Will Tax Free Municipal Bonds become Taxable?

Did you know that in President Obama's budget proposal for fiscal 2014 released in April includes a tax increase for formerly tax-free municipal bond interest?

First, some background: Municipal bonds (munis) are debt obligations issued by government entities. When you buy a municipal bond, you are loaning money to the issuer in exchange for a set number of interest payments over a predetermined period. At the end of that period, the bond reaches its maturity; and the full amount of your original investment is returned to you.

Tax-exempt municipal bonds are popular because the interest payments are (for most investors) exempt from federal income tax. In some cases they are also exempt from state and local income taxes. Taxpayers who are subject to the alternative minimum tax (AMT) must include interest income from certain munis when calculating the AMT.

Taxpayers in higher tax brackets are attracted to tax-exempt bonds. They are willing to accept the lower interest rates tax-free instead of higher taxable rates.

Obama's budget proposal would make municipal bond interest subject to a 28% cap for individuals earning more than $200,000 or more than $250,000 for couples. Municipal bond interest would remain exempt from the Medicare 3.8% surtax.

What does capping the exemption at 28% mean? If you're in the 39.6% tax bracket, your municipal bond interest would effectively be taxed at 11.6% (39.6% - 28.0%), while your tax rate for taxable bonds would be 43.4% (taxable income of 39.6% + 3.8% Medicare surtax). If you're in the 35% bracket, your municipal bond interest would effectively be taxed at 7.0% (35.0% - 28.0%), while your tax rate for taxable bonds would be 38.8% (35.0% + 3.8% Medicare surtax). If you're in a tax bracket lower than 35%, you wouldn't be affected by the proposed limit.

Obama's proposal applies to all municipal bonds prospectively, both existing bonds and future issues. It does not include a grandfather clause for previously issued bonds.

If investors see less of a tax break, they will demand higher interest to make up the loss; and higher interest rates will mean higher borrowing costs for governments. Further, a change in the taxability of the interest, even talk of a change, creates uncertainty. Investors view uncertainty as risk; and if they accept risk, they want to be appropriately rewarded. This will drive interest rates up and borrowing costs higher.

As a result of the tax exemption for municipal bond interest, the federal government effectively subsidizes spending and debt by state and local government agencies. The tax policy behind the exemption is to help state and local governments to borrow at a much lower interest rate to finance large public investments. But as Scott Hodge wrote for Forbes: ". . . the wisdom of that policy is based on the premise that state and local governments will make wise investments in vital infrastructure and public services. Statistical evidence suggests this is not always the case." He says, "In an era when many of our largest states are drowning in long-term debt incurred to finance spending on everything from lavish public employee pensions to privately-owned stadium construction, the last thing the federal government should be doing is encouraging even more borrowing at the state and local level."

On the other hand, Kelly Philips Erb, also writing for Forbes, says, "Think back to . . . why we have municipal bonds in the first place: it's to encourage private investment in public projects. Those funds are used to build our roads, improve our schools and fund our emergency responders; schools alone accounted for nearly one-third of state and local infrastructure expenditures financed by private investment over the last ten years. We should want to encourage that investment. If we don't,… what are the options now? Cut spending (meaning, realistically, those projects don't happen) or raise taxes (yes, on the rest of us)."

According to Reuters, this is the third time Obama has suggested capping the value of the municipal bond tax exemption for high-income earners. He did so in the 2013 budget proposal and also in his proposed American Jobs Act in 2011.

The budget proposal also calls for a new type of bond called a America Fast Forward (AFF) Bonds. These would be taxable bonds issued by state and local governments that would then receive a federal subsidy for the interest component of the bonds. They are similar to currently issued Build America Bonds (BABs). I thought the government was looking for ways to cut spending, not increase it.