CHICAGO — Access to the municipal bond market will be maintained only if market participants, especially state and local government officials, are willing to fight to preserve tax exemption, a new report warns.
The 18-page “special focus” report titled, “The Case for the Tax Exemption Remains Strong, Even As Threats Grow,” released Wednesday by Citi Research, argues municipal market participants need to “make it clear to Congress that curtailing access to the value of tax exemption would be a serious mistake.”
George Friedlander, Citi analyst and author of the report, said that his commentary on preserving tax exemption is essentially an advocacy piece to urge market participants to make the case that tax exemption provides an attractive form of support for state and local projects.
“It is too soon to make portfolio changes, but not too soon for state and local governments and other market participants to express their concerns to members of Congress,” the report said.
Friedlander spoke on a tax reform panel here at the National Association of Bond Lawyers’ 37th annual Bond Attorney’s Workshop.
He was joined by Bill Daly, director of government affairs at NABL, and Michael Decker, co-head of municipal securities at the Securities Industry and Financial Markets Association.
Friedlander said the threats to tax exemption, which would either reduce access to the muni market or reduce the value of the tax exemption for investors, are the greatest than any time since 1986, when Congress passed a massive overhaul of the Internal Revenue Code.
The Citi report argues that since the 1986 Tax Reform Act, the municipal bond market has “functioned as an extremely effective source of capital for a wide range of state and local projects.”
The report identifies four themes that threaten to move in the direction of reducing either access to the tax-exempt market or reducing the benefits from tax exemption to investors, as Congress seeks to find additional sources of revenue for deficit reduction.
There is the issue of efficiency of the tax exemption as it relates to the methodology used in a recent Joint Committee on Taxation report, which calculated how much of the benefit from tax exemption goes to investors as opposed to issuers.
The JCT report, “The Federal Revenue Effects of Tax-Exempt and Direct-Pay Tax Credit Bond Provisions,” which was published in July, provided a detailed analysis for calculating the cost to the federal government from the tax exemption of municipal bonds.
“The numbers are horribly wrong,” Friedlander told conference attendees on Thursday. “The flaws in their methodology are vast and identifiable.”
There is no way that the federal government could raise $124 billion over 10 years by eliminating tax exemption because their calculations are wrong, Friedlander insisted.
One of Citi’s main concerns is the Joint Committee on Taxes’ methodology and how it calculates the assumed marginal tax rate.
The Joint Committee on Taxes compares the yield from Moody’s Investors Service’s long-term corporate bond index and the yield from The Bond Buyer 20-Index, which it says has an average AA1 rating.
Friedlander says these indices are not appropriate to use because both show yields that are far higher than the market yields shown in the Muni Market Data-Line triple-A yield curve.
Citi estimates that the yield on the MMD is roughly 25 basis points lower than the other two indexes, which provides a marginal tax bracket of approximately 32%.
“The assumed marginal tax bracket is highly sensitive to the index being used and the use of the overly high-yielding BBI 20 simply results in too low of an effective marginal tax bracket,” the report said.
Another threat to tax exemption is the “fairness” issue, which suggests that the tradeoff where investors accept a lower yield in exchange for tax exemption on their income is somehow “unfair” because it falls heavily on high-wealth and high-income investors.
“If the municipal bond market is functioning effectively and efficiently as a source of capital for state and local government projects, questions related to fairness should subside,” the report said.
A third threat to tax exemption is the concept of governments overspending. Many lawmakers have suggested that reducing or subsidizing borrowing costs for state and local governments leads these governments to borrow more than they should.
Citi said the evidence against this perception is “straightforward and compelling.”
The report notes that when muni interest rates collapsed in 2011 and 2012, financing through the muni market for new money projects declined from an average of $249 billion in 2003 to 2010 to $146 billion in 2011 and an estimated annualized total of $137 billion in 2012.
Finally, the report mentions the general role and costs of tax expenditures that have been included in a variety of plans to reduce the federal deficit.
Many of the proposals fall under the category of “base broadening” where more income would be taxed, but at a lower average tax rate.