A recent research report by Merrill Lynch & Co. concludes that a soaring federal deficit and the tax hikes that may be necessary to combat it could make municipal bonds more attractive to investors in the coming years. But some market participants contend there are too many variable factors to be able to draw such a conclusion.

"For muni investors, the point is clear. The relative value of munis could rise substantially in future years," according to the Merrill research report, which was released yesterday. While the final outcome of the presidential election will have to wait for a few more months, the firm said it anticipates that taxes will rise "substantially" in the coming years, regardless of who is elected.

"We are not in the position of predicting the outcome of the election, but we have said before that we expect federal (and some state) taxes to rise substantially in the next few years," the report states.

The growing federal deficit, now projected to reach nearly $500 billion in 2009, will likely force the new president, whoever it is, to find additional ways to raise federal revenue, most likely through tax increases, Merrill said. Deficits are growing at the state level as well, the reported noted, citing New York's need to cut $1.2 billion from its $122 billion state budget.

Presidential hopeful Sen. Barack Obama, D-Ill., has already put forth proposals to raise the individual tax rate to 39.6% and to raise the average tax rate for top income-earners by about 9%, the Merrill report noted. Sen. John McCain, R-Ariz., the Republican contender for the presidency, supports lowering taxes, according to his campaign's Web site.

However, some market participants said it may be too soon to know how munis will be affected by the federal deficit and the election.

"Just from experience, I don't know if anybody's really going to make a lot of money in buying munis just from tax rates going higher," said Chris Mier, managing director and chief strategist for Loop Capital Markets LLC in Chicago.

While increased taxes would be a boon for munis in a fundamental economic sense, Mier said the complexities of the market make that difficult to predict.

"There are so many factors that influence the relative performance of these markets," he said. "I think if tax rates went up Jan. 1 of 2009, and you tried to see the adjustment empirically, it may not be that easy."

He cautioned against making any assumptions about how either candidate would act as president.

In 1992, when Arkansas Democrat Bill Clinton was poised to become president, market participants were worried that he would raise taxes and that those tax hikes would slow the economy, Mier noted. "But a lot of people's expectations didn't bear fruit," he said.

Since no one can know for sure what a candidate can and will do in the Oval Office, it's best to adopt a "wait-and-see" approach, he added.

Further, even if taxes are increased by the next president, any number of factors that influence the market could counteract its effect, Mier said.

"I wouldn't necessarily encourage people to speculate on the marginal tax rate and the effect it may have on the marketplace," he said.

"It's not that simple in my opinion," he said, noting that the recent turmoil in the auction-rate securities market could turn investors away from munis, even if higher tax rates make them more attractive.

"How do people's concerns and anxieties about investments in general, and munis in particular factor, into this equation?" Mier added.

Duncan Smith, a trader at Alexandra & James, said supply and demand factors will play a large role in future market performance.

"Munis are a supply- and demand-driven product," he said, adding that if higher tax rates make munis more attractive and drive up demand, "You would expect bonds to perform well."

However, issuers could end up issuing more debt, perhaps to deal with revenue shortfalls, and the increased supply could negate any increased demand, said Gary Strumeyer, president of BNY Capital Markets Inc.

Strumeyer also noted that competition from the equities market could impact muni demand.

Still, he said tax rates can strongly influence municipal bonds.

"All things being equal ... higher tax rates make municipals that much more valuable," he said. "If you assume that tax rates are going higher ... that's extremely positive for the bond market."

The tax rate is "an overwhelming factor" in driving the muni market, Strumeyer said. "Where income tax rates are going to be is going to be a driving force in the market."

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