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Municipal Bonds and the Tax Tug-of-War

September 15, 2023

Read Time 4 MIN

While recent headlines suggest municipal bonds are in danger of losing their federal tax exemption, we have seen this show before and believe the asset class will retain its tax-exempt status.

Every so often, whispers grow louder in financial circles about the potential end of the federal tax exemption for municipal bonds. These conversations have emerged, especially when concerns regarding federal spending come to the forefront, as was seen in the 1980s, 2009, and more recently in 2017. Now, once again, media headlines are warning that municipal bonds may be at risk of losing their federal tax exemption.

A Brief History of Municipal Bonds’ Tax Exemption

The federal tax exemption for municipal bonds has been a mainstay of the U.S. financial system for over a century, tracing its roots back to the Revenue Act of 1913. This Act, which reintroduced the federal income tax following the ratification of the 16th Amendment, specifically excluded interest from state and local bonds from an individual's gross income. This exemption essentially allows state and local governments to issue bonds at relatively lower interest rates, as the investors receiving the bond income are not taxed at the federal level.

Keeping Borrowing Rates Low

One of the primary benefits of the municipal bond tax exemption is that it makes borrowing cheaper for state and local governments. Over the decades, tax-exempt municipal bonds have financed a multitude of essential public projects, from schools, roads, and bridges to water treatment facilities and hospitals.

Contrast this with other developed countries, many of which do not have such exemptions in place. These countries often resort to direct federal financing for their infrastructure projects, leading to different borrowing dynamics and a potential strain on centralized fiscal policies. In the United States, the tax exemption provides a degree of fiscal independence to state and local governments. This independence allows them to prioritize projects that cater to the unique needs of their communities without an over-reliance on the federal government. In addition, municipal bond projects often lead to the creation of jobs in various sectors, from construction to administration, thereby stimulating local economies.

Understanding the Concerns

Tax exemption cannot be taken for granted. All tax exemptions are considered a budget expense, and from that viewpoint, municipal bonds cost the federal government about $40 billion a year. This amount increases as interest rates and federal income tax rates increase. Pre-refunded bonds lost their tax exemption in 2017, showing that municipal bonds are not immune.

Further, the current pressure on U.S. fiscal policy, punctuated by the recent rating downgrade, will push the budget office to find novel long-term cost savings, which will raise the consideration of expense lines once considered sacred cows, like the creation of the cap on state income tax in 2017. For newer politicians keen on making an immediate impact, the repeal or limitation of the tax exemption presents a seemingly straightforward method to increase federal revenue. At a surface level, eliminating the exemption could redirect billions into federal coffers. However, like previous periods where the tax exemption was called into question, we believe municipal bonds will ultimately retain their tax-exempt status.

Why Municipal Bonds Will Likely Retain Their Exempt Status

While the appeal of revisiting the municipal bond tax exemption might seem evident to politicians eager to make their mark, a deeper understanding reveals a more nuanced picture. Municipal bonds play a crucial role in stimulating local economies, and several compelling reasons suggest the continuation of this exemption:

  • Active Lobbying: Lobbyists have consistently educated legislative staffers about the benefits of this exemption, ensuring its value isn't lost amidst political changeovers. While many initially see the exemption as a tax break for the wealthy, the benefits to all levels of government are explained.
  • Strain on Local Governments: Removing this exemption would place undue stress on state and local governments, making them more reliant on federal aid, especially as infrastructure deteriorates.
  • Relatively Small Budget Impact: Though $40 billion is significant, it accounts for only about 2.5% of the budget gap. Its removal won't drastically alter the federal fiscal landscape.
  • Bipartisanship: The benefits of this exemption cut across party lines, making it a non-partisan issue. Both blue and red states and their voters reap the advantages, unlike the state income tax cap or the reduction of the mortgage interest cap Federal income tax deductions.

What Would Happen if Municipal Bonds Lost Their Federal Tax Exemption?

While it is an unlikely event, should there ever be a change in the tax exemption status of municipal bonds, it's essential to understand its implications:

  • We would not expect existing tax-exempt bonds to suddenly become taxable, and back taxes won't be owed.
  • The demand for tax-exempt debt would likely surge, pressuring yields.
  • State and local tax exemptions would still appeal to current buyers, and the altered tax status would attract new entrants to the market.

That said, while it's essential to remain vigilant about potential policy changes, the history, benefits, and bipartisan nature of the municipal bond tax exemption make a compelling case for its continued existence. Municipal bonds remain a cornerstone for infrastructure financing and, by extension, serve as a key catalyst for economic growth and job creation.

From an investment perspective, most investors seek stable and secure investment options in the face of economic decline marked by intense market volatility and wavering consumer confidence. With their strong credit ratings, lower volatility, and historically positive performance during economic downturns, municipal bonds can be a compelling way for investors to diversify their portfolio while also getting attractive tax-free income.

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Municipal bonds may be less liquid than taxable bonds. A portion of the dividends you receive may be subject to the federal alternative minimum tax (AMT). There is no guarantee that municipal bonds’ income will be exempt from federal, state or local income taxes, and changes in those tax rates or in alternative minimum tax rates or in the tax treatment of municipal bonds may make them less attractive as investments and cause them to lose value. Capital gains, if any, are subject to capital gains tax. When interest rates rise, bond prices fall.

All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.

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