Proposals to limit the tax-exemption on municipal bonds get short shrift from the majority of market participants, but some state and local government experts on Tuesday seemed resigned to the notion that tax-reform efforts will inevitably do just that.
“There is a fair amount of inevitability around some kind of proposal,” said Michael Zezas, vice president of research at Morgan Stanley.
Zezas, speaking at The Bond Buyer’s 501(c)3 Super Conference in New York, said both political parties have grassroots support in trimming the federal debt and noted that virtually all deficit-reduction proposals attack the various tax exemptions and deductions.
According to the White House, eliminating the tax exemption on muni bonds could save $230 billion over the next half-decade — about 15% of the $1.5 trillion in spending cuts or revenue increases that Congress’ supercommittee must find by Nov. 23.
Among the competing choices, like ridding the tax deduction in 401(k) plans or on charitable contributions, there is no obvious candidate to eliminate in favor of keeping tax-exempt bonds, Zezas said.
And compared with other ideas that tinker with muni bond taxation, he said President Obama’s proposal to cap the exemption at 28% meets the two-part test of being politically feasible and maintaining market efficiency.
He argued that investors have already priced in some kind of tax reform, and disagreed with comments suggesting issuer borrowing costs would necessarily jump 30 to 50 basis points if the cap were enacted.
“We think the president’s proposal checks the most boxes and does the least harm, politically,” Zezas said.
A notable defender of the status quo was Charles Samuels, legal counsel to the National Association of Health and Educational Facilities Finance Authorities, a Washington-based lobby group.
Samuels said market participants should not assume the tax exemption on muni bonds will fade away but instead mobilize to explain and protect this “critical franchise.”
“We have a good chance of, essentially, maintaining this market, if anything maybe even enhancing it,” he said. “And we shouldn’t be looking to the corporate side as our model for the future.”
Samuels suggested that efforts to meddle with muni tax exemption were coming from a small partisan group of economists within the Obama administration, namely the National Economic Council, which he described as politically sensitive group that is isolated from reality and has little business savvy.
“The Treasury, at the career level, has been shut down and isn’t having any input,” Samuels said.
Still, he conceded that some tax changes will hit the market in the coming years.
“My prediction is that we will get out of the supercommittee without radical change to municipal bonds,” Samuels said, “but over time, in the next couple of years, we will not be untouched.”
The conference also heard from prominent higher education issuers that have had broad success forgoing the tax-exempt option in favor of issuing taxable debt. The alternative can provide added flexibility to issuers concerned with compliance issues relating to an institution’s level of private use.
Allen Marcum, director of budget, finance and treasury at triple-A rated Massachusetts Institute of Technology, said tax compliance issues were looking burdensome when MIT sought to tap the municipal market earlier this year to raise $500 million for building and renovating academic enterprise and research facilities.
“An elevator in this building, a roof over here — when you start talking about tracking private use on all these tiny projects all over campus, it turns into a nightmare,” Marcum said. “So that was a major driver of why we decided to go taxable.”
MIT generated such demand from taxable capital markets last May that it dropped the tax-exempt portion of the deal, upsized the issuance amount to $750 million, and extended the maturity date out to 100 years.
The century bond featured a 5.60% coupon — a 130 basis point spread on the 30-year Treasury bond — and a make-whole call option at the Treasury rate plus 20 basis points.
Demand, mostly from insurance companies, was better than anticipated, and MIT found the pricing attractive despite lackluster appetite from international buyers, who picked up 20% of the deal.
The success of the offering, along with others, backs up the idea that if the tax exemption were capped or eliminated, it wouldn’t be a cataclysmic event. That’s good news for participants who think some kind of change is destined in the near future.
“To us it’s not a question of whether the tax exemption gets reformed,” Zezas added. “It will get reformed, post the 2012 elections. The question is, whose values will be reflected in that reform?”