We have arrived at this point on tax reform and the municipal market due to the need to fund corporate and individual tax cuts and to balance the budget over 10 years. Doubts about balancing the federal budget in the latter part of the 10 year period have already surfaced. The fall back is either more cuts or changing breaks in the later years.
We have two proposals on the table as to the treatment of Private Activity Bonds (PABs). The House has indicated its position to terminate PAB issuing activity. On the other hand, the Senate has signaled that it would like to continue to permit PAB issuance. Determining exact numbers for PAB issuance is challenging because they cut across so many sector lines. Most accounts place them in the range of 20% of the total market. If the bonds are repealed, based on last year’s total volume, the hit would be the elimination of about $90 billion of supply.
One of the ironies of the present market is that municipals are trading up in the acknowledgment that a good slice of issuance will be ceasing potentially. I am clearly not privy to the magic that is necessary to reconcile these two opposing positions on the matter. Reconciliation will be key in the resolution.
Unfortunately, we have been moving toward repealing the ability to do advance refundings for a very long time. When I first arrived in the business, the invested sinking fund rules were released. Then the rule with tax reform in the 1980s that one refunding would be allowed. We spent a lot of time calculating transferred proceeds penalties and such. All of those considerations would be no longer with a repeal of advanced refundings.
Refundings in a typical year are in the range of 25% of the market give or take a few percent. Yes, there is a cost to the Treasury for allowing refundings. But if you follow reciprocity to some of its natural conclusions, refundings in principle really should be a state and local matter. The bottom line is the costs to the Treasury are not all that great while the savings to states and localities have been quite sizeable in recent years and would continue to be, especially in a continuing low rate environment. To our chagrin, both Houses appear to be aligned on repealing advanced refundings.
SALT (State and Local Tax deduction) is also slated for repeal with one important exception. The House has heard more from the localities that the repeal is likely to affect them more in regards to their own creditworthiness. The receptivity by the House to the message is that they want to cap a property tax deduction at $10,000 per year. In the case of the house with the median value in the nation, this amount is more than sufficient to cover the full real estate tax payment. However, given the property values on both coasts, many pay in excess of this $10,000 cap. One of the aspects that rating agencies consider in their evaluations of localities is the degree of “financial flexibility.” There is very little doubt that imposing this cap in higher tax locales will contribute greatly to reducing said flexibility. In turn, ratings probably would be subject to more pressure.
Taking healthcare, housing, college & university, development, transportation and other more specialized bonds out of supply will significantly reduce the size of the municipal market. Assuming the newly configured market is approximately $250 billion, we will be significantly smaller than the corporate market, which has over $1 trillion of issuance in a year. One has to ponder the question about what resources will be devoted to the industry by professional organizations. Perhaps, when RFPs (Requests for Proposals) are sent out by issuers, there may not be as many responses on average. For investors, the consideration is somewhat different. The consideration will be whether or not there will be adequate liquidity in “normal” markets as well as in stressed ones. If there are not as many bids in the market, will spreads start to widen once again? Greater transparency has contributed to a somewhat narrower spread universe. A shrinking municipal market will introduce its own dynamic into the consideration.
The mortgage deduction is also a major consideration for municipals. The Senate plan maintains the current treatment in the tax code. The House version reduces the cap to $500,000. With a cap that low, valuations and assessed valuations will probably be reduced over time. How these two positions are reconciled depends on all of the other moving parts.
In the end assessment, the goal of this particular tax reform effort is to deliver the massive corporate tax cut, from 35% to 20%. A companion goal is to simplify matters and to provide relief in the form of middle class tax cuts. Concerning these latter two goals, the real truth of the matter will be the product of the final bill. On its face, the latter of these two goals has not been completely achieved at this point.
In a post-tax reform world, conservative states and localities may resort to selling even fewer bonds than they do now. More progressive states and localities are likely to continue to issue but the outcome will be at greater cost. The taxable market will find ways to accomplish the financings, but the transactions will not be accomplished on the terms that states and localities have become accustomed to in recent years. Underwriting spreads and fees have never been tighter than now in the municipal market. The taxable market does not adhere to the same practices.
Why can’t we just get along and let the municipal market function in its efficient manner? I know from a tax perspective it is not considered efficient from a revenue raising or spending perspective for the Treasury. However, those of us who work in and observe this market know that it is one of the best on delivering at low cost and providing a quality product.