(Photo: AP)

If and when President Donald Trump unveils his latest tax plan, which could be as early as Wednesday, financial advisors working with wealthy clients may want to pay particular attention to the treatment of municipal bonds.

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Many wealthy investors own municipal bonds or municipal bond funds because the interest on those bonds are exempt from federal, state and local income taxes. Those clients would benefit from cuts in the top marginal income tax rates, but the value of their muni holdings could drop if tax deductions on itemized returns are capped and if the deduction for state and local income taxes from federal taxes is eliminated.

Demand for munis could also decline if marginal corporate tax rates are cut since banks and insurance companies have been buyers of munis, according to Christopher Ryon, a municipal bond fund portfolio manager at Thornburg Investment Management.

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There’s also the possibility that municipal bonds could lose their tax-exempt status, but that appears less likely than the loss of the state and local tax deduction from federal returns.

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There’s no specific proposal yet, but Trump’s various tax plans to date and the most recent Republican tax plan “imply that they would get rid of most tax deductions,” says Howard Gleckman, senior fellow at the Urban-Brookings Tax Policy Center, a nonpartisan think tank based in Washington. “The assumption that everyone makes is that the state and local deduction will be on the block, and they’re probably right.”

Deductions would be eliminated or capped to help make up for the revenue lost from personal and corporate income tax cuts, and that would likely affect the muni market in states and cities that levy income taxes.

“If the state and local tax deduction is ended, it will be much more difficult for states and localities to raise taxes to pay their bills,” says Gleckman.

Those governments could turn more to revenue bonds, whose interest payments are tied to revenues collected from tolls or user fees, but there are no revenues for many of the projects that muni bonds pay for such as schools.

Those projects are usually financed with the general obligation bonds backed by the credit and taxing power of the issuer, but if governments have less ability to raise more taxes they could have a harder time servicing that debt.

“That’s where governors are in a real jam,” says Gleckman.

In addition to issuing more revenue bonds, states and municipalities could possibly issue more Build America Bonds, which are taxable, if the program, which expired in 2010, is renewed. That could happen as part of an infrastructure spending program if and when the White House offers one.

Under the Build America Bond program, issuers could receive a direct federal subsidy from the U.S. to help fund a portion of the borrowing costs or they could offer a tax credit to buyers – both equal to 35% of the interest costs.

Another option for high-tax states and municipals to fund projects if the state and local tax deduction is eliminated is to find other means to finance projects, including “raising prices of certain services,” says John Mouseau, director of fixed income at Cumberland Advisors.

Scott Greenberg, an analyst at the Tax Foundation, doesn’t expect that elimination of the state and local tax deduction will have much impact on the municipal bond market in the short run but says the change “might push a jurisdiction over the edge,” depending on “how much revenue they need in the future.”

Gleckman says it’s difficult for muni investors now to “make any kind of sensible judgment on what to do. You can’t even know as investor what your tax rate will be a year from now.”

What could be even more important for investors, says Gleckman, is “what’s going to happen to overall economy. It will swamp anything that happens to a tax bill.”

A new survey from Bankrate.com found that the biggest threat to the U.S. economy over the next six months is the political climate in Washington. Indeed, the federal government could shut down as of midnight this Friday if President Trump doesn’t sign a new spending bill — which Congress has yet to pass — into law.

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