April 12 (Bloomberg) -- Sugar Land, Texas, plans to pump $50 million into new parks around the city of 85,000, just the kind of project President Barack Obama wants to revitalize the U.S. economy by spurring investment in aging infrastructure.
Yet the Houston suburb would have to scale back that work, along with fixes to streets and buildings, if lawmakers adopt the president’s proposal to limit the century-old exemption on interest from municipal debt. The step was one of the Democrat’s ideas to generate revenue to curb the federal deficit, and was part of his fiscal 2014 budget released this week.
From Portland, Oregon, to Columbia, South Carolina, local officials said the policy would lift property taxes and utility rates, and curb issuance even as municipal interest rates are below their five-decade average. The recommendation for a 28 percent cap on income-tax deductions for the wealthiest households would boost tax-exempt yields as much as 0.7 percentage point, according to Citigroup Inc.
“It’s kind of ironic, encouraging communities to invest in infrastructure, but then you’re going to take away the benefit of our tax exemption,” Jennifer Brown, director of budget and research in Sugar Land, said in an interview. “It just ends up costing the local communities more.”
As states and cities repair their finances after the longest recession since the 1930s, they’re also taking on projects to alleviate a $1.6 trillion U.S. infrastructure gap.
Sixty percent of cities expect to increase investment in roads, bridges and schools this year, up from 35 percent in 2011, according to a National League of Cities survey. Yet 61 percent also said they’d cut the number of capital projects if a limit on munis’ tax-exemption were imposed.
Municipalities have sold $85 billion of long-term, fixed-rate debt this year, ahead of the pace last year, when they issued the most since 2010, data compiled by Bloomberg show.
Obama proposed spending $50 billion on new infrastructure projects. He asked Congress to create a national infrastructure bank and recommended a program called America Fast Forward Bonds. The debt would be similar to taxable Build America Bonds issued by localities in 2009 and 2010, and would pay as much as 50 percent of the interest on borrowings to build schools.
States and cities have borrowed $2.3 trillion in the past 10 years through the muni market for new projects, according to Matt Posner, legislative coordinator for Concord, Massachusetts-based Municipal Market Advisors.
The NLC estimated it would have cost cities an extra $173 billion over the past decade to finance the same initiatives if the tax cap were in place.
As it stands, the cap would apply to previously issued debt, not just issuance after such legislation is enacted.
“If you’re really interested in infrastructure, why would you tamper with that?” Posner, who’s based in New York, said in an interview. For investors, “there’s trust that when the broker sold you bonds, you’re buying an exempt product that will remain exempt. Dependency and permanency are things that markets trade on.”
The president “would not support anything that only had provisions that led to states and local governments being in more negative position to invest in the modern infrastructure our economy needs for both jobs and our future competitiveness,” Amy Brundage, a White House spokeswoman, said in an e-mail.
Some officials say a tax change wouldn’t halt issuance.
The cap “in reality wouldn’t stop us from coming to market,” said Tim Ewell, senior deputy county administrator in Contra Costa County, California. Still, the locality may have to reduce service levels to make up for higher interest costs, he said in an interview.
Investors saw just four months ago how the risk of a tax change can roil the market. Local debt lost 1.6 percent in December, the biggest slump in two years, according to Bank of America Merrill Lynch data. Individuals dumped munis in the second half of the month on concern that the tax exemption would be part of a deal to avoid the so-called fiscal cliff of tax increases and spending cuts.
Top-rated munis such as those issued by Sugar Land would become less valuable to the wealthiest buyers under Obama’s proposal. Benchmark 10-year munis yield 1.79 percent, Bloomberg data show. For investors in the top tax bracket, that’s equivalent to about a 3 percent taxable yield. That rate would drop to about 2.5 percent under a 28 percent cap.
The threat to the municipal-bond tax exemption isn’t new. In 2010, Obama’s deficit-cutting commission proposed doing away with it as part of an overhaul to lower income-tax rates and raise government revenue. In 2011, the president also suggested capping the benefit for top earners.
Neither plan advanced in Congress. On Wall Street, analysts such as George Friedlander, chief muni strategist at Citigroup, said the tax-free status of muni interest could be targeted by both Republicans and Democrats as part of revamping the tax code. Proposals are now being crafted by committees in both houses of Congress.
House Republican leader Eric Cantor indicated support for the tax-exemption, while 14 senators sent a letter to Obama on April 2 saying his proposals would add to the burden on localities. At a House hearing in March, both Republicans and Democrats expressed concern that changes to the exemption could cost local governments.
Cantor’s comments are the most meaningful because he’s most likely to have a major part in tax overhaul negotiations, said Michael Zezas, head of municipal strategy at Morgan Stanley in New York. The remarks led him to reduce the probability of a change to the exemption to 20 percent from 25 percent.
The mayor of Columbia, South Carolina, said that costs from a tax cap would trickle down from the wealthiest 2 percent to residents through higher taxes or water bills.
“There is this view that it’s a rich man’s loophole,” said Steve Benjamin, the Democratic mayor. The city is spending $100 million a year to upgrade its water and sewer system. “It’s not -- it’s a sacred partnership. And once we begin to disrupt it, who knows what happens next?”
About 1,000 miles (1,609 kilometers) southwest in Sugar Land, the city will ask voters in November to approve park projects for hiking, festivals and sports. Officials have pledged not to raise property taxes by more than 5 cents for the initiative.
“The 5-cent increase just wouldn’t buy as much, so we’d have to cut back on our projects,” said Brown, the budget and research director. “We’ll have to evaluate what we can afford.”
Localities are wrapping up the biggest week of issuance this year, selling about $10.8 billion, Bloomberg data show. Supply is poised to shrink to about $6.6 billion next week.
Even with the sales wave, yields on benchmark 10-year munis have fallen to the lowest since January, as investor selling related to tax season wanes.
The rally has driven muni yields to about even with those on federal debt for the first time in a month. The ratio of local yields to those on Treasuries is about 100 percent, the lowest since March 12. The smaller the percentage, the more expensive munis are relative to federal securities.
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