The Municipal Bonds for America coalition warned Friday that a retroactively applied 28% cap on the value of tax exemption would fundamentally alter 100 years of precedent, raise borrowing costs for issuers, limit infrastructure development and constrain economic development, while doing little to help solve the nation’s fiscal crisis.

The group issued the warning in a two-page paper, which also cited an analysis by Citigroup Municipal Strategists that found the value of outstanding municipal bonds could plummet by at least $185 billion because of uncertainty if a retroactively effective cap were adopted.

The cap would end 100 years of precedent in the relationship between the federal government and state and local governments by taxing state and local bonds, the coalition said.

For taxpayers in the 39.6% bracket, the 28% cap would amount to an 11.6% tax on income that was once entirely excluded from taxation, it said.

“Moreover, while the 28% limit is designed to target only wealthier investors, the reality is that all bond investors ... would feel the effect if the proposal were enacted,” the group added.

MBFA said 55.5% of all tax-exempt income is reported by taxpayers with adjusted gross incomes of less than $250,000. In addition, almost 60% of the tax-exempt income is reported by taxpayers over the age of 65. 

The muni market has already shown some of the impact a 28% cap would have, according to the coalition.

When investors felt the cap could be enacted for a period of time in December, muni bond funds experienced net cash outflows and the increase in tax-exempt bond yields was 14 to 40 basis points greater than the increase in Treasury bond yields.

For someone in the 39.6% bracket, the 28% cap would lower by 29 basis points the after-tax return on a tax-exempt bond, assuming an average yield of 2.5%, the group wrote in the paper.

Investors would demand higher yields to adjust for the cap. They could seek premiums of as much as 30 to 40 basis points to account for the future risk of tax increases, the coalition said.

President Obama first proposed a 28% cap on all tax expenditures, including the exclusion from income for muni bond interest, in a jobs bill, then proposed it again in his fiscal 2013 budget request. He is expected to propose the cap again in his fiscal 2014 budget request, which is due to be issued in March.

Democrats and Republicans supported the cap proposal in debates over a fiscal cliff agreement. Though the compromise reached did not include such a cap, it continues to be on the table in budget and tax reform discussions.

The paper’s findings resulted from research developed by members of MBFA’s technical advisory committee, which is led by Citigroup chief municipal strategist George Friedlander and Janney Montgomery Scott director and municipal credit analyst Tom Kozlik.

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