Court Street's George Friedlander sees emerging bondholder risk in state politics.
“The bottom line is that the efficiency of the tax-exemption, when measured properly, is actually quite high,” said George Friedlander, managing partner at Court Street Group.

WASHINGTON – The analysis used by the Joint Committee on Taxation to show tax-exempts are inefficient is flawed and unfairly hurts municipal bonds, George Friedlander, a managing partner at Court Street Group Research, said at a conference in Florida last week.

Friedlander has been making his case that the JCT is wrong as fears grow that Congress will propose revenue-neutral, comprehensive tax reform to lower individual and corporate tax rates and broaden the tax base, using caps or the elimination of tax-exempt bonds to pay for that.

At The National Municipal Bond Summit in Palm Beach, Fla., sponsored by The Bond Buyer and Bond Dealers of America last week as well as in a recent paper, Friedlander said the JCT estimates that eliminating tax exemption could raise up to $50 billion a year.

But this level of revenues can only be achieved if the elimination of tax exemption is applied retroactively – an outcome that would be devastating to the value of the $3.5 trillion to $3.7 trillion of outstanding bonds and that would cause a breach of promise made to bondholders. If the JCT's methodology is applied to only new bonds, the amount of additional revenues to Treasury would be only $20 billion over a five-year period, assuming current tax rates, he said.

The JCT has viewed tax exemption as an "inefficient subsidy" for years, based on its methodology, which it detailed in a report in July 2012. But Friedlander contends the JCT's methodology is flawed because it uses an "apples and oranges" comparison. It compares triple-A corporate bonds using a Standard and Poor's index to bonds rated A1/A+ in the Bond Buyer index, he said.

"They assume that because muni yields appear to be high as a percentage of corporate bond yields, the marginal tax rate of the marginal buyer of tax-exempt bonds must be low; and thus, everyone on a higher tax bracket must be earning a 'windfall,'" Friedlander said. "However … when muni yields are compared to what muni yields would have to be if these bonds came as taxable bonds, the low marginal tax rates for the marginal buyers of municipals disappears."

In comparing the two indices, Friedlander said, "We also noted that the Bond Buyer Index always yields sharply more than actual bonds in the muni market – at least 100 basis points more back then and at least 50-60 basis points more in the current, lower-yield environment."

In addition, he said, the JCT fails to take into account that the 20-year corporates it compares to tax exempts are essentially non-callable, while almost all munis have 10-year calls. The committee also fails to take into account that corporates are typically very large bullet maturities preferred by institutional buyers of taxable bonds and have better disclosure, compared to munis, which often have smaller, serial maturities and less disclosure.

Taking all of these factors into account, "munis priced in comparison with what they would have to yield in the taxable market puts the marginal rate of the marginal buyer of munis at around 30% and eliminates a very large proportion of the purported windfall," Friedlander said.

The JCT and other critics of munis assume that if tax-exempts didn't exist, investors would buy fully taxable bonds and pay taxes at their marginal rates, which is "the underpinning of their entire analysis," Friedlander said. But this is "a highly flawed assumption" because many investors would buy equities instead or would stay in cash or near-cash investments, he said.

"And the cost to state and local governments of having to fund in the fully taxable market would be sharply higher than under the JCT analysis," Friedlander said.

"The bottom line is that the efficiency of the tax-exemption, when measured properly, is actually quite high," he said.

He also contends that the tax-exempt bond market provides a kind of "sort and selection mechanism" for infrastructure projects. "There just isn't any easy way to measure the 'right amount' of support for infrastructure projects, unless the recipient of the support is committing to pay for a portion of the project in the form of bond debt service," he said.

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