WASHINGTON — Municipal market participants are increasingly anxious that a year-end “fiscal cliff” deal between the Obama administration and Congress will include some type of cap on tax exemption, perhaps even the 28% cap proposed by President Obama.

Many muni investors may not have appreciated the risk posed by proposals to cap the value of tax exemption until recent media reports and an investor call led by Citi last week significantly increased awareness of the issue, Matt Fabian, managing director at Municipal Market Advisors, wrote in an outlook report on Monday.

“There is little that is new: diluting, capping, or otherwise limiting the value of tax expenditures, including the tax exemption, has held broad bipartisan support for some time,” he wrote. “All of the President’s proposals to fix the fiscal cliff have included his 28% effective tax rate plan, while most Republican counteroffers have also included some form of cap or limit.”

The analysis comes hours after House Speaker John Boehner, R-Ohio., and the president met for 45 minutes on Monday at the White House in accelerated discussions to avert the fiscal cliff, a positive signal that a deal could be reached this week. It was the third face-to-face meeting in the last eight days. The fiscal cliff is the set of automatic tax increases and spending cuts to take effect in January.

Over the weekend, Boehner proposed to let tax rates rise on income earners over $1 million as well as closing some loopholes and limiting deductions in order to raise $1 trillion in new revenues. He also proposed raising $1 trillion from spending and entitlement cuts. Boehner’s concession on accepting a tax rate increase for the wealthy Americans is a possible indicator that the differences between the president and Republicans may be narrowing.

Some tax experts said it would be hard to achieve $1 trillion in new revenues without a cap on tax expenditures. 

While higher tax rates on the wealthy typically attract investors to the muni market because their interest earnings are excluded from taxes, placing a cap on the value of tax expenditures, including tax-exempt bond interest would crush the muni market, analysts have warned.

Specifically, muni analysts have said a 28% cap would be retroactive and would not only increase borrowing costs for state and local governments, but also erode the value of bonds in an investor’s portfolio.

“There would be a tradeoff but I think on balance the new retroactive tax would be net harmful,” said Chuck Samuels, a lawyer-member of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo PC.

Wells Fargo believes that the most likely scenario in a debt deal would be to cap deductions at 28% instead of capping deductions at a dollar amount. When people refer to caps on deductions they generally include tax exemption, which is actually an exclusion, but also a tax expenditure along with deductions.

Capping deductions at a dollar amount “is as draconian as eliminating tax exemption completely, given the other deductions that could crowd out tax-exempt interest such as the mortgage interest deduction, state and local tax deductions or charitable deductions,” wrote Natalie Cohen, senior analyst with Wells Fargo.

A 28% cap on the value of itemized deductions would “cheapen the market, as high-bracket investors sell to lower brackets, who would get a good deal,” Cohen wrote.

Earlier this year the Joint Committee on Taxation estimated that Obama’s proposal to place a 28% cap on the value of tax-exempt interest and other tax preferences for high-income earners would raise $520 billion over 10 years.

Perhaps the biggest concern is the uncertainty that such a cap would create in the muni market, the idea being that it could be steadily reduced in future years if debt and deficit problems remain unsolved.

“My gut is the shock of taxing munies, and retroactively, will be powerful and undermine the aura and perception of their being tax exempt,” Samuels said.

While some reports say that a deal could be floated as early as this week, not all Washington observers are sold that it can be accomplished before Christmas.

Ken Kies, former top Republican staff writer on the House Ways and Means Committee, now head of the Federal Policy Group, said he has seen enough of these type of negotiations in Washington to know that the key people at the bargaining table aren’t leaking details to the press.

Kies also said if key negotiators place a cap on itemized deductions and include municipal bonds they “are going to realize that this is grossly unfair to existing bondholders and if you do it on future bonds it wouldn’t raise any money.”

“It would be particularly unfair to investors,” Kies said, adding that a dollar amount cap would be more plausible.

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