Municipal bond tax exemption gets federal support, some states may still see underperformance


As CivSource reported earlier this month, the U.S. Conference of Mayors (USCM), The National League of Cities (NLC), and the National Association of Counties (NACo) all issued a unified statement in opposition to ending the tax exemption for municipal bonds. The measure has been under consideration at the federal level since last year as government scrambles for revenue. Last week, House Reps. Lee Terry (R-NE) and Richard Neal (D-MA) introduced a resolution in support of leaving municipal bonds unchanged. Today, the National League of Cities announced its support for the resolution.

“Our representatives should stand up for our cities and their residents by co-sponsoring this resolution. Without municipal bonds, local taxpayers will pay more to finance schools, hospitals, roads, water and sewage systems, transit systems and other critical infrastructure,” NLC President Marie Lopez Rogers, mayor, Avondale, AZ, said in a statement.

Proposals for changing how municipal bonds are dealt with in the tax code range from ending the tax exemption all together, to capping it at around 28%. Changing the tax structure of these bonds faces steep opposition from municipalities and the organizations that support them as cities and counties face continued federal and state budget cuts coupled with tax base compression. Three-quarters of infrastructure projects in the United States are financed by municipal bonds, removing or capping the exemption will increase borrowing costs for municipalities and levy an additional tax on individual, often middle class investors who are the largest holders of municipal bonds.

A recent survey done by Citigroup, says that two-thirds of asset managers expect the tax structure to remain unchanged. However, organizations like the NLC are only cautiously optimistic about the exemption remaining untouched.

Some cities are making efforts to provide more information to the public about municipal bond investments and their uses. Today, the state of Massachusetts launched a public information website about city and state bond investment. The website has more than 30,000 pages of financial reports and data and is primarily geared toward the mutual fund crowd, but also contains valuable information for public finance oriented individuals. The website launch follows changes to the state’s financial disclosure practices to provide more transparency to investors and the public.

Even if municipal bonds go unchanged at the Federal level, Barron’s notes that investors may see under performance out of their bond investments, if they hold bonds from a state that plans to cut its income tax. A number of states under Republican control are considering big cuts, or outright elimination of state income taxes, moves which will cause a drag on the investment for municipal bondholders.

States with low or no income taxes like Florida, see lower cost bond prices, and if enough states nearby also follow suit it essentially creates a race to the bottom. When federal tax rates increased recently, many investors moved into municipal bonds, a welcome move for state infrastructure projects and budget issues, but those investments could now see a drag if Republicans nationwide have their way on taxes. States that are considering cuts to income taxes most often consider replacing it with significant increases on sales tax, providing better overall rates for businesses, and hitting consumers at a higher rate as sales taxes impact low income and middle-class consumers purchasing power more than income based levies.