President Obama’s bipartisan fiscal reform commission cited a tax-reform bill that would eliminate tax-exempt bonds and replace them with tax-credit bonds as a potential way forward when it comes to simplifying the tax code and reducing the federal deficit, according to a draft proposal released Wednesday.

The report, released by the National Commission on Fiscal Responsibility and Reform, references a bill introduced in February by Sens. Ron Wyden, D-Ore., and Judd Gregg, R-N.H., as the basis for one of its recommendations for tax reform.

The report cites several key components of the Bipartisan Tax Fairness and Simplification Act of 2010, including the establishment of three individual tax brackets at 15%, 25% and 35%, and a repeal of the alternative minimum tax.

However, it does not mention another provision of the bill that would eliminate tax-exempt bonds for state and local governments.

Specifically, the measure stipulates that municipal bonds issued beginning in 2011 would be taxable and holders would receive a tax credit equal to 25% of the bonds’ interest cost.

That credit rate would be well below those of the existing tax-credit bond programs, which range from 70% to 100% of interest cost. The bill also would prohibit advance refundings.

The unveiling of the legislation set off a torrent of criticism from all sectors of the municipal market, as participants argued that the tax-credit bond market has not proven itself capable of meeting the financing needs of state and local governments and that such a proposal would drive up costs on already struggling municipalities.

The senators defended the provision as a way to make the tax code more equitable while raising revenue for the federal government. However, Wyden indicated shortly after the bill’s introduction that they would be open to hearing concerns from the muni market and pointed to the success of the Build America Bond program as evidence that alternative means of public finance can work. Wyden sponsored the original legislation creating BABs.

Another option in the report calls for scrapping all so-called tax expenditures, which would presumably include the tax exemption on municipal debt. However, the draft report opens the door to allowing such expenditures as long as they are paid for.

Market participants said Wednesday they planned to continue working with Congress to protect traditional tax-exempt financing in the wake of the commission’s recommendation.

“When the federal government begins to grapple with reducing the deficit, municipal finance will again be on the table,” said William Daly, senior vice president of government relations for the Bond Dealers of America. “We are going to work with issuers and others to defend the unique position and role of municipal bonds in the federal tax code as a way for states, counties and cities to meet their financing needs and for investors to meet their investment goals.”

The draft bill also recommends increasing the gas tax to fund transportation. Specifically, it calls for the gradual implementation of a 15-cent increase, beginning in 2013, which would be dedicated to funding transportation trust funds. The highway trust fund, which relies largely on gas tax revenue, has neared insolvency several times in recent years, requiring roughly $35 billion in extra funding from the federal government to stay afloat.

In a letter sent earlier this week, Sens. Thomas Carper, D-Del., and George Voinovich, R-Ohio, urged the commission to include a gas-tax hike in its report.

Obama authorized the commission by executive order in February, charging it with “identifying policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run.” It is led by Alan Simpson, a former Republican senator from Wyoming, and Erskine Bowles, former chief of staff to President Bill Clinton.

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