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Tax-Exemption Threats Are Still on the Radar

DEC 30, 2011 5:47pm ET
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WASHINGTON — The municipal securities market, still reeling from a handful of proposals President Obama and others offered during the last 14 months that pose the greatest threat to tax-exemption since 1986, may have a year’s respite due to partisan bickering in Congress and the forthcoming presidential election, according to tax experts.

But muni market participants are not writing the year off and vow to remain vigilant against any proposals to curtail or eliminate tax-exemption.

“I think it’s going to be very hard for this Congress to get anything done, especially on taxes,” said Howard Gleckman, a resident fellow at the Tax Policy Center. “It’s going to be like 2011. Congress is going to be spinning its wheels in the mud, only worse, with more mud and balder tires.”

When Congress returns in January, House and Senate conferees will have to debate a further extension of the payroll tax cuts, unemployment assistance, and Medicare reimbursements. “That’s going to take the first couple of months of the year,” he said.

The lawmakers also will have to do something about dozens of expiring tax provisions in so-called extenders legislation. Only a few of these affect the muni market, such as the low income housing tax credit.

This legislation is going to provoke “another fight,” Gleckman said.

“Legislatively, it’s going to be a really, really nonproductive year,” he said.

Lobbyists from muni market groups don’t expect Congress to enact comprehensive tax reform legislation. But they worry there will be tax or other legislation containing provisions that must be offset by revenue-raising provisions and that tax-exemption will be among the list of tax expenditures under consideration for cuts.

“I think the big issue on Capitol Hill is whether there will be any curtailment or elimination of the tax-exemption” for municipal bonds, said Michael Decker, managing director and co-head of the municipal securities division at the Securities Industry and Financial Markets Association.

Kristin Franceschi, president of the National Association of Bond Lawyers and a partner at DLA Piper LLP in Baltimore, agreed.

“I think this is something we have to worry about for 2012,” she said.

Franceschi noted that two bipartisan groups of former legislators and administration officials, as well as Obama, each recommended curbs to tax-exemption as a means of cutting the federal budget deficit.

“We are on a short list of tax expenditures, which is always mentioned when things come up for review,” she said.

Many lawmakers wrongly view tax-exempt bonds as simply a means for wealthy individuals to avoid paying their share of income taxes, she added.

Sequestration

Decker and others believe some lawmakers, particularly Republicans, will propose legislation to avoid sequestration in the wake of the so-called Super Committee’s failure to reach an agreement by Nov. 23 on how to reduce the federal budget deficit by $1.5 trillion over a 10-year period.

The Budget Control Act of 2011 specifies that the lack of action by the joint deficit reduction committee will trigger sequestration, under which $1.2 trillion in spending cuts, equally divided between defense and domestic programs and excluding entitlement programs, will begin taking affect in 2013.

A number of Republicans are already balking at the potential cuts to defense spending. Sen. John McCain, R-Ariz., the top Republican on the Senate Armed Services Committee, and others have vowed to propose a plan later this month that would avoid the cuts to defense required in 2013

“My guess is that, for sure, you will see some efforts by some people, particularly Republicans, to avoid sequestration,” said Chuck Samuels, a partner at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. who represents the National Association of Health and Higher Education Facilities Authorities. “That’s probably the number one biggest issue.”

But Gleckman, who predicted the Super Committee would not do anything, also is betting lawmakers find a way to avoid sequestration.

“The chance of sequestration happening is zero,” he said. “There’s one thing Congress can agree on — to not do anything about the budget deficit.”

Some Legislative Proposals

Decker also sees some lawmakers proposing legislation to extend all or part of the Bush cuts to income tax rates, which expire at the end of this year. “I wouldn’t be surprised if there are some efforts to at least look at those issues,” he said, referring to sequestration and the Bush tax cuts. “Either of those could require tax increases or revenue raisers of some kind.”

Samuels contends there will be efforts to introduce various tax reform legislative proposals, though certainly no action on major reforms.

“Given the partisan atmosphere, you can be pretty skeptical about the lack of success. But I wouldn’t be surprised if there isn’t some legislative activity that has people all excited and interested,” he said.

Bill Daly, Bond Dealers of America’s senior vice president for government relations, does not see an possibility of comprehensive tax reform during 2012, but said, setting that aside, “There are a series of things that are going to happen that are going to push Congress to deal with taxes,” such as the expiring tax law provisions.

The Obama administration was expected late Friday to ask Congress to increase the federal debt limit to avoid the need for another increase before the 2012 elections.

But Gleckman predicted any action on the Bush tax cuts, sequestration, or the federal debt limit will not come until after the presidential election.

“There’s just no percentage [for either party] in actually doing any of this before the election,” he said.

Samuels said he expects to see “some level of activity” on sequestration, tax reform, or bills lawmakers introduce easing muni tax law requirements for their constituent groups. “I can’t believe nothing is going to happen for 10 months,” he said.

Issuers Wary

Whatever happens, muni market groups plan to continue pressing their case for maintaining tax-exemption for municipal bonds.

“Certainly we were surprised by the president including caps and-or the elimination of tax-exemption in his jobs bill and deficit reduction plan, so certainly there is the potential that tax-exemption may come up in the course of a tax expenditure needed to pay for something,” said Lars Etzkorn, program director for the center for federal relations at the National League of Cities.

“I don’t think [Congress] will have the appetite to do systemic, wholesale tax reform,” he said. “That’s certainly a possibility in the new Congress after the presidential election. In that case, all tax expenditures will be on the table.”

“We have to do a good job of explaining that tax-exemption is not a tax expenditure, that it’s part of the original tax code and that what this really is, is a partnership between state and local governments and the federal governments to pay for three-quarters of the infrastructure in the country,” Etzkorn said. “Does the federal government have the capacity to pay for that differential? I think the answer we know in this tight economy is no.”

Susan Gaffney, director of the federal liaison center at the Government Finance Officers Association, agreed.

“GFOA, along with our state and local government partners, will be continuing our efforts to educate members of Congress about the importance of the tax-exempt bond market. Our opposition to any efforts that diminish or eliminate the federal tax exemption on muni securities remains strong, as this would impair the goal of providing needed and essential infrastructure for our country,” she said. “With the likelihood of tax reform on the horizon, this is an important effort for GFOA and the state and local government community.”

Threats to Munis

Municipal market participants were surprised and upset last September when Obama sent Congress his $447 billion American Jobs Act of 2011 and proposed that it be paid for in large part by limiting the value of tax-exempt interest, other tax preferences, and itemized deductions to 28% for individuals with incomes of more than $200,000 and families with incomes above $250,000.

That proposal, detailed in an 80-page document, would reduce the deficit by $410 billion over 10 years, according to the administration.

Market participants warned a 28% cap would dramatically reduce municipal bond demand and result in higher borrowing costs for state and local governments.

Matt Fabian, a managing director at Municipal Market Advisors, said Internal Revenue Service data from 2009 shows that 58% of all of the tax-exempt interest reported to the IRS was from individuals with incomes of $200,000 or more.

Then Obama sent the Super Committee a 284-page Debt Reduction Act of 2011 later that month that had the potential to even further limit the value of tax-exempt interest for higher-income taxpayers, beyond his earlier proposed 28% cap.

The president proposed requiring the Office of Management and Budget to establish steadily declining annual ratios for debt as a percentage of gross domestic product beginning in fiscal 2013. If the ratios were not met in any given year, automatic cuts in spending and tax preferences, such as tax-exempt interest, would be triggered. The value of muni bond interest could fluctuate and drop all the way down to zero, tax experts said.

This proposal was even scarier to muni market participants who warned it would make tax planning impossible for individuals and families and create a tremendous amount of uncertainty in the muni market.

Before that, in December 2010, the President’s National Commission on Fiscal Responsibility and Reform made recommendations for deficit reduction in 65-page report called “The Moment of Truth.” That document contained an “illustrative individual tax reform plan” recommending that there be no tax-exemption for new muni bonds.

The commission, which voted 11 to 7 for the report, failing to obtain the necessary supermajority of votes to move forward with it, was led by Democrat Erskine Bowles, former chief of staff to President Bill Clinton, and former Republican Alan Simpson from Wyoming.

A month before that, the Bipartisan Policy Center’s debt reduction task force issued a 137-page report called “Restoring America’s Future” that urged there be no tax-exemption for any new private-activity bonds, including bonds for single- and multifamily housing, airports, water and sewer facilities, hospitals, and small manufacturing facilities.

That task force was led by Alice Rivlin, a senior fellow at Brookings Institution, as well as former Sen. Pete Domenici from New Mexico, now a senior fellow at the BPC.

Rivlin helped found the Congressional Budget Office and formerly headed the Office of Management and Budget. She also was vice chair of the Federal Reserve Board.

Domenici formerly chaired the Senate Budget Committee.

In addition, Sens. Ron Wyden, D-Ore., and Dan Coats, R-Ind., introduced the Bipartisan Tax Fairness and Simplification Act earlier in the year, which would make all new munis tax-credit rather than tax-exempt bonds. Tax-credit bonds are taxable. The bondholder gets a credit toward its taxes rather than tax-exempt interest.

On other possible legislative action, Etzkorn said, “I’m the most optimistic I’ve ever been” that Congress will approve legislation allowing states and local governments to collect sales taxes from online retailers, closing a tax gap costing them billions of dollars per year and leveling the playing field for brick-and-mortar retailers.

GFOA and NAFFEFA plan to continue to push lawmakers to adopt legislation that would permanently raise the limit for bank-qualified bonds to $30 million from $10 million.

This would mean that banks could deduct 80% of the cost of buying and carrying the tax-exempt bonds sold by issuers whose annual bond issuance is less than $30 million.

Sen. Jeff Bingaman, D-N.M., and at least three Republican co-sponsors, have sponsored a bill that wold raise the limit to $30 million.

“We are hoping this can gain traction in 2012,” Gaffney said.

On the regulatory front, market participants would like to see guidance or new rules on the issue price of new munis, reissuance, the public approval process for PAB issues, and allocation and accounting.

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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