WASHINGTON – Municipal market participants are making a grave mistake if they focus only on tax reform’s potential curbs to the muni tax exemption because some non-bond proposals could have disastrous indirect effects on the muni market, said former House Democratic tax counsel John Buckley.

“I think it’s unlikely that [Congress or the administration] will make a direct assault on the ability of state and local governments to issue tax-exempt bonds,” Buckley, the former chief tax counsel for House Ways and Means Committee Democrats, said to members of the American Bar Association’s tax exempt financing committee who met here on May 12.

Many members of Congress like tax-exempt bonds because they see them as infrastructure spending, he said during a tax reform panel at the meeting.

In addition, Trump months ago told a group of mayors that he wants to preserve the muni tax exemption. Treasury Secretary Steven Mnuchin, at a Senate Finance Committee hearing last week, said the same thing.

“But that doesn’t mean that you’ve won the fight because I think the indirect effects of [tax reform] could be dramatic” for tax-exempt bonds, Buckley said. “Too often people are focused on just their section of the tax code while their pocket is being picked in other ways,” he said.

“In this debate you have to focus on things other than just merely Section 103,” he said, referring to the section of the federal tax code that governs tax-exempt bonds.

The biggest impact on munis could come from the proposed corporate rate reduction rather than individual rate reductions that are in the tax plans of both the House Republicans and President Trump, he said. Most muni market participants focus on the proposed drop in the top individual tax rate. But for taxpayers at the $100,000 to $400,000 income level the rates don’t change that much in the tax reform proposals and “that’s the group for whom tax-exempt bonds are targeted,” he said.

“There simply are not enough wealthy people paying the very top rates to clear the market for tax-exempt bonds,” he added.

“But the corporate rate reduction will be destructive” for the muni bond market, he said. “Right now 25% of tax-exempt bonds are held by banks, life insurance companies and property and casualty insurance companies,” Buckley said. “Reducing the corporate rate from 35% to 20% or 15% is essentially going to take those investors out of the [muni bond] market unless there is an equally-sized increase in tax-exempt bond rates …. The spread between corporate and tax-exempt bond rates “could disappear,” Buckley told the lawyers.

With the loss of that part of the market, “there has to be a significant upward revision in tax-exempt bond rates because there’s no reason to believe that there’s going to be a flood of individuals coming into the market to replace those institutions,” he said.

Environmental group’s lawsuit over President Trump’s Infrastructure Council contends the president is handing over federal policy decisions to private individuals without public scrutiny.
President Donald Trump
President Trump's tax plan has several provisions that would indirectly hurt the municipal bond market, according to former House Democratic tax counsel John Buckley.

The repeal of deductibility of state and local taxes, which administration officials said they plan to propose, would also “have a dramatic impact on state and local financing,” Buckley told the lawyers. A repeal of that deduction would make it harder for governments to raise taxes, potentially hurt their finances, and add credit risk to the market, he said.

“And it flies right in the face of the push for infrastructure because of the direct revenue impact,” said Carol Lew, a shareholder at the Stradling Yocca Carlson & Rauth who moderated the panel.

“That’s right,” said Buckley.

But Howard Gleckman, a senior fellow at the Urban Institute and Brookings Institution’s Tax Policy Center who was also on the panel, said, “I think it’s going to be challenging for that preference to be repealed.” To pass legislation with no support from Democrats, House Republicans could not lose any more than 21 votes from their own party, he said. However, there are more than 21 Republican members in the House from the top 10 states with the highest taxes that would be hardest hit by that proposal.

Buckley also said that the president’s tax reform plan effectively repeals the mortgage interest deduction or the deduction for charitable giving, despite what administration officials say. The standard deduction will be so high -- at about $24,000 -- that nobody but the top 5% of wealthy taxpayers will choose to itemize deductions instead of taking the standard deduction, he suggested.

The impact of the repeal of the federal deductibility of state and local taxes and the indirect repeal of the mortgage interest deduction could easily put downward pressure on home prices and values, Buckley said. This will erode local real property taxes and governmental finances, he said.

“You could easily win the battle, and I think you will, there will be no direct limitations on tax-exempt bonds, but you could lose the war. You’ll have a tax incentive that has limited viability or benefit for your issuers,” Buckley told the lawyers.

Buckley said there are other indirect tax reform proposals that could impact munis like the House Republican proposal to eliminate the ability of businesses to deduct their interest cost, which would take corporations that are not financial institutions out of the market.

Another House Republican tax reform proposal Buckley did not mention but that has been highlighted by George Friedlander, a managing partner at Court Street Group Research, would allow families and individuals to deduct 50% of investment earnings such as capital gains, dividends and interest income, leading to rates of 6%, 12.5% and 16.5% (depending on an individual’s tax bracket). This would make corporate bonds more attractive to investors than munis, Friedlander has said.

In talking about the impacts from individual and corporate tax rate reductions, Treasury Department associate tax legislative counsel John Cross, who was also on the panel, said, “That arguably is one of the biggest structural weaknesses of the [municipal bond] market now is that it’s too dependent on individual investors.”

Buckley said, “People should start exploring alternative subsidies for state and local borrowing along the lines of the Build America Bond model or the other models that are not dependent on rate reductions and that may give you access to other markets for your bonds.”

Lew said pushing BABs over munis may be “a hard sell” to state and local governments because their subsidy payments have been eroded by sequestration. BABs are taxable bonds for which the Treasury makes subsidy payments to issuers at the rate of roughly 35% of their interest costs in lieu of investors receiving tax-free interest. Sequestration has eaten into BAB issuers’ 35% subsidy rates.

But Cross said that if state and local governments use BABs instead of munis, they would not have to argue they’re benefiting the wealthy or that they’re creating an inefficient subsidy because the market clearing rate reduces the efficiency of the subsidy. Plus, sequestration could be addressed directly with an exception for BABs, he said.

“Not that there’s anything in the works on that at all,” said Cross. “It’s just a potential optional tool. If you want more infrastructure, that would be an add-on way to encourage that, that economists would love.”

“Obviously, infrastructure’s a much better topic for state and local governments than tax reform,” Cross told the lawyers. “In tax reform, tax-exempt bonds are a revenue raiser. In infrastructure tax-exempt bonds are tax incentives for financing public infrastructure, which might include an optional version of a Build America Bond program or other kinds of incentives [that] may be a more-cost effective way other than full direct federal appropriations of funds to encourage increases in infrastructure in that vast [part] of the country that doesn’t necessarily suit itself to public-private partnership or federal tax credits for private investors.”

“I would encourage you all in looking at these topics to weigh in on the importance of tax incentives to support public financing in various ways on infrastructure,” he said.

Asked about caps on tax-exempt bonds, Buckley said he doesn’t see that passing Congress. The Democrats did not support the surtax on muni interest proposed by Camp or the cap in the value of munis proposed by Obama.

Buckley said it’s easier to get revenue by going after one big target so you don’t make everyone angry. The Tax Reform Act of 1986 went after tax shelters for example, he pointed out.

Cross said, “That was one of the big problems with Camp and the Obama administration ideas to just cap all the deductions or cap everything at some rate. [That] didn’t take on anything but it affected everything and it had huge internal complexity as to how you would actually apply that.”

Gleckman noted that for a few hours one recent afternoon, there was a story floated that the administration would go after retirement accounts. That would raise several trillions of dollars of revenues over 10 years, according to Cross.

But Buckley said he thinks the administration or Republicans might try to raise revenues by converting 401(k)s, which allow employees to contribute pre-tax earnings to their retirement plans, into Roth 401(k)s, which allow taxpayers to contribute post-tax funds to individual retirement arrangements.

If that happens, that could have an indirect effect on tax-exempt bonds, Buckley said. Tax-exempt bonds provide a permanent reduction of tax but Roth 401ks provide a permanent reduction in tax at taxable bond rates and would be more attractive, he said.

Gleckman talked about the similarities and differences of the House Republican tax reform plan and Trump’s plan.

Both would significantly cut individual and corporate tax rates, repeal the alternative minimum tax and raise the standard deduction. Both would cut taxes on investment income, although House Republicans' cuts would be greater than Trump’s. Both would focus most tax cuts on high-income people. Both say they would eliminate or reduce tax preferences, but neither specifies a single provision that they would eliminate or reduce.

Howard Gleckman, senior fellow at the Urban Institute and Brookings Institution’s Tax Policy Center
Howard Gleckman, senior fellow at the Tax Policy Center, compares the Trump and House Republican tax reform plans.

Trump’s one-page description of his tax plan says he would eliminate the tax breaks that mainly benefit the wealthiest taxpayers. But he also says he would maintain the mortgage interest deduction and the deduction for charitable giving, which actually favor wealthy taxpayers, Gleckman said.

“The question of how they would treat tax-exempt bonds is unknown,” said Gleckman. You could interpret eliminating tax breaks for the wealthy as including the tax exemption for muni bonds but nothing is stated on that, he said.

Both the House Republican and Trump tax reform proposals would include a repatriation tax on income earned by U.S. based multinationals that sit, nominally, overseas. And both would add trillions of dollars to the federal deficit, according to Gleckman.

There are some significant differences, Gleckman said. The House Republican leaders say they want their plan to be revenue-neutral after dynamic scoring. The Tax Policy Center says the House Republican plan would be less expensive than Trump’s, but would still add $3.5 trillion to the debt over the next 10 years. Trump’s most recent campaign tax reform plan would add $7 trillion to the national debt over 10 years with dynamic scoring, he said, adding the Center could not score the one-page plan because it was so general.

More recently the president has sounded less interested in a revenue neutral tax bill. He’s been using the phrase, “prime the pump,” indicating he sees tax reform as a stimulus for the economy, Gleckman said.

The House Republican bill includes the destination-based cash flow tax, the DBCFT. That includes two pieces. One is the destination-based border adjustable tax, currently the most controversial piece of the plan. The other is the cash-flow piece – a business level consumption tax that would allow firms to expense capital investment, but limit their ability to deduct interest cost, Gleckman said. Trump seems to oppose both of those, he said.

As for revenues, BAT would bring in $1 trillion over 10 years and the interest deduction would bring in another $1 trillion over 10 years. “Without that revenue, it becomes very difficult to see how revenue-neutral tax reform could happen,” said Gleckman. Generally speaking, a one percentage point drop in the corporate tax rate costs about $100 billion over 10 years, he said.

Another difference is pass-throughs, Gleckman said. The House Republicans would tax limited partnerships and sole proprietorships at a 25% rate and the president would tax them at a 15% rate. With the top individual tax rate in the mid-30% range, having a pass-through rate that low would tempt everybody to turn themselves into pass-throughs if they could, Gleckman said. That could also tempt people to move investment income into pass-throughs.

Gleckman said he thinks the administration and Congress are unlikely to push through anything but tax cuts.

But Buckley had a different view. “We’re in a period of total uncertainty,” he said, adding, “There are three possible outcomes for tax legislation this year.”

The first would be cuts in individual and corporate tax rates unaccompanied by any base broadening. “That is the path of least resistance,” he said. However budget rules would require it to be temporary. The proposed cuts in the corporate tax rate are complicated by a budget rule that says you can’t have significant out-year tax losses. A corporate rate reduction would create out-year revenue losses even if the rate cut is terminated within the 10-year period.

“There are many reasons why I think just the straight rate reduction is not going to happen,” Buckley said.

The next option is a real tax reform effort like the House Republican plan or the plan offered by Camp in 2014. That type of effort, which would involve base-broadening, could be permanent. “I don’t think you can dismiss that,” said Buckley, especially since the Speaker of the House and the head of the House Ways and Means Committee are firmly committed to that path.

The third option, which Buckley sees as most likely, would be a “typical congressional mish-mash” involving rate cuts, small business changes mostly in the international area, and changes in the individual tax area. The plans are all similar on the individual side. They all want to repeal most itemized deductions, increase the standard deduction to $24,000, and repeal personal exemptions, he said.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.