WASHINGTON — President Obama’s jobs bill proposal to cap tax-exempt interest for higher-income taxpayers surprised muni bond market participants and was seen as a betrayal by some issuers who, according to one analyst, could have to pay about $10 billion more in added interest costs over the life of their muni bonds if the proposal is enacted.

While most market participants don’t think the American Jobs Act stands a chance of approval by Congress, several tax experts warned that the cap on tax-exempt interest is ominous sign for future debates on deficit reduction and tax reform because it’s now on the table for discussion and would have to be part of any proposal to cut income tax rates.

The bill, which Obama sent to Congress Monday, would limit the tax value of tax-exempt interest from muni bonds, other expenditures and deductions to 28% for all individuals with $200,000 or more of taxable income and married couples with $250,000 or more. It would apply to taxable years beginning on or after Jan. 1, 2013. There would be no grandfathering for the tax-exempt bonds investors now hold.

This was the first time the president has proposed a cap on tax-exempt interest. His fiscal 2012 budget plan proposed limiting itemized deductions to 28% for higher income earners. However, tax-exempt bond interest is an exclusion, not a deduction, and has never part of those proposals until Obama added it in his jobs bill.

Obama and Gene Sperling, director of the National Economic Council, briefed state and local officials on the bill Friday, focusing on the aid that would go to governments and asking for their support. They did not mention the cap on tax-exempt interest.

State and local groups have thought the threat to tax-exemption was most likely to come from the deficit reduction deliberations or tax reform, not the president.

“Here it is, somebody that we thought we had as an ally — the president — [and he] is already starting to erode” the value of in his proposal to cap the value of tax-exempt interest, said Timothy Firestine, chief administrative officer for Montgomery County, Md., and a member of the Government Finance Officers Association’s debt committee.

“The issuer community is pretty angry about it,” Firestine said. “I’m feeling there’s a little bait-and-switch going on to get us out there in helping to sell the jobs agenda. But I think we look pretty foolish if we are supporting something that affects us negatively.”

“Clearly, we would prefer a bill that didn’t include any limitation on muni tax deductibility,” said Lars Etzkorn, legislative council for the National League of Cities.

Matt Fabian, a managing director at Municipal Market Advisors, said state and local issuers could end up paying about $10 billion in additional interest costs over the life of their bonds.

The estimate is based on two assumptions: that an investor who wants to buy a 5% coupon bond and is paying a 28% tax rate would need to receive an extra 50 basis points to replicate the after-tax current yield produced with a 35% marginal rate; and that the market returns to a more normal rate of issuance of about $300 billion per year.

Most market participants said lawmakers will never pass the jobs bill, but warned about the implications of the president’s proposal.

“I would be shocked if the Republicans went for this,” said one tax expert. “It’s extremely complicated and it’s a thinly disguised increase in marginal tax rates that politicians don’t want to call an increase in marginal rates.”

“I don’t think the market believes this is going to happen. The markets aren’t pricing this proposal at the moment, particularly the tax increases like the municipal bond provision,” said Howard Gleckman, a resident fellow at the Tax Policy Center. “The Republicans will say this is a tax increase.”

“I don’t see this happening,” he added, “But state and local governments in general and tax-exempts specifically are going to be in the bullseye when it comes to deficit reduction.”

“The focus on the jobs bill is misplaced,” John Buckley, a professor at Georgetown University Law Center and former chief tax counsel of the House Ways and Means Committee, said Tuesday during a conference call hosted by the Council of Development Finance Agencies.

They should instead be worried about deficit reduction and tax reform, he said, referring to Obama’s deficit reduction commission, which included the elimination of tax-exemption as an “illustration” of needed cuts in tax expenditures in a report issued in November.

Buckley also warned those on the call that they should be worried about proposals by House Ways and Means Committee chairman Dave Camp, R-Mich., House Budget Committee chairman Paul Ryan, R-Wis., and the so-called Gang of Six to lower income tax rates and repeal tax expenditures.

“I guarantee you that cannot be done without repeal of the tax-exemption for state and local government bonds,” he said.

George Friedlander, a municipal analyst with Citi, said: “This is not the camel’s nose under the tent. This is maybe everything but the tail. ... If passed, this would be extremely damaging to the muni market.”

“We’ve always been able to say to investors that it’s possible something might be done to tax municipal bonds in the future, but [lawmakers] are going to leave existing bonds as they are,” he said.

The tax-exempt market works because municipal investors agree to a lower bond yield on the assumption that the interest will be tax-exempt. “That implied promise was always considered sacrosanct by Congress,” Friedlander said. “There’s never been an ex-post-facto change. This is a large departure from that.”

“I think we’re in a very awkward and dangerous situation in this marketplace,” said Chris Mier, head of analytical services at Loop Capital Markets. “This is the worst possible time to be talking about this stuff in the market,. The problem we have right now specifically is that when you get these kinds of proposals in the public arena it causes investors, justifiably, to be concerned about buying bonds.

“The immediate concern from an issuer’s standpoint is 'how much demand do I lose while Congress kicks this proposal around?’ ”

But other market participants said there should not be a dramatic impact on the municipal market.

“I think the market, perhaps unintentionally, has already  priced in a change in the tax treatment of municipal bonds,” said Peter Hayes, head of municipals, who along with his team oversees about $99.4 billion municipal bond assets at BlackRock. “I think the [effect of the proposed cap] is going to be minimal.”

Muni bonds “are very attractive on a relative basis. That leads me to believe that you’re not going to see imminent selling,” he said.

Michael Zezas, a municipal strategist at Morgan Stanley, said he doesn’t think there will be a huge impact in the market, because it is not likely the proposal will be approved by Congress and because “current yields now encapsulate bigger concerns than the levels of tax rates,” such as credit and liquidity risk.

Zezas said the market is worried about the ongoing credit challenges faced by state and local governments and whether the market could absorb a significant new supply of munis given the current low issuance and outflows from muni funds.

“Historically there has not been a consistent observable relationship between risk premium and tax rates,” he said.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.