S&P: Tax-Exemption Threats Pose Credit Risks

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Municipal issuers could experience a significant jump in borrowing costs and reduced access to the market if congressional and administration proposals to curb or eliminate tax exemption are adopted, Standard & Poor’s said in a report released Monday.

The eight-page report, “Cutting Popular U.S. Tax Programs Could Harm Tax-Exempt Bond Issuers,” details the negative impact of tax reform proposals to reduce or eliminate the tax exemption for municipal bonds, the mortgage interest deduction, and state and local  property tax deductions.

If any changes made to these three tax expenditures were retroactive, interest rates on outstanding variable rate debt would increase, said Steven Murphy, senior managing director and head of U.S. public finance at S&P. Refinancings, which have been increasingly popular due to historically low interest rates, would become much less viable, he added.

The muni bond tax exemption, mortgage interest rate deduction and state and local property tax deductions will collectively cost the federal government $173.3 billion in forgone revenue in fiscal year 2014, which begins on Oct. 1. If all three were completely eliminated it would cut the federal deficit, currently $560 billion, by 30% this year, the report said.

“We anticipate that lawmakers will take a hard look at these three tax expenditures,” the report said. “In our view, they should consider the critical role these tax provisions play in the municipal finance sector, the housing industry, and the overall economy.”

If ending the tax exemption for municipal borrowers leads to higher state and local taxes, low-income taxpayers could see their tax bills increase, the report said. This outcome would be at odds with any suggestion that the municipal tax exemption should be ended because it unfairly benefits the wealthy, S&P said.

Not only would a change in the tax exemption cause a significant disruption in the municipal market, investors can be expected to seek alternative compensation for a reduced tax benefit, leading to an increase in debt issuance costs. While some proposals to alter the municipal bond market would potentially expand the universe of bond buyers, S&P believes most issuers, especially smaller ones, could find themselves with reduced market access.

“The market for large issuers is more established, and their bonds are relatively liquid, so they have better crossover appeal,” the report said.

S&P said one factor in its rating analysis is debt burden. An increase in debt service would be significant enough to push carrying charges into what the rating agency considers a higher category.

The report analyzed 11 state and local issuers based on their current debt service as a percent of government spending versus debt service if all of their bonds had been taxable.

For example, Westminster, Colo., has a 17.8% ratio of debt service as a percentage of its government spending. If all of its bonds had been taxable that debt service would rise to 21.6% and result in a high ratio category.

Increased debt service costs would force issuers to chose between capital investments, reserve maintenance, taxation, user fee levels and providing key services, the report said.

“An inability to address capital needs poses credit risk similar to how increasing pension liabilities became a credit weakness if pension contributions are repeatedly deferred and the liability becomes increasingly underfunded,” S&P said.

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