We’ve argued that the notoriously convoluted U.S. tax code requires a comprehensive overhaul that would phase out distortions. But discrete tweaks to the system can and often do create more problems than they solve.
President Barack Obama’s proposal to reduce the exemption that high earners can claim on interest for their municipal-bond investments is a good example: It should be rejected on the grounds that it only makes sense as part of a sweeping reform.
Politicians have been trying to kill the special tax status of muni bonds since Andrew Mellon was Treasury secretary almost 100 years ago. But there are a few good reasons the federal government has wanted to keep the exemption: State and local governments are a (rightly) powerful constituency; capital markets are the most efficient way to match investors with local infrastructure needs, and should be encouraged; and municipal projects tend to be in the public interest.
The administration justifies the measure -- one of several intended to pay for the $447 billion American Jobs Act -- as a means of getting the rich to kick in their “fair share.” It’s true that higher earners are the greatest beneficiaries of this tax benefit. But significantly limiting the exemption would probably cause collateral damage in the long run by driving up interest rates for municipalities to borrow. That would mean higher taxes, more expensive services and a lower propensity for local governments to undertake capital projects.
In other words, it won’t just be “millionaires and billionaires” footing the bill -- it will be everyone.
Effect on Market
How disruptive would this new tax, which the administration estimates will bring in $30 billion a year, be for the muni market? A report from Morgan Stanley Research saw little impact, pointing out that the premiums investors demand to hold munis over Treasuries “have little direct relationship with tax rates historically.” A report from Citigroup Global Markets, by contrast, argued that curbing the exemption would “increase state and local borrowing costs significantly.” On balance, we suspect the impact on interest rates will be relatively small initially. (Certainly the proposal has had little effect on the market since the announcement, according to Bloomberg pricing data.) Of course, that could change rapidly if historically low Treasury yields rise and munis start to look less attractive.
Such conflicting analyses suggest one thing: No one really knows how much this limit on exemptions would affect interest rates, especially after complexities like the alternative minimum tax (itself a more urgent problem to fix) are taken into account. All the more reason not to make hasty changes that could disrupt a $2.9 trillion market while states and municipalities are reeling from busted budgets and high unemployment.
If the aim is to help states build infrastructure and create jobs, Obama’s proposal starts to look somewhat unserious, given that it would probably make public-works projects more expensive. When one considers its chances of passing in Congress -- approximately 0.0 percent, according to the latest Bloomberg View calculations -- it starts to look downright disingenuous.
This reform should certainly be an element of a broader discussion about an overhaul of the tax code that eliminates all or almost all such exemptions and deductions, broadens the tax base and lowers marginal rates. Until that overhaul is on the table, not all exemptions are created equal -- and proposals such as this one, which make it appear that budgetary problems can be solved merely by making the rich a little less so, are just distractions.
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