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Could Municipal Bonds Lose Their Tax-Exempt Status?

Posted by: Ben Levisohn on August 19, 2009

Will municipal bonds lose their tax exempt status? That’s the proposal found on page 211 of a 264 page report titled “Budget Options, Volume 2,” that the Congressional Budget Office released on Aug. 6. The CBO proposes eliminating the tax-exempt status of state and local government bonds in favor of tax credits.

The move would bring an estimated $19.8 billion into government coffers from 2010-2019, but investors in the top tax bracket would probably pay more than they currently save by buying munis. At least that appears gist of this phrase: “…switching to the credit would prevent bondholders from receiving gains that exceed the investment returns necessary to induce them to buy the bonds.”

The proposal was, however, just one of 66 made in the second volume of the report and the Bond Buyer reported that muni market pros didn’t expect the proposal to become reality. “…the potential revenue gains are relatively small compared to other options and might not be worth the backlash,” it quoted experts as saying.

Here’s the question: Would you continue to invest in munis if their tax exempt status was replaced with a tax credit?

Reader Comments

john boeger

August 19, 2009 8:13 PM

i am in favor of all persons, who owe taxes and who pay those taxes, receiving all health care and free education for their children that they are entitled under the law. i am against illegal immigrants or anyone who does not have a valid social security number from receiving those same benefits because they could not be valid taxpayers. anyone who conspires and helps violate these principles is obviously a lawbreaker or a person who has interests in seeing to it that some persons pay taxes and others do not. this would include quite a few politicians. i wonder what would happen if the top 15 million income earners in this country did not pay any of their taxes?

note--good work by the justice dep. in going after persons with secrete swiss accts.


August 19, 2009 11:38 PM

Absolutely NOT! The tax exemption is a known variable. Under the proposed credit idea, the Treasury would determine the amount of the credit and that could lead to a lesser amount for the taxpayer. Never trust the government to do the right thing.


August 20, 2009 1:35 AM

Last time I checked, the Constitution say that the Federal Government cannot tax Munis


August 20, 2009 9:15 AM

I wouldn't invest in muni bonds now, even as they are. Why would anyone want to invest in securities where the issuers base their ability to pay interest and repay principal to the bondholders based largely on tax receipts.. which are down almost 20% nationally. It's easy to buy a muni bond, but try to sell it and you have a big fat loss. Plus all muni bonds are on credit watch for downgrade. When your muni bond gets downgraded you suffer a big loss. Keep 'em! People don't care what quality investment they buy, they only care about the yield today and "gulp" as to whether they will ever get their principal back.


August 20, 2009 9:30 AM

You can do anything on a going forward basis without affecting existing bonds.

The real question, in my mind, is what the bonds are issued for. Should we have municipal bonds for arenas?

Slick Rick

August 20, 2009 10:27 AM

Absolutely. Tax exemption is priced in to the yield, so without it investors would just seek higher returns. This will end up hurting states though, because now they will be paying larger returns and waiting till April to collect their income, where before they had it netted out.


August 20, 2009 10:39 AM

Would this credit trigger the Alternative Minimum Tax or would the credit be exempt from the Alternative Minimum Tax? If the credit would the income exempt from AMT it could benefit some taxpayers.


August 20, 2009 12:31 PM

Here's a better idea, let's tax the interest only on Munis that finance assets not owned by the issuing authority. If the investors of Nationwide Arena try to blackmail the city of Columbus, OH into issuing bonds for them, the feds could take away the bonds tax exempt status, rendering the bonds useless.


August 20, 2009 1:21 PM

When I went through economics class many years ago I was taught the primary reason for the existance of municiple bonds was for municipalities to ba able to finance public projects at a lower finance rate than borrowing on the open market. Eliminating the tax exempt status would harm the public more than the tax revenue raised would benefit.


August 20, 2009 1:31 PM

Munis currently are a perfect non-IRA retirement investment. If the tax exemption were eliminated in favor of a tax credit, this would be useless to those of us who have no or little taxable income.


August 20, 2009 2:37 PM

These last two are just ridiculous.

If you don't trust the government, why even consider municipal bonds in the first place?

"Last time I checked, the Constitution say that the Federal Government cannot tax Munis" Are you kidding me? Care to read it again?

btw, yes I will continue to invest in munis as long as the net return remains competitive. I'm in a low tax bracket anyway.


August 20, 2009 3:50 PM

To upset another American system that has worked as well as the municipal market has worked and saved the various municipalities in keeping their costs of doing business at a managable level would be the best way to keep the economy from ever getting back on track.

econ grad

August 20, 2009 5:13 PM

This proposal will do three things:

1. Raise money for the federal government

2. Increase taxes on the wealthy

3. Increase borrowing costs for municipalities

1 is good for all of us 2 is good for some of us and 3 is bad for all of us. Average Joe people who like this idea because they think rich people have been getting a free ride in munis should know that they will pay more in local taxes even though they have never bought and never will buy mini bonds.

Ask an economist - taxing muni bonds is a tax for all of us.


August 21, 2009 9:42 AM

This doesn't save the tapayer a dime. Any dollar you save as a tax payer on the federal level, you will have to pay on the municipal level. It's simple math.

Further, why should corporations be allowed to issue tax free debt, but not munis? Corporations write interest expenses off of their taxable income, thus they don't pay the federal government taxes on their debt. It's simply a shell game. The federal goverment either subsides debt by not taxing the bond holder (munis) or not taxing the bond issuer (corps).

Yet no one is out there lobbying to repel corporate exemption of interest costs.

It's almost as if the corporates have better lobbyists at the federal level than munis....


August 21, 2009 12:43 PM

In direct answer to your question, NO, I would not have bought any of my tax exempt investments absent the tax exemption. This is an insanely idiotic idea both in an absolute sense and relative to other ideas.


August 21, 2009 9:42 PM

Joe is would like to point out that there is a large portion of Article 1 of the Constitution that deals with "intergovernmental tax immunity" and was left wide open in Polluck v. Farmers .... do your research before claiming something is ridiculous. The federal government does tax munis because they're being nice.

Rusty Cage

August 25, 2009 4:47 PM

No, I'm not a buyer if the bonds lose their exemption status. And, Mark-Anthony is correct. I remember the case of States' bonds possibly losing exemption status to enable the Federal Government to recover taxes, reaching the Supreme Court in the late 1780's, and the Feds lost. The States' abilities to raise funds through bonds, tax exempt, has remained ever since.


August 25, 2009 6:05 PM

Muni bonds, tax credits, deductions, etc. promote lower GDP growth as each entity will focus on avoiding tax versus producting more product.

Effort and cost spent in tax avoidance could be used to build product for export, improve infrastructure, etc.


August 26, 2009 1:45 AM

Well, Mark-Antony, maybe you should dig a little deeper regarding that case. From the Supreme Court syllabus in THAT case.....

"A tax upon income derived from the interest of bonds issued by a municipal corporation is a tax upon the power of the State and its instrumentalities to borrow money, and is consequently repugnant to the Constitution of the United States." Do your research.

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