Paper: Curbs to Tax Exemption Could Help or Hurt Low-Income Households

Reform to the tax-exemption for municipal bond interest could be a benefit or a burden for lower-income households, depending on how state and local governments respond to higher borrowing costs, according to a paper from the Tax Policy Center.

The paper aims to determine who benefits from the tax-exemption and how the benefits are distributed across income groups under current law. It also looks at how people could benefit or be burdened by capping the value of the tax-exemption at 28%, as was proposed in President Obama’s fiscal year 2014 budget.

In its analyses, the Tax Policy Center took into consideration factors not included in traditional models used by the Treasury Department’s office of tax analysis and Congress’ Joint Committee on Taxation.

Standard analyses of who benefits from the exemption do not take into account the implicit taxes investors pay by accepting lower yields on tax-exempt bonds relative to taxable bonds, and the implicit subsidies on the yields of taxable bonds because they are higher than they would be if there was no exception for municipal bonds.

They also don’t take into consideration the fact that the tax-exemption for municipal bonds results in state and local governments paying less to finance debt, while issuers of taxable bonds pay more. State and local governments can use their savings from lower borrowing costs to lower taxes or increase spending on public services such as education, road maintenance and police protection, the paper said.

The center found across its analyses that the wealthy benefits the most from the tax exemption. But how state and local governments respond to lower borrowing costs could impact how lower-income households are affected by the exemption.

If state and local governments use the savings from lower borrowing costs primarily to increase services, then lower income people would benefit from the exemption.

However, if state and local governments just use the savings from lower borrowing costs to lower taxes, then lower-income households will receive little benefit or will be worse off.. Corporate bonds have higher yields as a result of the exemption, which means that people have to pay higher prices for private consumer goods. The higher prices could exceed the benefits of lower taxes for lower-income households, according to the paper.

Under tax reform that caps the value of the exemption at 28%, the largest share of the burden from the cap would be on the wealthy. Also, borrowing costs would increase for state and local governments and the prices of consumer goods would decrease, the paper said.

If state and local governments respond to their increased borrowing costs only by raising taxes, lower income households could benefit because they would be helped more from reductions in the prices of private goods than they would be hurt by higher taxes. But if states and localities respond to the higher borrowing costs by just cutting services, lower income households would be burdened, the study shows.

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