WASHINGTON - Congress should preserve the tax-exemption for municipal bonds and increase the bank-qualified bond limit, the Bond Dealers of America and affiliated coalitions told tax reform working groups in recent letters.
BDA sent a letter to three of the Senate Finance Committee working groups: community development & infrastructure, individual income tax and savings & investment. Additionally, the Municipal Bonds for America Coalition and a coalition of market groups that supports increasing the bank-qualified bond limit sent letters to the community development & infrastructure group.
The working groups are supposed to issue reports with recommendations by the end of May. Senate Finance Committee Chairman Orrin Hatch, R-Utah, has said that his aim is for the working groups' efforts to contribute to a tax-reform bill to be introduced this year.
The BDA and MBFA letters stressed the importance of the municipal bond tax exemption.
"Limiting or eliminating the tax-exemption of municipal bonds would significantly increase costs to state and local governments, which would cause decreased investment in critical infrastructure projects and increased taxes for residents," BDA said in its letter, which was signed by its chief executive officer, Mike Nicholas.
Capping the value of the municipal bond tax exemption at 28%, as President Obama has proposed, would increase borrowing costs for new issues by up to 70 basis points, which would lead to an increase of 15% to 20% in infrastructure costs for state and local governments, BDA said, citing data from a 2013 report written by local government groups.
"These increased costs would either force issuers to raise taxes, utility rates, and user fees in order to maintain budget sustainability or would result in less capital being directed into public infrastructure," BDA said. "Taxing a previously untaxed security would also destroy investor confidence, creating volatility and uncertainty in a historically stable market."
MBFA said that "repealing or altering the current law tax exemption for municipal bonds will not address the concerns driving tax reform." The group countered each of the arguments for taxing muni interest.
One factor motivating tax reform is fiscal pressure on the federal government. But taxing muni interest or replacing munis with some other type of financing vehicle won't do anything to address the issues causing the federal fiscal problems and will shift federal costs onto state and local governments, MBFA said.
Policymakers are also interested in simplifying the tax code, but MBFA said that "imposing a new tax on municipal bond interest would increase complexity by upending more than 100 years of legal precedent and unsettling markets that have been in existence for centuries." Issuers would be forced to enter the taxable bond market, where the median municipal bond issue is much smaller than the median corporate bond issue.
"A partial tax could even be more complicated, as the tax status of a municipal bond changes with its holder's income, and bonds' value in the secondary market depending on investors making similar calculations," MBFA said.
While some critics of the muni exemption think it is an "inefficient windfall for wealthy investors," research has shown that analyses from the Joint Committee on Taxation and others significantly overstate the inefficiency and revenue loss from the exemption, MBFA said.
Also, investors don't just buy munis because they're tax exempt; they also buy them because the market is stable and the investments are safe. And much of household municipal bond income goes to investors over the age of 65 as well as to those making less than $250,000.
Arguments have been made that muni interest should be taxed to curb state and local government spending. However, MBFA argued that compared to the federal government's bonds, "municipal bonds are far more closely watched by state and local governments, require far more state and local input to issue, and result in far more responsible governance."
BDA and MBFA said that alternative infrastructure financing mechanisms to munis be a supplement to, and not a replacement of, tax-exempt bonds.
BDA noted that the Build America Bond program in 2009 and 2010 was successful in financing more than $180 billion in new projects, but said that "while selling these bonds, BDA member firms sometimes encountered skepticism from issuers and investors about the government honoring long-term subsidies in the face of growing budget pressure."
MBFA noted that BABs were popular because their subsidy rate of 35% of interest costs exceeded many issuers' increased cost for issuing taxable debt. However, the lower subsidy rates that are currently being proposed would be less than the increased cost of issuing taxable bonds. And sequestration has shown that the federal government can reduce its subsidy payments to issuers to meet its budget needs.
Senate Finance Committee ranking minority member Sen. Ron Wyden, D-Ore., has previously proposed moving from tax-exempts to tax credit bonds, which are taxable and allow individual bondholders to receive a tax credit in lieu of paying them tax-exempt interest. However, there has been limited demand for tax-credit bonds and issuers are hesitant to sell them, MBFA said.
Several lawmakers have proposed creating a federal infrastructure bank that could provide loans, loan guarantees and/or direct federal grants for infrastructure. But due to federal budget constraints, an infrastructure bank would likely make few if any grants and would be more likely to provide loan guarantees than loans. Federally guaranteed bonds cannot be exempt from federal income tax, so any state and local bonds guaranteed by an infrastructure bank would have to be taxable, limiting or eliminating the cost benefit of the guarantee, MBFA said.
The BDA letter and the letter from the bank-qualified bond coalition also urged the Senators on the working groups to make improvements to the bank-qualified bond program. The letters urged them to increase the annual bank-qualified bond debt limit to $30 million from $10 million, index the amount to inflation, and apply the limit at the borrower level rather than the issuer level.
"These improvements will allow for increased bank participation in the market, driving down the cost of capital for smaller issuers and reducing costs for taxpayers," BDA said
Under current law, banks can buy the bonds of issuers who issue $10 million or less of tax-exempt bonds per year and deduct 80% of their carrying costs, the interest expense they incur from purchasing or carrying an inventory of tax-exempt bonds.
Bank-qualified bonds allow local governments and charities to pay up to 0.5 percentage points less in borrowing costs, according to the letter from the coalition, whose members include BDA, the Government Finance Officers Association and the Independent Community Bankers of America.
Under the American Recovery and Reinvestment Act, the $10 million limit was temporarily increased to $30 million and the limit was applied at the borrower level, but those tax law changes expired at the end of 2010. Outside of that temporary increase, the bank-qualified limit has not been raised or indexed to inflation.
"By permanently enacting these changes, local governments, schools, hospitals, colleges and others, will be able to more easily access capital markets, and sell debt in a more efficient, less costly manner," the coalition said. Bank-qualified bond issuers on average save between 25 and 40 basis points compared to a traditional bond offering, so that on a 15-year, $3.89 million bank-qualified bond financing, an issuer could save between $146,000 and $233,000, according to the group's letter.
