Jan. 13, 2003 — President Bush’s proposal to eliminate taxes on corporate dividends could cause problems for the municipal bond market.

At the very least, money managers and market watchers said, the plan might make stocks more appealing to individual investors, who have long bought municipal bonds because of their tax advantages. Interest income produced by bonds issued by state and local governments is not taxed by Washington, and often is not subject to state tax.

“Everything else being equal, (municipal bonds) would face some additional competition from (equities),” said Arnold Kaufman, editor of The Outlook, a Standard & Poor’s investment newsletter that focuses on corporate stock dividends.

“We think at the margin it certainly makes stocks more attractive,” Mary Miller, assistant director of fixed-income investments for T.Rowe Price Group (TROW), said of the administration’s plan to end taxation of dividend payments. Price oversees about $8.5 billion in municipal bond funds.

If enacted, the proposal also would force state and local governments issuing bonds to hike their yields to encourage people to invest in them, observers said.

Some, however, don’t believe municipal bonds or bond funds will suffer as a result of the tax law change.

Dick Berry, who manages about $1.2 billion in municipal bond funds for AIM Funds, said he doubted investors would pull out of munis “primarily because common stocks yield so little, and it’s hard to find many that even pay a dividend anymore.” Depending on their maturity, municipal bonds tend to yield about twice as much as stocks, he said.

Regardless of the tax status of dividends, municipal bonds will still appeal to people seeking investments that are less volatile and risky than stocks, some money managers said.

“I don’t think there is any advantage that is lost in a municipal bond offering if dividends become tax-free,” said Marc Freedman, a financial planner in Peabody, Mass. Freedman, the president of Freedman Financial, said he is not advising his clients to change their investments until the fate of the President’s proposal and its ultimate form are known.

Miller also noted that it is uncertain what changes will be made in the fiscal stimulus package unveiled by the President last week, if it is approved at all. In any case, people should not base their investment decisions solely on tax considerations, she said. Desired returns and risk tolerance are also part of the equation.

Similarly, the Vanguard Group, the second largest mutual fund complex, posted a notice on its website last week cautioning investors to resist changing their investment portfolios “based on the current proposals because any final legislation may be quite different.”

Although potential tax law changes can roil municipal bonds, the market for these securities has largely ignored the Bush plan so far, observers said. The lack of a reaction, Kaufman said, shows “there’s a good deal of skepticism about whether (the plan) will pass and what final shape it will take.”