U.S. Should Weigh Changes to Muni Bond Tax, Senator Says

Congress should consider changing the subsidies awarded to the $3.7 trillion municipal bond market to ensure that all taxpayers receive the same benefit, said the U.S. Senate Finance Committee chairman.

Twenty cents of every $1 spent on the tax-exemption for municipal bonds benefits higher-income investors, said the chairman, Democrat Max Baucus, of Montana, at a hearing today. Because income from state and local debt isn’t taxed, those in higher federal tax breaks receive the greatest benefit.

Lawmakers should “consider providing a uniform subsidy for bondholders,” Baucus said at the hearing in Washington. “A uniform subsidy would mean each taxpayer receives the same subsidy regardless of tax bracket.”

State and local-government leaders have pleaded with Congress to keep the tax-exemption as the federal government seeks ways to narrow its budget deficit. Investors are willing to accept lower returns on municipal bonds because of the tax break, which holds down the cost of public works projects.

Today’s hearing focused on how an overhaul of the federal tax code could affect state and local governments. Lawmakers discussed the potential need for Internet companies to collect sales taxes from customers.

Build America Bonds

Baucus cited the Build America Bonds program, which provided direct subsidies instead of tax breaks before it expired at the end of 2010, as an example of how the federal cost could be spread more evenly. Baucus and other lawmakers at the hearing didn’t endorse specific changes.

President Barack Obama has proposed reviving Build America Bonds, along with changes to tax breaks for traditional municipal debt. Top Democratic tax writers in the House have said Republicans are unfairly excluding Build America Bonds and benefits for energy manufacturing from a debate over reviving expired tax provisions.

The potential threat to the tax-exemption given to investors in state and local-government bonds has been a subject of speculation on Wall Street since 2010, when a commission appointed by Obama proposed ending it as a way to help cut the deficit. Obama has also proposed curbing the tax break for top-earners to limit their ability to push down their overall tax rate.

Municipal bond rates have dropped to their lowest in half a century as the Federal Reserve holds down interest rates, new bond sales have ebbed, and investors have shifted money to safe havens.

Bond Yields

Yields on 20-year general-obligation bonds fell to 3.9 percent the week ended April 19, near the lowest since the 1960s, according to a Bond Buyer index.

Senator Maria Cantwell, a Democrat from Washington, said she is concerned that changes to the tax treatment of bonds could affect utility customers in her region. Senator Orrin Hatch, the top Republican on the panel, said the president’s proposal to limit the value of the municipal bond tax break for those in the top tax bracket would penalize cities and states with higher interest bills.

“The president’s proposal would increase borrowing costs for state and local governments,” he said.

Frank Sammartino, the assistant director of tax analysis for the Congressional Budget Office, said Obama’s plan would still leave municipal bonds attractive to top-earners compared to corporate bonds.

“For most taxpayers, we think it’s not going to have a very big effect,” he said at the hearing.

Congressional Action

No curbs to the tax break have advanced in Congress, where there is broad disagreement between Democrats and Republicans over taxes. No Senators endorsed the outright repeal or proposed specific curbs at today’s hearing, either.

Any changes to the federal government’s treatment may influence the municipal bond market, which is dominated by individuals seeking tax-free income.

The prospect of eliminating the tax-break has drawn opposition from groups including the National League of Cities and the Securities Industry and Financial Markets Association, which lobbies for Wall Street banks and investment firms.

More than two dozen groups representing public officials, bond lawyers, and finance companies sent a letter to the Senate Finance Committee this week to leave municipal bond income untaxed. The groups, which included the National League of Cities and the National Association of State Treasurers, said the tax break supports state and local governments that oversee three-quarters of the nation’s infrastructure spending.

“Maintaining the tax-exempt status of municipal bonds is essential to help our national economy grow, create jobs, and best serve the constituencies of every community,” the groups wrote in the April 23 letter in advance of the hearing.

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