Maryland Income Tax Hike Could Spur Residents to Look at Munis

WASHINGTON — A recently enacted boost in the state personal income tax rate will likely spur Maryland residents to buy more municipal bonds sold by the state and its local governments, experts, say — if they can find them.

And while bonds issued by states with higher income taxes, like New York, California, and Massachusetts, typically trade at a premium, Maryland and those states could lose those benefits if the U.S. Supreme Court this summer decides to change the way states tax debt issued by other states.

“As more people are included in the income tax base, [greater demand] is going to be a natural [result] for the states that allow for in-state exemption of munis from their state taxes,” said Reid Smith, senior portfolio manager at Vanguard Group, which oversees $100 billion in municipal debt. “From an investor in muniland perspective, we love income taxes.”

Smith, who currently manages several muni bond funds for Vanguard, noted that “two-thirds of our market is still retail-generated buying, so it is very sensitive to an after-tax yield and an income benefit to individual investors.”

To address budget problems, Maryland raised income tax rates in a special session that ended in November. Like most states, Maryland taxes residents who own bonds issued out of state while allowing bonds sold by the state and its local governments to enjoy an exemption from state income taxes. In 2006, Maryland had the highest median household income in the nation, $65,144, according to a report published last summer by the Census Bureau. The U.S. median is $48,451.

“More investors will be looking to avoid taxes now that they are paying more,” said Mark DeMitry, a portfolio manager at OppenheimerFunds Inc., which oversees $33 billion municipal debt. “As the rate goes higher more and more people become attracted to earning a tax-free rate of return.”

Triple-A rated Maryland is not a high-volume issuer of tax-exempt debt, typically floating general obligation bonds only twice a year. All issuers in the state sold a combined $6.4 billion in bonds during 2007, ranking 22d in total volume for states nationwide, according to Thomson Financial.

“To the extent that you have a rising state income tax and more demand for in-state paper, that translates to lower yields to issuers,” Smith said. “There is always a demand factor for in-state paper. To the extent that you are in a state with a high income tax rate that has very low supply, then you are going to see more of a premium paid for in-state paper. So those yields are going to fall lower.”

“On the other hand if you are within a state that has more than ample supply of debt being brought to market, that supply has to reach outside of the state demand and reach national demand,” he continued. “In that case, those yields are going to have to rise to the point where an out-of-state investor would be interested in buying the paper.”

Maryland expects to sell $350 million of general obligation bonds on Feb. 27 and plans to issue again in July, according to debt management director Patti Konrad. The state last hit the market in August when it sold $375 million of GOs.

The prevailing out-of-state-bond taxing practice has come under fire from some investors and is the focus of Kentucky v. Davis, a case that has reached the Supreme Court. Plaintiffs say that Kentucky’s practice of taxing out-of-state bonds owned by state residents is a violation of the dormant clause of the Constitution. If the court rules in favor of Kentucky and deems its bond-taxing policy constitutional, then the status quo of the municipal market would be upheld, allowing 42 other states to continue with their taxing practices. But if the court rules in favor of Davis, states could no longer exempt just their own debt. A decision is expected by summer.

“What we are facing right now is the decision on the Kentucky v. Davis case before the Supreme Court, which could have substantial ramifications on the benefit for in-state tax exemptions among states,” Smith said.Under the new tax regime, those with marginal income over $200,000, or $150,000 for single filers without children, will be subject to a 5% tax. People who make over $350,000, or $300,000 for single filers, will be taxed at a 5.25% rate and Marylanders with income over $500,000 will be taxed at 5.5%.

The new tax regime went into effect at the beginning of the year. The previous rate had maxed out at 4.75% for anyone with taxable income over $3,000.

Thomson’s Municipal Market Data indicates that as of late last week, 30-year Maryland GOs yielded 4.18% for a full taxable equivalent yield of 6.75%. The taxable equivalent yield represents the rate an investor would need to earn from a taxable investment to equal the tax-free yield.

The tax rate hike was part of a package of tax increases enacted to help close a $1.7 billion state budget shortfall for fiscal 2009. The package also increased the corporate tax rate and raised the state sales tax, while expanding it to cover more services.

The higher taxes have been challenged in a lawsuit filed by Maryland Republicans last month. The suit claims that the taxes cannot be imposed because the General Assembly violated a provision of the state constitution during the special session that prohibits either chamber from adjourning for more than three days without approval of the other body. However, a judge last week sided with Democrats that the technicality does not invalidate the work of the special session. Republicans are considering whether to appeal.

In total, the new taxes are expected to raise about $1.3 billion. Spending cuts to close the remaining budget gap will be determined by Gov. Martin O’Malley and the legislature during the annual 90-day session that began Wednesday.

Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings all rate Maryland triple-A and anticipate the state will deal with its budget shortfall in the coming session.

“We expect them to address it,” said Standard & Poor’s analyst Robin Prunty. “What they choose or propose to address the structural budget deficit is a policy issue for the state, but that they address it this year is what we are most concerned about from a credit perspective.”

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