Slapping federal taxes on municipal bonds, a big temptation for a federal government craving more revenue, could in fact hurt the cities and states that issue the bonds, Larry Swedroe, principal and director of research for the BAM Alliance, wrote in an article for CBS MoneyWatch.
The reason is that if municipal bonds were taxed at the federal level, municipal issuers would have to pay higher interest rates on their debt to holders, ultimately earning less money on those instruments.
By some estimates, the U.S. government forgoes about $32 billion a year in taxes by exempting municipal bonds.
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There are at least three proposals floating around in Washington to take away a slice of municipal bond revenues from localities, according to Swedroe. One would take away the exemption for munis that raise money for business, but still allow the exemption for bonds that finance public works.
The second would allow taxing all municipal bonds, and the third would allow the exemption only up to 28 percent.
“While the federal government would collect more revenue, municipal finances would take a hit,” he wrote.
“We can only wonder how many people believe that a shift in revenue from local government to the federal government is a good idea.”
Currently, 10-year AA-rated municipal bonds are yielding more than the 10-year U.S. Treasury, in part because the market is pricing in the danger that the federal government could swoop in to tax even existing municipal bonds, Swedroe noted.
“So municipalities are currently paying higher rates simply because of the threat of their debt being taxed.”
The only reason munis have historically traded at a discount to Treasury bonds of the same maturity has been their tax exemption, he said. Without the exemption, investors would most likely demand significantly higher rates on munis.
Forbes quoted one well-known municipal bond advisers as suggesting in a year-end letter to clients that “some portion of the income you receive from so-called ‘tax-exempt’ municipal bonds will be subject to Federal income tax.”
Nevertheless, First Manhattan Co., a leading manager of tax-free bond porfolios, strongly advised its clients not to sell munis and to possibly use any opportunity to accumulate more munis should “turbulence” cause prices to decline, Forbes said.
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