To stimulate investment in infrastructure and to boost domestic employment, Congress should permit pension fund purchasers of municipal bonds to reassign only the tax-benefit - the exemption feature - of those bonds to U.S. taxpayers seeking tax deductions.
When the late Chief Justice John Marshall issued his famous dictum that "the power to tax is the power to destroy," he probably didn't have interest on municipal bonds in mind.
At the time, in McCulloch v. Maryland (1819), Marshall was ruling that the Bank of the United States, Alexander Hamilton's predecessor to our Federal Reserve System, could not be taxed by the state of Maryland. This led to the development of the "intergovernmental tax immunity" doctrine in constitutional law.
The doctrine peaked for municipals in Pollack v. Farmers' Home Trust Co. (1895), waned by the 1940's, and finally died, as to municipal interest, in the bearer-bond case South Carolina v. Baker (1988), where the Supreme Court found that the interest-exemption was a congressional policy choice, not a constitutional requirement.
Nonetheless, the federal tax exemption for interest on municipal bonds remains firmly imbedded in our fiscal federalism. As a political matter, it is highly unlikely to be repealed.
Another important tax-law feature is imbedded in the same fiscal federalism. Many organizations have been traditionally exempt from federal, state, and local income and other taxation, not only §501(c)(3) organizations formed for charitable, religious, or educational purposes, but also other nonprofits that have vast accumulations of funds for investment: pension funds, endowments, private foundations, and the like.
Owing to their existing tax-exempt status, those nonprofit organizations do not invest in municipal bonds - do not lend money for basic American infrastructure, largely financed through those bonds - because they are required by law to invest for the sole and exclusive benefit of and to maximize returns for their fund beneficiaries. Therefore they cannot purchase instruments with below-market returns, like municipals.
Now, by shielding states and localities from federal taxation, John Marshall and his successors meant to respect, by not burdening - indeed, by subsidizing - local decision-making autonomy. So, too, did the post-Baker Congress. But unintended consequences, as we now see, have led to an artificially limited market for investment in basic American infrastructure, one that is anachronistically domestic, because it is effectively limited to U.S. taxpayers, cut off from both domestic tax-exempt institutional investors and from foreign sources of capital.
It should be possible, however, to devise a solution to correct for those unintended consequences of the federal tax system. This can be done without reviving a "taxable bond option," which could lead to federal bureaucratic approval (or not) of state and local projects, and annual congressional appropriation (or not) of state and local subsidies.
It can also be done without eliminating the interest-exemption subsidy for state and localities that is part of the existing market structure or taxing the income of pension funds or similar tax-exempt organizations, which have trillions of dollars of assets to invest. Until the recent collapse, public pension funds alone had about $3 trillion under management, more than the entire principal amount of municipals outstanding.
The solution requires a precise breakdown of the nature of the returns on a typical municipal bond. Each bond has two separate features: first, annual cashflow (principal and interest ) at a tax-exempt rate, and second, annual tax benefits (exclusions, deductions, exemptions) measured by the amount of annual tax-exempt interest.
Congress could amend the Internal Revenue Code to reflect those two distinct features of a single municipal bond by permitting a tax-exempt organization like a pension fund to purchase a municipal bond and hold the first feature, the below-market cashflow, but to sell the second feature, the tax benefit, to a U.S. taxpayer, one with an appetite for the deduction, exclusion, or exemption. This would resemble the sale of the tax benefits of depreciation, without that program's complex disadvantages.
The change would transform municipals into market-rate investments for tax-exempt organizations such as pension funds, endowments, and private foundations - not to mention foreign investors like "sovereign wealth" funds, if they too were permitted to transfer the tax benefits.
No longer would purchasing municipals be - as it was in memorable fiscal crises - largely a way for pension funds to rescue troubled municipalities. Bankers could arrange for a simultaneous closing on both features, with the two different sets of investors, and there would be a concentration on the tax opinion of bond counsel, especially in the case of refundings. States and localities would, of course, be permitted to continue to issue traditional tax-exempt municipals, preserving the existing market structure.
This plan would be a winner for states and localities. Especially now, when individual investors comprise such a large part of the market, the plan would attract institutional investors, exponentially increasing demand for municipals and lowering rates.
This plan would also be a winner for the U.S. Treasury. Because taxpayers will bid for the tax-benefit feature without having to link that investment to a long-term, investment-grade yield like the one on municipals, the competition should reduce or eliminate the "windfall" gains to high-bracket taxpayers so disfavored by Treasury. This will align the state and local subsidy with the federal revenue cost, increase the subsidy by reducing rates, and at the same time reduce the subsidy cost to Treasury.
Further, like their counterparts around the world, domestic public pension funds will win by having a new long-term, high-quality class of investment asset, with the added benefit of supporting domestic infrastructure, creating jobs that are not exportable, and relieving the burdens on state and local contributors to public pension funds. In addition, political pressure on those funds to invest in risky, "economically targeted investments" for social purposes would be relieved, in favor of publicly offered, high-quality municipals.
Finally, market participants should also expect to win, even though they have long suspected - like most men and women of conservative temperament - that one thing leads to another. Improved municipal disclosure should evolve from the renewed attention being paid to transparency in current global credit markets. And investment bankers will have new deals.
To John Marshall's dictum that the power to tax was the power to destroy, the late Justice Oliver Wendell Holmes Jr. responded: "Not while this Court sits." Perhaps while the next Congress sits, members can rearrange the furniture of our public finance to make it more comfortable in global credit markets and to keep it away from the Fed window.
Eugene W. Harper Jr. is a partner of Squire, Sanders & Dempsey LLP in New York City. The views expressed here are his own.
