WASHINGTON — The threat to tax-exemption for municipal bonds is the greatest ever due to the pressing need to reduce the federal deficit, several experts said here at a conference Thursday.
"There are real threats that all kinds of activities will cost more or will have less benefit to them and state and local bonds are certainly on that list," George Friedlander, managing director and chief muni strategist at Citi, told attendees at the Council of Development Finance Agencies summit on Thursday.
Friedlander is concerned about two options Congress is weighing to curtail tax-exemption for munis — including replacing them with tax-credit bonds and capping tax-exemption for investors with higher incomes.
Tax-credit bonds, he said, simply don't work well in the muni market. The 28% cap on the value of tax-exemption for the wealthy that was proposed in President Obama's 2013 fiscal budget would cause state and local borrowing costs to skyrocket by at least 50 to 75 basis points in the present low yield environment, Friedlander said.
"The costs are substantial and the one concern with the 28% cap is that in a number of the proposals the administration has come out with, that 28% number is just the first shot across the bow," Friedlander said. "If there was a need for additional deficit reduction, that 28% cap could go substantially lower, and for the muni market, what's really problematic about it is that it would be applied retroactively."
Another way tax-exemption could be curtailed is if lawmakers limited who could access the tax-exempt market, Friedlander said. Private-activity bond issuers such as 501(c)(3)s, hospitals and universities would likely see caps on how much they could issue under this scenario.
"There is a real threat here that when we get to true deficit reduction or tax reform or both, which are at least somewhat likely to happen in 2013, we will be on the list of ways to reduce costs," Friedlander said. "In looking for ways to reduce the deficit, a change that reduces the federal deficit and increases the cost structure at the state and local level is still considered a win, as long as it reduces the federal deficit."
Currently, the federal government has nearly $16 trillion of total outstanding public debt. For the fourth year since the financial crisis in 2008, the federal budget deficit will exceed $1 trillion for the fiscal year 2012, which ends in September.
Meanwhile, Michael Decker, managing director and co-head of munis at the Securities Industry and Financial Markets Association, said over the past few years he has observed a change in the rhetoric from both sides of the aisle in Washington with respect to tax-exemption.
He said tax-exemption is now being characterized by lawmakers more as a tax preference for wealthy taxpayers and less as an economic benefit for state and local governments.
"This changes the dynamic in terms of our ability to color the issue for members of Congress," Decker said. "This change in perception is what has really driven the administration to focus on reducing the tax benefit associated with earning tax-exempt interest. They really portrayed that as a tax fairness issue."
There is a sense in Washington that everyone will have to bear some pain in order to fix the federal fiscal problems, Decker said, citing several "third rails" of tax policy, including the popular mortgage interest deduction and charitable deduction that are now on the chopping block. If those sacred cows are no longer sacred, then tax-exemption is certainly in the mix, Decker said.
Separately, Friedlander noted that the methodology used in a recent Joint Committee on Taxation report on the costs of tax-exemption is fundamentally flawed. Among one of the most egregious problems is that it doesn't account for sharply higher costs of small issuers when they have to compete in the taxable bond market, he said.
