09.28.2011 Effects of Proposal to Limit Exemption of Municipal Bond Interest

President Obama, in his effort to reduce the federal deficit, has proposed in his American Jobs Act to restrict high-income ($200,000 and up) holders of tax-exempt bonds from using that tax exemption to reduce their marginal income tax rates below 28%. Tax-exempt (also often called municipal) bonds are issued for a variety of governmental purposes, including the general operations of state and local governments, governmental construction and improvements, educational and charitable institutions, economic development and a myriad of other statutorily-approved public and private purposes. The Internal Revenue Code currently contains elaborate rules and regulations governing what types of facilities may be financed by either true governmental bonds (issued for facilities and projects owned and operated by governmental entities) or private activity bonds (facilities owned and operated by charitable institutions and certain designated types of facilities owned, operated or used by private owners). If the borrowing entity complies with the complex rules of the Internal Revenue Code, the bonds issued for its benefit will bear interest that is not included in the gross income of the holder of such bonds for federal income (and most state and local) tax purposes.

Restricting the availability of the traditional tax exemption for interest earned by a higher-income municipal bondholder will increase the amount of interest which that bondholder will require to induce him to buy the bond and thereby extend credit for the governmental purpose. Other factors, such as credit quality of the borrower and duration of the debt, also affect the rate of interest required to adequately compensate the bondholder for the risk of nonpayment, but those factors would not be affected by a change in the current tax law to limit the benefit of the interest exemption.

The current tax exemption for interest earnings on municipal bonds means that a lender can make a loan of comparable creditworthiness at a lower rate of return (interest) than if the interest were taxable, since the lender will realize the same after-tax return on the bond. The simple math is that, all other factors being equal (credit quality, length and terms of repayment, security, etc.), a lender who demands a return of X% on a fully-tax-exempt bond will require interest of X + Y% for the same bond where the interest is being taxed (Y being the percentage value of the extra taxes now being due). Investors having a variety of investment options will invariably demand a higher return from a taxable bond than from a tax-exempt bond. Therefore, the additional cost of limiting the value of the tax exemption for municipal bond interest will be passed directly and completely to the governmental body issuing the bonds, rather than being absorbed by the tax-paying bondholder.

Shifting this incremental increase in the cost of financing state and local government projects directly to the state and local bond issuers would be a Pyrrhic victory at best for the federal Treasury. Most state and local governments, already being dependent on federal funds for many programs, would simply be pushed that much further away from ongoing solvency.

Rather than being derived solely from the “rich” holders of state and local government bonds, the revenue generated by an increased tax on that bond interest would be paid directly by the state and local governments and their citizens in the form of increased borrowing costs, ironically making the infrastructure projects sought to be promoted by the American Jobs Act that much more costly to the localities attempting to finance them.

For more information about this topic, please contact the author or any member of the Williams Mullen Economic Development Team.

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