In this article we consider the current environment and congressional discussions related to the potential removal or cap of the municipal tax exemption. We see the outright removal of the federal tax exemption from exempt municipal bonds as a low probability but not zero, and we believe that if the federal exemption were to be fully rescinded it would likely be done prospectively (not retroactively) — which would reduce some of the federal benefit. There may instead be a cap applied on municipal bond interest exemptions, possibly 28%, which would have a more likely path in our view to be applied retroactively but would still generate less savings at the federal level while creating financial pressure on state and local governments (SLGs). The cap is not a new consideration. It was proposed by the Obama administration in its 2013, 2014, and 2016 fiscal year budgets; and it will continue to face significant opposition, as it did then. We continue to monitor, as this is a highly uncertain environment. The municipal exemption is one of many areas being reviewed as a potential federal cost savings.
The Numbers
The full elimination of the federal exemption would generate approximately $250 billion in federal tax receipts over 10yrs — that is less than 1.5% of total federal tax expenditures.
The cost of a full elimination to state and local governments, reflecting the increase in borrowing costs (higher yields), would be around 35% to 40% higher, or an increase in costs to SLGs of $824 billion.
Alternatively, a 28% cap on the exemption might provide federal tax receipts of under $50 billion.
SLG Ramifications
Infrastructure projects (schools, affordable housing, etc.) would potentially be reduced or kicked down the road as their price tags increase.
- Refinancing current debt burdens would become a much higher hurdle for SLGs.
- With a cap or elimination of the exemption, the municipal bond buyer base might be reduced, limiting available capital to SLGs and making projects more expensive.
The Hurdles
The exemption has been in place since 1913, and the biggest impact to its removal would be the downstream effect to SLGs.
- Historically, as a precedent, Congress has often applied changes to tax laws prospectively, not retroactively.
- Common sense would suggest that removing the exemption retroactively would face intense scrutiny and legal challenges citing contract law and due process.
- Currently issued bonds are generally deemed legal contracts with a promise to repay, covenants, official documents, and enforceability.
- Contract Clause: Constitution Article I, Section 10
- As this clause restricts only at the state level, we consider the argument may be deemed weak at pushing against a change at the federal level.
- Due Process Clause: 5th Amendment and 14th Amendment
- While providing legal challenge arguments, the federal government could justify the action based on federal legislative power over tax policy (Article I, Section 8).
The much lower potential tax receipts attainable from applying a 28% cap on the interest exemption may reduce the political will at the federal level when balanced against resulting state and local government impact, legal challenges, and investor impact on constituents.
Potential Market Impacts:
While we believe the probability of the exemption’s being fully eliminated or capped is low, we still consider the ramifications. A number of potential impacts should be considered:
A prospective (vs retroactive) full elimination of the municipal exemption
- may favor existing muni bonds due to their future scarcity and supply versus demand, but there is a relative cap to how valuable an exempt municipal can effectively remain relative to Treasuries. When the tax benefit of the exemption is fully realized in the price, any further upside versus Treasuries is largely tapped out.
- may result in lower-rated and/or higher-leveraged municipalities facing pressure as their ability to raise funds for operations may become strained and thus incur downgrade risk. These may underperform.
- may result in longer-dated municipals that maintain the exemption having the highest demand and likely the biggest positive move in ratios relative to Treasuries.
- may result in a lower probability of call exercises on exempt paper, as refinancing opportunity would decrease significantly, thereby increasing effective durations and (once again) demand for longer municipals that are grandfathered — potentially favoring lower coupons.
- A retroactive (vs prospective) full elimination of the municipal exemption
- would be a high-impact event for both SLGs and millions of individual investors (households). Again, we view a retroactive change as a low probability.
- may undermine investor trust in the federal government and potentially lead to a risk-off.
- may see existing municipals adjust market yields to an equivalency of taxable yields and a removal of a buyer base. The addition of more taxable municipals to the overall market may widen spreads from current levels.
- may see credits experience downgrades resulting from higher financing costs.
- A cap of the municipal bond income exemption for investors
- may see some reduction in the buyer base for municipal bonds, putting pressure on liquidity and pricing
- may see significant widening in municipal bonds immediately as the exemption benefit is reset into valuation and ratios to Treasuries.
- may continue to see demand in the market for municipal bonds, but with adjusted values for both reduced liquidity and a reduced tax benefit.
The discussion about the municipal bond federal exemption falls into the overall landscape of ‘uncertainties’ in the market right now. This exemption has been considered and proposed in the past and will continue to face heavy opposition. While no one can say with conviction what lies ahead, we are considering the potential outcomes and weighing the conviction of our probabilities. We will continue to monitor.
Benjamin C. Pease
EVP & Managing Director of Asset Management | Chief Innovation Officer
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