Supercommittee May Take Up Obama’s Threat to Muni-Bond Tax Break

Congress’s deficit-cutting supercommittee may cap or end a tax exemption that helps set state and local debt prices, raising borrowing costs and disrupting the $2.9 trillion municipal-bond market.

Bankers, bondholders and issuers are preparing for an attack on the tax break investors get for interest earned on some municipal securities, already targeted by President Barack Obama in his jobs and deficit-reduction proposals. The exemption, which has never been cut, lowers the cost of loans for schools, highways, hospitals and other public works.

“They’re looking at everything, and the tax exemption is on the table,” said Steven Boyd, principal with Halyard Asset Management LLC in White Plains, New York, which oversees $400 million. “It’s a factor weighing on investors’ minds.”

Should the 12-member supercommittee whittle down or erase the advantage for high-income investors to own municipal bonds, demand may shrink, pushing up costs for states and local governments. The exemption is projected to save owners of the tax-exempt securities $230 billion from 2012 to 2016, according to the White House’s Office of Management and Budget.

Because federal aid also may be cut to reduce the deficit, some municipal borrowers already avoid the debt market, said Lisa Quateman, the managing partner of Polsinelli Shugart PC’s Los Angeles office. That’s especially true when the financing may depend at least partly on dollars from Washington, the bond lawyer said.

Automatic Cuts

The supercommittee, which began meeting Sept. 8, has a mandate to find $1.5 trillion of spending cuts or revenue increases over 10 years. If it fails to meet a Nov. 23 deadline, that would trigger $1.2 trillion in automatic reductions, about half taken from defense spending.

Capping or eliminating the exemption “would have the dual effect of reducing the demand for municipal bonds and increasing the costs of municipal issuers,” according to a report from Nuveen Asset Management in Chicago. “This will exacerbate fiscal stress at the state and local level.”

Whether Obama’s proposal succeeds in limiting the exemption to 28 percent of interest earnings, down from 35 percent now, for couples earning more than $250,000 a year, his inclusion of the curb raises the chance that the supercommittee will consider it, said Matt Fabian, managing director with Municipal Market Advisors, a Concord, Massachusetts-based research firm.

“This should confirm that fear that the tax exemption could be affected,” Fabian said.

Concern in California

California Treasurer Bill Lockyer estimates the changes sought by Obama in his jobs plan may cost his state as much as $7.7 billion in higher borrowing expenses. Lockyer also cited concern that the exemption is increasingly at risk as a result.

“It opens the door to a much broader debate about the elimination of tax-exempt bonds,” Lockyer said Sept. 16 at a Bond Buyer conference in Carlsbad, California. The state is the largest issuer of municipal debt.

The renewed threat to the exemption for the securities comes as a struggling economy and a deficit-cutting Congress add to fiscal pressures on state and local governments that have grappled with ways to survive the worst fiscal crisis since the 1930s. Some including New Jersey have slashed jobs while others, such as Illinois, have raised taxes.

The supercommittee also may look at cutting federal spending for programs that municipal governments depend on to pay for health care for the poor and to run schools and hospitals, said Richard Ciccarone, managing director at McDonnell Investment Management in Oak Brook, Illinois.

Aid at Stake

Federal grants to state and local governments are expected to total $424.9 billion in fiscal 2012, according to Office of Management and Budget data.

“It’s like trying to fly through a narrow canyon,” said Ciccarone, whose company has $14.9 billion of assets under management, including $8.3 billion of municipal bonds. “It’s difficult to steer a course that avoids damage.”

Obama’s decision to include limiting the exemption for municipal bonds, included in the federal income-tax law codified in 1913, came as a surprise, said Victoria Rostow, director of government affairs for the National Association of Bond Lawyers in Washington. Obama packaged the proposal with ways to pay for his $447 billion jobs plan.

“It came out of the blue from the White House,” Rostow said. “They hadn’t endorsed it before.”

Previously Targeted

The idea of phasing out the exemption has been raised in the past year as part of a broader discussion of ways to reduce the federal deficit. A proposal in the House of Representatives by Budget Committee Chairman Paul Ryan, a Wisconsin Republican, sought an end to the break.

A report from Obama’s 2010 fiscal commission led by Alan Simpson and Erskin Bowles, which the president embraced in December, also proposed ending the exemption, Bank of New York Mellon Corp. said in a report.

The “urgent scramble” to address the federal deficit “will reasonably seek to uncover every scheme to broadly raise revenues, bringing all major tax expenditure loopholes under intense scrutiny,” Mellon’s Steven Harvey, a senior portfolio manager in Boston, and Nathan Harris, a research analyst, said in the report. The break is the 11th biggest for taxpayers after such deductible expenses as employer-provided health coverage and home-mortgage interest, according to White House data.

Yet limiting the exemption for higher-income taxpayers may produce relatively little benefit, Harvey said in a statement released with the report. In 2008, for instance, “more than half of the 5.5 million tax returns reporting receipt of tax-exempt interest were filed by taxpayers with adjusted gross income below $100,000.”

While yields for municipal bonds are near historic lows, often they pay more than comparable treasury securities, said McDonnell Investment’s Ciccarone. A top-rated 10-year muni priced to yield 2.2 percent on Sept. 20 paid 26 basis points more than a taxable 10-year Treasury, according to data compiled by Bloomberg. A basis point is 0.01 percentage point.

“Prices are very attractive,” Ciccarone said.