WASHINGTON — Tax-exempt bonds face a serious threat from tax reform or deficit reduction, experts agreed at a tax policy meeting held here late last week.

“I think that the state and local tax-exempt bonds are under attack,” John Buckley, former chief Democratic tax counsel for the House Ways and Means Committee, said at the meeting, which was sponsored by the Urban Institute and the Tax Policy Center and George Mason University. “There is no question about it.”

Buckley cited two primary reasons why the elimination or restriction of tax exemption is attractive to some lawmakers: it is portrayed as a tax increase on upper income taxpayers and it would shrink local government. He was joined by four other tax experts who spoke on a panel titled “Fallout from Federal Tax Reform: Implications for State and Local Revenues.”

Buckley was skeptical that any large tax-reform package to retroactively make municipal bonds taxable would ever pass Congress. However, he would not rule out Congress making munis taxable on a prospective basis.

He pointed to president Franklin D. Roosevelt’s unsuccessful attempt during the Great Depression to repeal tax-exempt bonds on a prospective and retroactive basis. “I am convinced that if Roosevelt proposed repeal of tax-exempt bonds prospectively” he might have been successful and ... we wouldn’t have been talking about this issue today,” Buckley said. “I don’t think it’s going to be any different in tax reform or budget deals for that matter” today, he added.

Kim Rueben, a senior fellow at the Tax Policy Center, said there is a sense in Washington that revenues need to be raised at the federal level due to the ballooning deficit, which is expected to reach $1.1 trillion this year.

“I do think that some of the things that we let have tax-exempt status maybe should be considered,” Rueben said. “It’s not very clear to me that private-activity bonds and some of the higher education bonds should be tax-exempt.”

“There is some middle ground when you are talking about changing the definition of the volume of tax-exempt bonds ... versus saying this is all or nothing,” she added.

Frank Shafroth, director of George Mason University’s Center for State and Local Government Leadership, which co-sponsored the forum, argued that tax expenditures, including tax-exemption, should be incorporated into the federal budget process to enhance scrutiny of the revenue impact on state and local governments.

He suggested tax expenditures should receive comparable treatment to that of unfunded federal mandates, where the Congressional Budget Office is required to identify and estimate costs of unfunded mandates throughout the budget process.

The panelists agreed that state and local government groups need to take initiative and get themselves heard in front of lawmakers to outline the importance of tax exemption. However, panel moderator Howard Gleckman, a resident fellow at the Urban Institute, said that effective state and local lobbying has diminished over the last decade partially due to the bitter partisanship among groups’ Republican and Democratic  members.

The panelists also discussed sequestration, which if enacted, would force a total of $255 million of cuts in federal payments to issuers of Build America Bonds and other direct-pay debt, according to a recent report from the Office of Management and Budget.

Under the BAB program, which was created under the American Recovery and Reinvestment Act in 2009 and expired in 2010, taxable bonds are issued and the issuers receive subsidy payments from the federal government equal to 35% of their interest costs.

Buckley said he was “surprised” that the sequester would reach BABs because they were financed by permanent appropriations for tax refunds. He called OMB’s interpretation of sequestration “extraordinary and strange.”

A recent Morgan Stanley research brief found that if BAB subsidies were cut as part of sequestration, it could decrease debt-servicing capacity and potentially trigger extraordinary optional redemption provisions.

The payment cuts would not “materially increase credit or call risk for the market generally,” but it could weaken the possibility that BABs return to the market, wrote Morgan Stanley analyst Michael Zezas.

Since the sequestration report was issued, the market has not reflected any obvious concern and the BAB index has remained flat, Zezas wrote.

The pending subsidy cut represents a “modest portion of the total BAB debt-service obligation and we view the risk to bond repayments as minimal, and believe most issuers have adequate resources to fund the shortfall,” Zezas wrote.

The subsidy cut represents 3% of annual BAB interest which would reduce the BAB interest subsidy to 32% from 35%. For example, an issuer with $100 million of BABs outstanding bears the risk of losing $159,600 of its annual federal interest subsidy, according to the report.

All of the tax policy panelists on Friday agreed that if BABs were resurrected, it would be good as a supplement, but not a replacement, to the municipal bond market. Rueben and Buckley both said that it would be too difficult to fully replace BABs with tax exemption and it is sensible that they serve on an optional basis as they did in 2010.

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