A Congressional Research Service analysis found that although several recent fiscal reform plans contain proposals that would modify the tax treatment of state and local government bonds, the “direction of broader tax reform will likely dictate which modifications, if any are made” to such debt instruments.

The 22-page report published last week detailed how and why state and local governments issue debt and described the purpose of a variety of municipal bonds such as private-activity bonds, refunding bonds, arbitrage bonds and tax-credit bonds.

Steven Maguire, author of the report, touched on three primary proposals that “focus on altering the tax treatment of state and local debt to provide a more economically efficient subsidy with a lower federal revenue cost.”

The proposals include: President Obama’s fiscal 2013 budget plan to place a 28% cap on the value of tax-exempt interest to reduce the deficit by $584 billion over 10 years; the Bowles-Simpson deficit reduction report to scale back or eliminate tax expenditures; and the Congressional Budget Office’s “revenue options” report to change the tax exclusion for investors to a direct tax subsidy to issuers.

In addition to tax reform proposals to modify tax-exemption, the report noted there are other policy issues that would affect munis, such as whether “constraints should be relaxed on the types of activities, such as infrastructure spending, for which entities can issue tax-exempt debt.”

Another possible area of reform is the list of activities that classify tax-exempt PABs and whether they should be included in the annual volume cap, the report said. The 2012 PAB cap is $95 per capita or $284.56 million, which ever is greater.

Maguire also outlined the costs of tax-exemption to the federal government, calling the revenue losses “substantial.” The annual federal revenue loss or tax expenditure on outstanding tax-exempt bonds issued for public purposes for 2011 was $26.2 billion, the report said.

The amount of forgone tax revenue from the exclusion of interest income on public-purpose tax-exempt bonds over the last 18 years has fluctuated between $19 billion and $30 billion each year, the report said.

Over the 2013 to 2017 budget window, the estimated revenue loss is expected to be $227.5 billion, or the 10th largest tax expenditure in the federal budget, according to the report. The estimate for future years assume that the tax cuts implemented in 2001 and 2003 expire.

“The higher tax rates beginning in 2013 result in a larger tax expenditure because more revenue could have been raised at the higher rates,” the report said.

Earlier this year the CRS issued a report that suggested there are impediments to broadening the tax base by eliminating or reducing tax expenditures — such as tax-exemption for muni bond interest — because they are viewed as “serving an important purpose” and are “quite popular” with the public.

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