This year marks the 100th anniversary of the passage of the Federal Income Tax, and the exemption against taxing income from municipal bond investments. This month also marks the 25th anniversary of the creation of the Anthony Commission On Public Finance. Why should you care?
As the philosopher Yogi Berra would say, current efforts to curb or eliminate tax exemption for munis is "déjà-vu all over again." In the 1980's it started innocently enough, with a federal law (TEFRA of 1982) requiring the registration of tax-exempt bonds so that the government could track ownership of these securities. Politicians like Senator Bob Dole denied that it had anything to do with taxing income on municipal bonds. The late Grady Patterson, a long-time Treasurer of the State of South Carolina and who did not suffer fools gladly, saw the future and instituted a lawsuit against then-Secretary of the Treasury James Baker. Viewed as a test of states' rights under the Constitution, eventually Grady lost the case; in 1986, the Federal Government was successful in limiting the types of bonds that could be issued, as well as subjecting some tax-exempt income to an alternative minimum tax. In 1988, The Supreme Court not only affirmed the right of the U.S. to require municipal bond registration, it went further and stated that Congress could tax interest income on municipal bonds if it so desired on the basis that tax exemption of municipal bonds is not protected by the Constitution. This was in direct opposition to an 1895 Supreme Court ruling in the case of Pollack v. Farmers' Loan & Trust Co.
Tax-exemption of the interest on municipal bonds has been one of the most important fiscal tools that a state or city can use to keep costs down to their taxpayers, because it allows them to borrow money in the bond market at lower costs of interest compared to other types of borrowing. The last time that tax-exemption for munis was in real jeopardy was in 1986-1992. In a classic case of déjà-vu, the President and Congress are seeking to curb or eliminate this tax-saving tool for state and local governments in order to finance their record of fiscal recklessness and deficit borrowing.
In 1988, Congressman Beryl Anthony of Arkansas was a member of the House Ways & Means Committee, the group charged with the law of federal taxation. Like other uninformed Congressman, Rep. Anthony viewed muni bonds as little more than a tax-loophole that benefitted the rich. Until he was approached by his state's' Director of Industrial Development and his boss, a young Governor of Arkansas as that went on to become President of the United States, Bill Clinton. They explained that curbing or eliminating tax exemption on municipal bonds would harm the state's efforts to attract business to the state, and would end up raising State budget costs on building expensive projects like jails, prisons, schools, bridges and roads. The argument wasn't wasted on this influential member of Congress.
In 1988, when I headed up S&P's municipal bond rating department, I was invited to join as a charter member of Rep. Anthony's Commission on Public Finance, with the mission of educating the public and lawmakers on the cost benefits of municipal bonds to state and local governments. Membership on the Commission was bi-partisan-Bill Clinton's co-chairman was the late Carroll Campbell, then Governor of South Carolina.; Republican State Treasurer Ed Alter of Utah was joined later by Democrat Ann Richards, later to precede George Bush as Governor of Texas.
The Commission met about 10 times from 1988 through 1992; it issued its comprehensive report and recommendations to Congress and the public in October 1989. The Commission was divided into 5 task forces, and I was fortunate to be on Task Force 1, chaired by Bill Clinton, charged with developing the mission statement and policy goals of the Commission. Here are some excerpts from that report:
"One of the most disturbing trends has been the reduced perception of a partnership between the federal government and state and local governments. State and local governments are increasingly perceived as "just another special interest group"… Provisions that cost state and local governments far more than they "save" in Washington have passed. Little consideration has been given to the fact that federal, state and local expenditures are all paid for from the same source-the taxpayers of the United States.
"The Commission's ... recommendations reflect… a public policy that: Accepts the responsibility of Congress to prevent abuses …to exploit interest rate differentials created solely by the tax law; Promotes cooperation between Congress and state and local governments…in the use of tax-exempt financing to solve the immense needs for infrastructure expansion and replacement and extension of needed governmental services; Does not require that public projects be financed in any particular way….and encourages…the application of a truly federal cost-benefit analysis that recognizes that legislative provisions that cost citizens more as state and local government taxpayers than they save as federal taxpayers are simply unsound public policy."
While the Commission didn't try to overturn the 1986 federal incursion into taxing municipal bonds, it helped prevent further attacks, and helped convince future Congresses that tax-exempt municipal bonds could provide incentives to help build programs and projects that were badly needed for the repair and replacement of our crumbling infrastructure.
I consider my work on the Anthony Commission as one of the highlights of my career in the municipal bond sector, because I believe in the value of a strong state and local government sector. The federal government does little to finance the infrastructure that we use in our everyday lives: schools, bridges, roads, airports, and in many cases, potable water or electric service. And I am hard pressed to believe that a private company would want to get involved in the treatment and disposal of sewage - most wouldn't want to touch that business with a 10 foot pole (pun intended). Their construction relies on state and local governments. As Jim Lebenthal loves to say, "They were built by the workhorse of investments: Municipal Bonds."
Our infrastructure, and the market that provides the capital to build it, is the envy of the world; foreign nations send representatives and commissions to the U.S. to see if it can be replicated in their countries. That is why I agreed to serve on the Technical Advisory Committee of Municipal Bonds For America, a non-partisan coalition of municipal bond issuers and State and local government officials along with other municipal market professionals working together to explain the benefits of the tax-exempt municipal bond market which provides the financing needed to build vital infrastructure throughout the United States. It is the latter-day Anthony Commission, 25 years later.
The Importance of Municipal Bonds as a Retirement Asset
Contrary to popular belief, muni bonds are not just a loophole for wealthy investors. In recent years, munis are increasingly bought by middle income investors to provide income for their children's education and for their eventual retirement. Higher education is minimally funded from federal programs, and Social Security retirement funds continue to be underfunded, raising doubts about peoples' ability to plan for their golden years. A move like taxing municipal bond income above a threshold such as 28% of income could dramatically affect lifelong strategies that people employ to be able to retire affordably. While wealthy taxpayers do indeed benefit from tax exemption, for many of our retired clients, their only source of income is from their portfolio of municipal bonds or tax-exempt municipal bond funds. In these days where people are constantly bombarded by news about underfunded pension plans and the projected "bankruptcy" of Social Security, laws that would limit tax-exemption on municipal bonds would just add fuel to that bonfire.
A Disclaimer from the Author
There are those that would say my editorial is biased, because as a municipal bond credit analyst I make all of my income from the tax-exempt market. But note this: there will always be a market for municipal bonds. State and local governments don't have the option of an "IPO" or stock sales to shareholders. And for expensive items like a new school or a bridge, they simply can't be paid for from this year's annual receipts, just like people cannot pay for a new home with just cash. If municipal bonds became taxable, cities and states would still need to sell bonds (albeit at higher interest rates). Frankly, my compensation and value as a municipal bond analyst would probably increase, because new taxable investors, unfamiliar with the safety of municipal bonds and fearful because of daily negative press about budget "deficits" would need someone like me to guide them through a market which is totally unfamiliar to them. Ironically, curbing or eliminating tax exemption for municipal bonds could give the muni analyst industry an unexpected boost!
So, why do I support continuing tax exemption for municipal bonds in its current form? Because it works. And it works because it lowers the interest cost to a state or a city when it sells bonds for big-ticket projects. Projects that cannot be financed by the taxable sector, nor can they be financed by a cumbersome federal government that increasingly is paralyzed by political friction.
In 2013, Congressional discussions on balanced budgets and tax reform will squarely put the future of tax-exempt financing at a fork-in-the-road. To paraphrase my favorite philosopher, Yogi Berra, I would give this advice to the new Congress. When it reaches the tax-exempt municipal bond interest fork-in-the-road later this year: "DON'T TAKE IT."
Richard Larkin is a senior vice president and director of credit analysis
at Herbert J. Sims and will sit on a panel on this topic Feb. 25 at
The Bond Buyer and BDA's Fifth Annual National Municipal Bond Summit.