GFOA: Concerns with Capping the Exemption of Muni Bond InterestA cap on the exemption of tax-exempt municipal bond interest would have the effect of increasing borrowing costs for state and local governments. A partial tax on otherwise tax-exempt municipal bond interest earned by certain taxpayers would cause investors to demand higher returns on their municipal bond investments to absorb the taxes they would now have to pay.
In addition to higher borrowing costs for state and local governments, there will be less investment in infrastructure, and fewer jobs. Such action would come at the wrong time when the country continues its economic recovery, state and local finances are already under pressure and infrastructure investment is woefully inadequate.
The federal tax-exemption on municipal bond interest has been in place since the income tax was promulgated in 1913. As a result, state and local governments save, on average, approximately two percentage points on their borrowing to finance investment in public infrastructure. It has generated trillions of dollars of investment in vital public infrastructure and has saved state and local governments hundreds of billions in interest costs.
28% Cap on Deductions and Exemptions
Investors with adjusted gross income exceeding the thresholds set by the President’s proposal ($200,000 for individual and $250,000 for married taxpayers) would no longer be able to receive the full benefit of various tax deductions, adjustments and exemptions. This includes limiting the current full tax-exemption on interest earned from municipal securities. The proposal places a 28% cap on the exemption, which would effectively impose a 7% tax on otherwise tax-exempt interest for investors in the 35-percent bracket. To illustrate –
| ||Currently a person in the 35% bracket earning $100,000 in tax exempt interest effectively saves $35,000, due to the fact that the interest is not taxed. (If the investor had $100,000 in a taxable investment they would pay $35,000 in taxes.) However, under the President’s proposal, this same investor would not receive the 35%/$35,000 benefit - instead the benefit would be capped at 28%. This means that same $100,000 in municipal interest is only worth a $28,000 tax benefit (vs. a current $35,000 benefit); and the investor would be responsible for paying tax on the $7,000 of interest. This would thus make income on tax-exempt bond interest, taxable. |
An additional concern with this proposal is that it would apply to interest on bonds that have already been issued and investors have already purchased. This would represent a violation of the basic assumption by investors that Congress will not change the terms governing the taxability of interest for bonds already outstanding. In the nearly 100 year history of the tax-exemption, Congress has never applied a retroactive tax to bonds already held by investors. By proposing to affect the tax exempt interest benefit on outstanding bonds, as well as on bonds sold in the future, the proposal creates an element of tax risk for investors who would expect to be compensated for this new risk. It is estimated that state and local borrowing rates could rise between 60-75 basis points if the proposal is enacted.
Dollar Threshold Cap on Deductions and Exemptions (e.g., $50,000)
Another type of cap would limit the total amount that taxpayers from ALL income brackets may use for federal income tax purposes. For instance, Congress could set a limit, for example $50,000, for all of their deductions and exemptions (e.g., home mortgage, charitable, state and local taxes, municipal bond interest) that a taxpayer may take on their federal return. This type of proposal could lead to there being no benefit to a taxpayer earning tax exempt interest because the limit of the amount that they can use, may be reached by other types of deductions and exemptions. Because this proposal would affect all taxpayers and could lead to a zero tax benefit for municipal securities, it is estimated that state and local borrowing costs could rise between 120-150 basis points if this proposal is enacted.
The costs of these proposals would be borne not by investors but by state and local governments in the form of higher borrowing costs. The vast majority of state and local borrowing is undertaken to finance schools, roads, water and sewer systems, airports, transit systems and other vital public infrastructure. Higher borrowing costs for state and local governments would translate into less investment in infrastructure and fewer jobs.