A ‘legal Armageddon’?

It’s virtually impossible to envision lawmakers removing the exemption from outstanding debt. That would break a promise to investors and, at the least, trigger a “legal Armageddon,” as one market professional told The Bond Buyer.

And eliminating it completely is unlikely, a Lord Abbett portfolio manager said, as “the benefits are too big for it to go away.”

Perhaps other, minor changes will be made to the exemption. We simply don’t know.

Where does that leave investors?

Robust demand continues, especially as investors who parked their cash in money-market accounts see their yields sink.

At the same time, the recent tax-equivalent yield on an A-rated municipal bond is 7.30% for those at the 40.8% tax rate, a fact hard to ignore given the various scenarios and the uncertainty over whether they will occur.

Nevertheless, we urge investors to learn more and share their thoughts with Congressional leaders.

For more on the impact of municipal bonds: https://www.gfoa.org/protecting-bonds

To contact congressional leaders:

The Honorable John Thune
Majority Leader, U.S. Senate
511 Dirksen Senate Office Building
Washington, DC 20510

The Honorable Mike Johnson
Speaker, U.S. House of Representatives
568 Cannon House Office Building
Washington, DC 20515

The Honorable Charles Schumer
Minority Leader, U.S. Senate
322 Hart Senate Office Building
Washington, DC 20510

The Honorable Hakeem Jeffries
Minority Leder, U.S. House of Representatives
2433 Rayburn House Office Building
Washington, DC 20515