Calls for the elimination of tax-exempt interest could seriously disrupt the municipal bond market, while incremental action to rein in the tax-exempt interest cost to the federal government is more likely than an all-out end to munis, market observers with the Bond Dealers of America said Monday.
Part of the discussion over deficit reduction and tax reform in recent months has included talk of replacing tax-exempt interest on new state and local government bonds with a federal tax credit or subsidy. Advocates have said the move would save the federal government money on the current municipal market, which they criticize as an inefficient way for Washington to subsidize state and local projects.
But the shift to a taxable muni market would likely bring unintended consequences.
There are “real doubts if the market would function properly” if municipal interest became taxable, said Mark Vitner, senior economist at Wells Fargo Securities LLC and chairman of BDA’s economic advisory committee.
Without a precedent for an all-taxable municipal market, “I don’t know what the impact would be on the muni market if munis were taxable,” he said, adding that “significant studies” would need to be conducted before attempting such a plan. “Who is going to be the ultimate market for [munis] if they are not tax-free?”
Still, there may be “more room for compromise” on curbing some tax-exempt interest as the tax reform debate unfolds, Vitner said. For example, lawmakers might rein in the federal tax exemption on new bonds for certain projects, he said.
Vitner was speaking at the Bond Dealers of America’s press conference for its semiannual economic survey of members’ economists. The survey said economists expect the economy to grow 2.9% in 2011 and for the unemployment rate to average 8.7% for the year.
The BDA polled 11 members during the first week of April for the survey. Vitner said that since then, some economists have trimmed back their gross domestic product forecasts for the first quarter, which ended March 31. A wider trade deficit for February likely means trade will subtract from GDP growth in the first quarter, he said.
The Federal Reserve in January increased its GDP growth forecast to a range of 3.4% to 3.9% for 2011, up from 3.0% to 3.6%. The Fed’s unemployment range edged down to 8.8% to 9.0% for 2011 from 8.9% to 9.1%. The Fed is scheduled to update its economic forecast on Wednesday.
Vitner said state and local governments will continue to be a headwind for GDP growth this year. The state and local sector “is going to be a drag on economic activity over the next several quarters,” he said. Governments are seeing stronger tax revenues, especially in sales taxes, but they remain unsure about the income picture in fiscal 2012. As a result, muni issuance “is going to be slow to recover,” he said.
Survey respondents said California, Florida, New York, Nevada, Illinois, and New Jersey face the most difficult budget situations. North Dakota, Alaska, South Dakota, and Wyoming are in the best budgetary shape. The debate over tax-exempt interest is drawing the most attention since the 1986 tax reform debate, said BDA chief executive Michael Nicholas. He said the best approach for the market would be to offer issuers tax-exempt and taxable bonds with a direct-pay, federal subsidy, similar to Build America Bonds.
The BDA “is strongly opposed” to the end of tax-exempt interest, Nicholas said. The threat to the market “should not be discounted,” and the group is working to educate lawmakers about the tax-exempt issue “to get ahead” of a serious tax reform push in 2012 and 2013, he said.
