Municipal Bonds Face-off With Fundamental Tax Reform

Interest earned on municipal bonds has been exempt from federal taxes since the tax code was adopted, but policymakers interested in fundamental tax reform have recently considered making a change. As reported in Governing, federal policymakers have considered making the shift before but are now eyeing it more closely,

Concerns over the exemption have been mounting for state and local leaders over several years. In 2011, the Simpson-Bowles commission proposed revoking the tax-exempt status of muni bond earnings. Last year, President Obama proposed capping it. Now there’s a fear in some circles that with Washington’s interest in deficit reduction, lawmakers are likely to tinker with the exemption. A recent report by Citi says that the exemption faces the biggest threat it’s faced since tax reform in the 1980s.

The Tax Policy Center recently hosted a panel discussion focusing on the impact of tax changes on state and local governments.  Forbes magazine recently posed the question, Should Congress Curb Tax-Exempt Municipal Bonds?, and Bloomberg news reported how reducing the tax break on municipal bonds would be “an instant job killer” according to a delegation of U.S. Mayors lobbying Capitol Hill.

Determining the effect of a curb on tax-exempt status of municipal bonds is difficult before the specifics are known.  As described by Governing,

Just how much could a change cost state and local governments? It’s hard to say. Lawmakers might choose to cap the benefit so that it’s only fully enjoyed by those in the 28 percent tax bracket or below (investors in a higher bracket would be left paying the difference). Or the exemption could be capped at a certain dollar amount. The exemption could be eliminated altogether. Or Congress could do nothing to it.

One Maryland official is quoted as summing up the effect simply,

“All this really does is shift who pays from the federal government to local governments,” said Timothy Firestine, chief administrative officer of Montgomery County, Md.  “You look at who built most of the basic infrastructure in the country, and it happens at the local level.”

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