The White House may be commended for putting its shoulder to the wheel in its just-released budget to develop policies aimed at curing the nation's infrastructure woes. Each policy idea — enhanced private activity bonds, a new breed of direct-pay tax credit bonds, helping banks to purchase more small issuances of tax-exempt debt without tax penalty, among others — is a starting point for a discussion with a new Congress that stakeholders can hope will be productive. But while the Administration generates fresh ideas for "one-stop shopping" at federal agencies for public private partnerships, boldly breaks down volume caps and plants a stake in the ground for permanent infrastructure incentives — when it comes to tax-exempt municipal bonds issues by state and local governments, they just can't leave well enough alone. The White House wants to limit the federal tax exemption for municipal bonds. In doing so, the Administration shoots itself in the foot by focusing state and local government stakeholders, who may otherwise support the Administration's menu of options for financing the nation's infrastructure, on defending their very lifeblood.
Specifically, the Administration budget once again imposes a 28% limit on the value of the municipal bond tax exemption, making municipal bond interest income partially taxable for high earners. The reason for this is not that such a limit is good politics; the coalition opposing this partial tax is broad and powerful and, as state and local government stakeholders, they typically wear the "white hat". The reason for the limit is instead a compulsion to over-engineer a financial instrument that is the simple product of the nation's founding principles and a Constitution that establishes the state and federal governments as co-sovereigns. Need proof that tax-exempt municipal bonds are a founding principle? The exemption for municipal bonds can be found in the original, 31-page tax code, and is a reflection of the fear that federal taxing powers would impair the rights of the state.
Municipal bonds comprise a $3.8 trillion marketplace that operates to facilitate efficient and effective local decisions about infrastructure and permits state and local government to affordably tap the capital markets. State and local government groups and bankers alike estimate that limiting the tax exemption for municipal bonds will significantly raise the very infrastructure costs the Administration is trying to address. So, taxing municipal bonds is bad politics, and undercuts the central message of the budget that puts urgency around the nation's infrastructure. Then why the push — from the Administration and some in both parties in Congress — to tweak tax-exempt bonds?
There are two urges that taxing tax-exempt bonds seems to satisfy. One is to increase the "efficiency" of these bonds; the second is to increase tax revenues from high earners. With respect to efficiency, high earners can benefit more than those in lower income brackets from the tax exemption as, assuring a deep marketplace, municipal bonds are priced to attract both higher and lower income investors. In essence, the intended federal subsidy is subject to a marketplace and depending upon market conditions, one dollar of federal subsidy can fail to result in a full dollar of subsidy to the state and local government while providing more of a benefit than intended for higher income brackets.
Why not then, logically, take these good bonds and make them perfectly efficient creatures in the eyes of the federal government? The problem is, to do so, the federal government must overstep its boundaries — a national, foundational boundary — and tinker with something that is not a federal government program but, a financial market.
Think of the $3.8 trillion municipal bond market as an orchestra playing music around the clock. What the federal government proposes to do is to take the orchestra and turn it into a radio with a volume knob. The federal government knows the right sound level and this year, it is 28%. Next year, it may be 25%. Or, the knob can be turned down — all the way. After all, that tax-exemption looks a lot like forgone federal tax revenue. One can see it is hard to resist adding a knob and then using it to shift federal burdens. By the same token, the certainty state and local government and investors rely upon from the municipal bond market would be eroded as the federal government puts its revenue desires above the priorities of state and local governments. Ultimately, their borrowing costs would rise in the name of "efficiency".
The second urge that taxing tax-exempt bonds seems to satisfy is taking tax avoidance tools away from high earners. There are many ways to go about addressing high earners, and many exist concurrently in the tax code; AMT, "PEP" and "PEASE" and other phase outs. Taxing tax-exempt bonds is yet another way to get at these earners. But is it the right way? The Administration is focused on infusing private capital into public infrastructure under a new public private partnership initiative. By a similar token, since high earners have their choice of investments, don't we want to affirmatively attract them to investments in infrastructure with inherently public purposes that can benefit everyone in their communities?
The Administration budget is a starting point and hopefully, will continue to spur the needed debate on how best to finance our infrastructure. At the end of the day, it is likely that a concept like taxing tax-exempt bonds will win or lose based upon politics and not on the federal government's particular view of the efficiency. On the politics, large and broad coalitions are ready to defend the tax exemption. Let's hope that their efforts can be redirected to supporting some of the new options for enhancing infrastructure that have been put forward rather than being forced to play defense to sustain a marketplace that is a national founding principle. By over-engineering and taxing municipal bonds, policymakers could make a quest for perfection the enemy of the public good.
Susan Collet is president of H Street Capitol Strategies, LLC
