(Updates with Morgan Stanley research in eighth paragraph.)
Sept. 13 (Bloomberg) -- President Barack Obama proposed curbing the amount of interest from municipal bonds that top earners can exclude from their taxable income, a step that may diminish demand for state and local-government securities.
The president’s $447 billion job-creation plan would pare the tax break for municipal-bond interest to 28 percent for couples earning more than $250,000 a year. Such tax-exempt interest is currently worth 35 percent for earners in the top tax bracket because that’s the amount they would otherwise have to pay on their income.
Any move to limit the tax advantage for municipal securities would face resistance from local-government officials because the break bolsters demand for their debt, lowering the interest rates they pay when borrowing for public works. Investors in the $2.9 trillion market for municipal bonds are willing to accept lower returns because the income isn’t taxed.
“We’re very much opposed” to limiting the tax exemption, said Mike Nicholas, chief executive of the Bond Dealers of America, a Washington-based lobbying group for banks that underwrite municipal bonds. “You’re going to end up punishing state and local governments.”
States, cities and counties have yet to fully recover from the strains of the 18-month recession that ended in June 2009. States faced budget deficits of about $89 billion this fiscal year, according to the National Conference of State Legislatures. State and local governments combined have cut 680,000 jobs since 2008, according to Labor Department statistics.
The tax break has faced challenges in Congress amid a push to rein in the federal deficit, though no proposals have advanced. The president’s deficit-reduction commission recommended scrapping it last year as part of an overhaul of the U.S. tax code, while Senator Ron Wyden, a Democrat from Oregon, proposed replacing the tax exemption with a credit.
The proposal had limited impact on trading in municipal securities today. Top-rated municipal debt maturing in 10 years yielded about 2.06 percent, little changed from yesterday, according to BVAL pricing data.
Morgan Stanley analysts found little correlation going back to 1983 between tax changes and prices of municipal bonds. Shifts in tax rates were trumped by investor perceptions of credit risk and liquidity, the analysts said in a report today.
Scott Eldridge, director of portfolio management for Caprin Asset Management in Richmond, Virginia, said he’s seen no signs of investors selling bonds on the proposed change, which he expects would face political obstacles given the cost it would impose on state and local governments.
“We haven’t seen anything to suggest that the market is reacting to this now,” said Eldridge, whose company holds about $800 million of municipal bonds.
Republicans gave the president’s jobs plan a tepid reaction. Michael Steel, a spokesman for House Speaker John Boehner, an Ohio Republican, criticized the proposal, which also seeks to roll back breaks for private-equity fund managers and oil companies, as a tax on businesses.
While previous efforts to repeal the exemption have faltered, there’s concern that it may be drawn into efforts to curb the federal deficit, said Lars Etzkorn, a lobbyist for the National League of Cities.
“We’re concerned that some budget-control exercise could get out of control,” he said.
The president’s proposal is narrower and would only limit the benefits, not revoke them entirely, for those in the top tax brackets. It is part of a group of tax breaks targeted to pay for a plan designed to stimulate the economy in part by giving states aid to keep teachers and emergency-worker jobs.
The proposed change, which was included on page 136 of the 155-page bill, wasn’t trumpeted by the administration. The measure would take effect at the start of 2013, according to a summary from the administration.
The Government Finance Officers Association, which represents public borrowers, said it was concerned about any move to limit the tax exemption for municipal securities.
“Limiting the amount of tax-exempt interest that can be deducted would likely affect demand and therefore increase debt- issuance costs for all governments who need to access the bond market,” said Susan Gaffney, a Washington lobbyist for the group.
The plan would curb the value of the tax break to the benefit it affords to earners in the 28 percent bracket. The exemption effectively provides a 35 percent tax break for top earners because that’s what they pay on other income. For couples earning less than $250,000, or individuals below $200,000 for single taxpayers, there would be no change, said Meg Reilly, a spokeswoman for the White House Office of Management and Budget.
Local governments will probably rally to oppose the measure, said Michael Schroeder, president and chief investment officer of Wasmer, Schroeder & Co., which manages about $3 billion of municipal bonds in Naples, Florida.
“There’s a healthy skepticism about it passing in its current form,” he said. “As written it’s dead on arrival.”
--With assistance from Darrell Preston in Dallas. Editors: Jodi Schneider, Mark Tannenbaum, Mark Schoifet
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