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Administration Proposal Eliminates Tax Free Status of Muni Bonds for the Affluent

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President Barack Obama’s deficit reduction plan includes a controversial call for eliminating the tax-free status of muni bonds for affluent taxpayers. The provision would dramatically impact planning options for the retirees who favor tax-free bonds, and also shift the way state and local governments secure much needed funding for public projects.

The administration can expect strong resistance to the proposal from Republicans and state and local governments that rely on the tax-free status of their bonds to create additional demand and lower their borrowing costs. Investors are willing to take much lower returns on municipal bonds than they are on other investments since income on the bonds is not taxed. That keeps the cost of borrowing down for states and local governments. Eliminate the tax break and states will see their borrowing costs rise significantly.

Obama has not released any data on how his proposal would affect investors and bond issuers. But California Treasurer Bill Lockyer said earlier this month that trimming the tax-free status of munis could cost California $7.7 billion—at a time when California, and many other states, are struggling to stay afloat. Many investors are already leery of munis after a group of municipalities declared bankruptcy following the financial crisis.

The states have significant power in Washington, D.C., which forced the president to include provisions in his plan that would give states two-year interest-free loans to cover unemployment benefits when they run out of cash and another that would provide cash to the states to pay their public employees.

At its essence, the president’s muni bond plan would not generate positive cash flow for the government; it would just shift income from muni bond investors to public-sector employees. The president’s proposal, which would affect only taxpayers making $200,000 or more, would bring in an estimated $32 billion for the federal government. At the same time, it would give the states $35 billion to help avoid public employee layoffs.

If the president’s muni bond proposal won’t actually cut the deficit, what’s prompting the move? One possibility is that the president is trying to strengthen Washington’s power in the states. Without the exemption, states will have a harder time funding their projects, and the federal government will be positioned to step in with its Build America bonds program.

That program reduces the cost of borrowing for states and local governments by offering issuers and purchasers subsidies and tax credits. Extension of the program could be conditioned on state compliance with federal initiatives.

In addition to hurting the states, eliminating the muni bond interest exemption would hurt retirees at a time when retirement security is at a modern day low. The plan would apply to all bonds, including new and outstanding bonds. As a result, existing bonds, with their low yields, would instantaneously lose their appeal,  which could send investors scrambling to divest themselves of their existing muni bond holdings.

Municipal bonds are the foundation of many retirees tax management strategies since they can be a good supplemental investment for people who have maxed out their IRAs and other tax advantaged retirement plans. Taking away the muni bond interest exemption would strike at the already fragile retirement plans of many Americans.

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See also The Law Professor’s blog at AdvisorFYI.