By Liam Denning / Bloomberg Opinion
Much of politics boils down to a fight over who pays for what. One live, if under the radar, debate about the looming Republican tax bill and municipal bonds certainly fits that description.
But it also goes way beyond, encompassing the physical fabric of daily life and the financial fabric of local democracy. Muni bonds, a $4.1 trillion market, are the lifeblood of state and local spending, as well as quasi-public entities such as non-profit hospitals and charter schools. Interest paid on these bonds has been tax exempt forever; as have attempts to overturn that. Now a combination of the explosion in federal debt since 2008 plus Republicans’ search for offsets to extend the 2017 tax cuts present a potentially powerful catalyst.
A leaked GOP menu of potential tax-cut ‘pay-fors’ projected that ending the muni exemption would save $250 billion over 10 years. Stephen Moore, an economic whisperer to President Trump, recently re-floated the idea of closing this “loophole.” Meanwhile, Scott Greenberg, tax counsel to the House Ways and Means Committee, is a former think-tanker who happened to write a prominent anti-muni-exemption paper in 2016. “The threat is real,” says Matt Fabian, partner at Municipal Market Analytics Inc., a research firm.
Investors are exempt from paying federal tax — and, in many cases, state tax, too — on the interest earned on an estimated 85 percent of muni bonds. Unlike most other bonds, therefore, they are mainly held by individuals. The tax shield subsidizes local investment by encouraging bondholders to accept a lower yield. The market is also extraordinarily fragmented, encompassing big states like California and tiny rural villages, with somewhere in the region of 40,000-50,000 issuers.
Canning the exemption would deliver a price shock. There is some relevant history here: When a similar proposal was raised in the Senate Finance Committee in March 1986, The New York Times reported that trading in munis “ground to a virtual standstill.”
A recent analysis by the Government Finance Officers Association calculated an average spread between taxable and tax-exempt muni bonds of 2.1 percentage points. Even if the market’s fragmentation suggests a range of such spreads applying, bumping the yield of a new 10-year, 3.5 percent bond by that much would imply a 16 percent price cut and a roughly 40 percent increase in interest charges. The GFOA estimates the incremental collective cost over 10 years at north of $800 billion, or around $6,500 per U.S. household. States and localities would either have to raise other charges such as property taxes to compensate or simply curtail investment and services. For many, a measure touted as securing a federal tax cut would amount to an effective local tax increase.
Beyond the issue of cost, however, there is a more existential one of access. As it is, the muni market is incredibly lopsided, with a very long tail of small entities. Fabian says that out of about 37,000 issuers listed on Bloomberg, some 19,000 account for less than 10 percent of the market. Justin Marlowe, director of the University of Chicago’s Center for Municipal Finance, says the 100 most actively traded muni issuers account for half the liquidity in secondary trading. Meanwhile, he adds, a recent analysis by his department shows that, on average, 52 percent of issuers in a typical Congressional district are infrequent borrowers with a relatively small amount of bonds outstanding.
Take away the exemption and there’s no doubt that the taxable munis’ higher yields and diversification attributes will attract some financial institutions and international investors, but they are more likely to target bigger issuers. Thousands of smaller, less liquid ones, many lacking a credit rating or much financial disclosure, might find no ready buyers at an affordable yield once the retail crowd loses its main rationale. At that point, Nowhereville’s sewer system would be just another, rather obscure issuer fighting for attention in the vast sea of taxable corporate and sovereign bonds.
There are potential workarounds. Marlowe points to the “regionalization” of municipal finance, such as establishing state banks, which could borrow big in the muni market and then lend to smaller entities downstream, or grouping multiple issuers into bigger entities like regional transit authorities or co-operatives. The added friction would still generate higher costs and take time to evolve, however. More importantly, these wouldn’t fix the other big issue: Loss of autonomy.
It’s worth recalling that the initial, late-19th century justification for exempting munis from federal tax wasn’t financial but instead constitutional, holding that the federal government couldn’t tax income derived from state activities. Subsequent Supreme Court rulings have determined that muni interest income can be taxed if politicians will it. Yet, even if that older issue is now legally moot, the ramifications for the relationship between federal, state and local authorities remains.
Replacing the exemption with, say a state infrastructure bank or federal grants — improbable, given the GOP’s priority of clawing back revenue — might mitigate issues of cost and access to funding. But those options would undoubtedly come with strings attached: Greater oversight from afar, standardized conditions, changing terms. The same goes for grouping issuers together. Meanwhile, a further alternative, privatizing municipal assets outright, would subject locals to the demands, and rates, of profit-seeking entities.
The tax exemption doesn’t just provide cheaper funding to mayors, county officials and statehouses, but also a degree of freedom to chart their own course, as moderated by the market and residents’ support. Should munis lose their tax shield, it would not merely roil a peculiarly American market, but the peculiarly diffuse practice of American governance, too.
Liam Denning is a Bloomberg Opinion columnist covering energy. A former banker, he edited the Wall Street Journal’s Heard on the Street column and wrote the Financial Times’s Lex column.
Talk to us
> Give us your news tips.
> Send us a letter to the editor.
> More Herald contact information.
