Municipal Bonds for America (MBFA), a coalition of state and local government and Wall Street groups, sent two identical, three-page letters to congressional leaders and President Obama outlining the negative consequences of implementing such a cap. In the letters they strongly urged the leaders to preserve the tax exempt status of interest on municipal bonds.
In a separate letter, 21 state and local government and other muni market groups including the National Governors Association and the National League of Cities, called on Obama and House Speaker John Boehner, R-Ohio., to retain the tax exclusion for municipal bond interest and not include in a year-end negotiation to avert the fiscal cliff.
"Markets are reacting in part to the perception that Congress will tax a portion of interest on new and currently held municipal bonds, and that such a tax may become larger in the future. Should the cap become a reality, the result will be a significant increase in borrowing costs for state and local governments — an increase far exceeding 34 basis points, and which may even exceed the amount of revenue raised by the tax itself," the MBFA wrote.
Within the last week bond yields have been rising sharply due to the threat of a 28% cap, the letter said. The municipal AAA ten-year benchmark yield has risen from 1.48% on Dec. 7 to 1.82% on Dec. 18, an increase of 34 basis points, it said.
The 28% cap proposal has been floated several times — once in Obama's 2011 jobs bill and then again in his fiscal 2013 budget request. Obama's most recent fiscal cliff proposal includes a 28% cap that would take effect on Jan. 1, 2014 and would apply to all outstanding municipal bonds. There have been reports that Boehner, R-Ohio., accepted Obama's proposal to limit tax deductions and exclusions.
The market reaction comes as Boehner and Obama continue to negotiate final terms of a deal to avert the fiscal cliff, a set of steep automatic tax hikes and federal budget spending cuts set to go into effect in less than 11 days. It is estimated that Obama and Boehner are about $450 billion apart in their proposals.
On Thursday, the House forged ahead to vote on Boehner's "Plan B" proposal to allow tax rates rise on those earning more than $1 million and a companion bill to replace the $109 billion of first-year sequester cuts for military and domestic spending with other budget cuts, as prospects for a pre-Christmas deal faded.
GOP leaders claimed they had enough votes to approve the measures despite Obama's veto threat on Wednesday.
"If Senate Democrats and the White House refuse to act, they'll be responsible for the largest tax hike in American history," Boehner said at a press conference Thursday.
George Friedlander, Citi's chief municipal strategist and chair of the MBFA's newly formed technical advisory committee, said the strongest credits in the market are already paying 15 basis points and weaker credits are paying even more, 50-60 basis points, due to the increased concerns about the retroactive nature of the 28% cap.
Pointing to the Municipal Market Data triple A scale, Friedlander said there is "considerable noise in it," even though the muni market is typically highly sensitive around year-end.
"The bottom line is that the muni market was clearly hurt by the perception that both sides might agree to this," Friedlander said. "The cap on the benefit is not a done deal, so the impact would probably increase if the retroactive cap actually becomes law."
In a Citi research report published Tuesday, Friedlander said that as a result of higher taxes, "investors are going to demand a substantially higher return on the new bonds they purchase, and issuers are simply going to have to pay more. Investors could face significant erosion in the market value of existing holdings."
Citi had estimated that a 28% cap would result in 40 to 60 basis points in higher yields and that the total impact on the market value would be in the $200 billion range.
"The market is now signaling that the ultimate cost in yield and market erosion could exceed this amount," the report said.
The letter sent by the NGA and 20 other groups estimated that taxing muni bonds would immediately increase borrowing costs by as much as two percentage points, which translates into a 25% increase in infrastructure costs. Additionally, the groups said that the $40 billion annual cost from the muni bond exclusion leverages $400 billion in new infrastructure projects annually.
The possibility of tax treatment on outstanding muni bonds, "creates uncertainty and would have a chilling effect on infrastructure investments and jobs," they wrote.
The MBFA also cautioned lawmakers that small issuers would be disproportionately affected as the tax exemption "is more critical to their ability to access capital markets than for large issuers."
"Measures that increase local borrowing costs will continue to cause the financial markets to react negatively, and possibly in a manner last seen in bond markets during the late 2008 fiscal crisis," the MBFA wrote. "The result will be to shift a significant cost burden to local governments and the taxpayers they serve."
Separately, Moody's Investors Service published a report Thursday detailing the negative impact the fiscal cliff would have on the U.S. economy and public finance credits. The nine-page report stressed that one of the "unfavorable consequences" of a fiscal cliff deal would be the 28% cap, which would raise funding costs of all U.S. public finance credits.
"Rating changes could ensue for public finance credits that have direct or in some cases indirect linkages to the rating and the credit standing of the U.S. government," the report said. "These rating changes would occur if Moody's lowers the U.S. government's Aaa negative rating as a result of the fiscal cliff or a federal budget agreement that fails to reduce the ratio of federal debt-to-GDP over the medium term.
The 7.5% to 9.5% across-the-board cuts included in the $1.2 trillion sequestration is broad but would have a localized impact on states, Moody's said. The largest component of the sequester is approximately 9.4% or $30 billion in across-the-board cuts to discretionary defense programs. This would be most heavily felt in states such as Maryland, New Mexico and Virginia that have high concentrations of defense procurement contracting.
The 2001 and 2003 Bush-era tax cuts, which are scheduled to expire at the end of 2012, would have diverse effects on state revenues, the report said. They will increase revenues in states with personal income taxes that are tied to the federal tax code. However, higher income taxes will "dampen consumer confidence, reduce personal consumption expenditures and slow state sales tax collections."