Taxation-Threat Revival Keeps Local Debt Cheapest: Muni CreditWilliam Selway and Brian Chappatta
The threat from Washington to the $3.7 trillion municipal market’s tax break won’t go away.
A proposal yesterday by House Ways and Means Committee Chairman Dave Camp, a Michigan Republican, is the latest that would raise money for the U.S. Treasury by taxing income investors receive from local-government debt, which has been exempt since the federal tax was implemented a century ago.
No change has advanced in the politically divided Congress. Yet since President Barack Obama’s deficit-reduction panel unveiled proposals in December 2010 that would end munis’ tax exemption, the bonds’ yields have tended to exceed those on Treasuries. That’s a shift from the previous decade, when muni interest rates were typically only about 90 percent of those on federal debt, a reflection of their tax benefit to top earners.
“It reinforces the general opinion that we have very few friends in Washington -- it doesn’t matter if you’re talking Democrats or Republicans,” Chris Mier, chief muni strategist at Loop Capital Markets in Chicago, said of Camp’s plan. “These kinds of proposals are going to continue to come up.”
Camp yesterday suggested taxing some muni interest for the highest earners -- individuals with incomes of about $400,000 and couples above $450,000 -- as part of tax changes that would also lower rates for individuals and corporations.
While it’s seen as having little chance of advancing ahead of November’s mid-term elections, it shows that both Democrats and Republicans are willing to reconsider how munis are taxed.
“It just adds to the list of concerns on the tax reform front,” said John Dillon, a managing director with Morgan Stanley Wealth Management in Purchase, New York. “You have this tax reform cloud hanging over the market.”
Yields on benchmark 10-year munis set an eight-month low of 2.55 percent yesterday amid a dearth of tax-free issuance, data compiled by Bloomberg show.
Yet since Dec. 1, 2010, the interest rate has averaged about 103 percent of that on similar-maturity Treasuries, Bloomberg data show. In the 10 years before that, local-bond yields averaged 91 percent of those on federal debt. The ratio is an indication of relative value between the two asset classes. The higher it is, the cheaper munis are compared with Treasuries.
“The current ratio does reflect, among other things, the presence of ongoing tax threats,” Mier said.
The tax debate isn’t the only contributor to the elevated ratio. Some cities and states are still mending their finances after the 18-month recession that ended in 2009. Detroit’s record bankruptcy filing in July also brought scrutiny to about $1.1 trillion of general obligations.
Camp’s proposal may be the starting point for changes next year, said Susan Collet, a lobbyist with Bond Dealers of America, a Washington-based trade group that represents securities firms and opposes changes to munis’ treatment.
“There’s no chance of near-term passage,” she said. “There are going to be a lot of shifting dynamics in the next Congress. But this is something that they will be able to grab.”
The tax break for munis cost the Treasury about $39 billion in the most recent budget year, according to the Office of Management and Budget. The size of the break has made it a potential source of revenue for lawmakers looking to shrink the federal deficit or find money to offset tax cuts.
The Democratic president’s deficit-cutting commission in 2010 proposed eliminating the municipal exemption. Obama has since backed taxing some tax-exempt income received by the wealthiest taxpayers, an approach that was echoed in Camp’s proposal. Camp also recommended eliminating the exemption for new private-activity bonds, which are sold by local governments to finance corporate projects.
“Municipals are caught in the cross-hairs,” said Dillon at Morgan Stanley. The risk that such proposals could advance “is going to dog the market for the next couple of years.”
Local governments have lobbied Congress to keep legislators from taxing their bonds, arguing that it would push up borrowing costs and hurt taxpayers.
Last year, more than 100 members of the U.S. House of Representatives signed a letter supporting the tax advantage.
Under Camp’s framework, the deduction for state and local taxes, which particularly benefits residents of high-tax states like New York and New Jersey, would be eliminated.
Senator Charles Schumer of New York, a senior Democrat on the Finance Committee, called the plan “dead on arrival.”
Recommendations to tax municipal debt will probably keep resurfacing, said Matt Posner, who follows federal policy for Municipal Market Advisors, a Concord, Massachusetts-based research firm.
“Camp’s idea to put a tax on higher income earners’ municipal exemption is something we could see pop up again,” Posner said.