Municipal Bond Madness

Congress, in case you haven’t heard, is toying with the idea of tax reform—ordinarily something we’d cheer, considering our tax code is too complex and rather costly to comply with. But as part of this effort, legislators are also looking for new sources of revenue—including the interest on tax-exempt bonds, like municipal bonds. Needless to say, this would hurt muni bond owners and create unintended consequences, but thankfully, Washington gridlock makes it unlikely to pass.

Calls to tax muni bond interest aren’t new. The Obama administration’s floated it in past budget proposals, and Congress considered it in a potential fiscal cliff deal late last year. And predictably, they’re taking something simple—a blanket tax exemption—and turning it into something rather more complex. Muni bond interest would become like any other potential itemized deduction—investors can claim a certain amount as tax free, but anything over the limit would be subject to ordinary income tax rates. Right now, those limits coincide with an individual’s prevailing tax rate—someone in the 35% tax bracket earning $100,000 could deduct $35,000—but the proposal would drop the limits to 28% for those in the top-three brackets.

This would ding many fixed income investors. The muni bond market is currently about $3.7 trillion. Retirees own much of that specifically for the tax-free income—a less costly way to help meet their ongoing cash flow needs. The proposed legislation would undermine that strategy and, potentially, their long-term retirement planning—the higher taxes would be an unforeseen long-term expense.

Municipalities would also feel a pinch from rising borrowing costs. Tax-free interest gives investors an incentive to purchase munis, and they’re willing to accept a lower yield as a tradeoff. Without it, muni bond demand likely falls, forcing municipalities to offer higher yields to entice investors. Some estimate municipalities could face $9 billion a year in additional borrowing costs—no small strain on cities’ finances. With more money going to debt service, municipalities would have less revenue for infrastructure projects, development and public services. That could crimp public works, force cities to seek more funds from the federal or state governments and, potentially, lead to even higher taxes down the road.

On the bright side, thanks to gridlock, this seems unlikely to pass. With Congress divided, anything extreme has little chance of passing—and in our view, this proposal qualifies as “extreme.” The 2014 midterm elections also help. Since the Senate contest structurally favors Republicans (fewer seats up for reelection), Democrats have every incentive to moderate—especially those in traditionally Republican constituencies. Taxing muni bond interest isn’t too popular with voters or businesses who understand the unintended consequences—the very people sitting Senators need to please in order to win re-election. Republican Senators, too, have similar incentives.

So while a muni bond tax would be bad news, fixed income investors likely needn’t fret—chatter may swirl through Washington for a while longer, but cooler heads should prevail.