WASHINGTON – Any discussion of altering the current tax treatment of municipal bonds injects uncertainty into bond markets and raises questions for investors who would demand risk premiums on future bond issuances, the nation's governors warned leaders of the Senate Finance Committee.

That’s among the points the National Governors’ Association raised to Senate Finance Committee Chairman Orrin Hatch, R-Utah, in a recent letter that expressed concern that tax reform might impose a cap on the value of tax exemption for municipal bonds. Hatch has asked for public comments on tax reform.

It’s less drastic than eliminating the current tax exclusion, to be sure, but NGA says a cap on tax exemption still would be damaging to the municipal bond market.

President Barack Obama proposed a 28% cap in a series of budget requests while in office, and some members of Congress have also proposed caps.

Sen. Orrin Hatch, R-Utah
Sen. Orrin Hatch, R-Utah Bloomberg News

“Proposals to cap all federal deductions and exclusions remain a perennial suggestion to help reduce the deficit and streamline the federal tax code,’’ NGA wrote in its letter, which was also sent to Sen. Ron Wyden, the committee's top Democrat. “While its form could vary either as a percentage cap on high-income taxpayers, or a hard dollar cap applied to all taxpayers who itemize their returns, the effect on municipal bonds would be damaging.”

Justin Underwood, director of the Municipal Bonds for America coalition, said Thursday that a cap on the municipal bond interest exemption would “fall squarely on U.S. towns and cities.’’

The result would be “increased interest costs, reduced ability to finance badly-needed infrastructure projects, like roads, schools, bridges, hospitals, and water and sewer systems,’’ he said, as well increased economic burdens on taxpayers.

NGA told the Senate Finance Committee chairman that a ‘hard dollar’ cap on federal deductions and the exclusion of muni interest would crowd out “lower-valued deductions and exclusions in favor of higher valued ones like mortgage interest and charitable contributions, effectively making municipal bonds taxable for most taxpayers who itemize.’’

But NGA General Counsel David Parkhurst said in a phone interview on Thursday that as far as his organization is concerned, the tax exclusion for municipal bonds remains at risk of being eliminated.

“Everything is at risk,’’ Parkhurst said. “We don’t even have hard language. We’ve got no bill to react to. So we have to work from the presumption that everything is at risk. We’re keeping the pedal to the floor her on the car making the case.’’

The House Ways and Means Committee and the Senate Finance Committee are planning to hold hearings and markup details of the tax legislation after Labor Day.

The so-called Big Six who negotiated tax reform for months have issued only a statement of principles for tax reform, leaving it to these two committees to work out legislative language. The Big Six are Hatch, Senate Majority Leader Mitch McConnell, R-Ky.; House Speaker Paul Ryan, R-Wis.; House Ways and Means Chairman Kevin Brady, R-Texas; Treasury Secretary Steven Mnuchin, and National Economic Council Chairman Gary Cohn.

Mnuchin appears to favor eliminating the federal deduction for state and local taxes, Parkhurst said. That deduction, commonly referred to as SALT, is “the real issue that’s in play,’’ he said.

NGA has partnered with the Government Finance Officers Association and other groups to lobby House lawmakers on the importance of tax-exempt bonds and the state and local income tax deduction, also known as SALT, to their constituents.

GFOA earlier this summer released an analysis of how many households claim the SALT deduction in each congressional district around the nation. The analysis found more than 50% the SALT deduction went to taxpayers with adjusted gross incomes under $200,000.

Likewise, the Municipal Bonds for America Coalition has been persistent in lobbying key lawmakers on the importance of tax-exempt municipal bonds to financing local infrastructure.

Parkhurst said the Trump administration is aware of the important role the muni bond market would play in achieving its goal of $1 trillion in new infrastructure spending over 10 years.

“Infrastructure and tax reform is a natural hook,’’ Parkhurst said. “The administration has been clear there’s no new federal money coming for this proposal they have been talking about. The engine remains on the backs of state and locals to make this happen. The muni bond market is the fuel that’s going to keep that engine pumping.’’

Parkhurst predicted the danger of lawmakers trying to cap the tax-exempt interest on municipal bonds might happen if comprehensive tax reform fails. “If the politics are too hard to do full bore tax reform, then phase two becomes a haircut,’’ he said.

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