Muni bonds and the tax reform fight

Trump's tax reform plan expires next year and that means the municipal market's low-cost financing structure could be threatened.

Photo by Joshua Woods on Unsplash

Happy weekend, readers! There’s a lot of uncertainty about the 2024 election but one thing is for sure whichever party comes out on top: Former President Trump’s tax reform act expires next year and tax breaks will be a hot topic. 

There are already signals that the low-cost financing available to governments through the municipal market will be targeted. This week’s newsletter looks at what’s the latest threat and what to expect in next year’s inevitable debate over the tax exemption for municipal bonds.

Yet another threat to the municipal bond tax exemption

The 2017 Tax Cuts and Jobs Act (TCJA) expires next year and many are worried about what that means for municipal bonds. At a panel I moderated earlier this month, both participants warned that members of Congress were likely to target the income tax exemption that helps fuel demand in the municipal market. In fact, the Government Finance Officers Association’s Emily Brock said it was one of the post-election questions that worried her most.

And with good reason: Last month, the conservative think tank AEI issued a report on how to make the TCJA permanent—a nearly $4 trillion cost over 10 years. Dumping the federal tax exemption on income municipal bond holders earn from those investments was among the many “pay-for” suggestions.

“That made my blood pressure go up,” Brock said at the conference hosted by the Council of Development Finance Agencies (CDFA). “It always feels like we have to defend the tax exemption.”

Such a move, said co-panelist Brett Bolton, from the Bond Dealers of America, would “kneecap state and local governments’ abilities to provide basic infrastructure.”

• Read the panel recap from the Bond Buyer (subscriber paywall)

How much would it save? According to the latest report from the Joint Committee on Taxation (JCT), the tax revenue the federal government forgoes on municipal bond interest totals just under $181 billion over five years (2022-26). 

That’s about $36 billion per year. For comparison (also according to the JCT report):

• The mortgage interest deduction costs $41 billion annually.

• The tax exemption for retirement and pension contributions and earnings costs an average of $404 billion annually.

• Exempting capital gains taxation on stock inherited after someone’s death costs just under $60 billion annually.

The biggest misconception about the muni bond tax exemption

Brock noted that she and others repeatedly have to defend the federal tax exemption for munis. A big reason is that it seems like it’s just a tax break for the rich. It most definitely is—muni bonds have historically been attractive to high-income earners as a way to shield income from taxation.

• Market Watch: Some wealthy households made lots of income but had no tax bill in 2020. Here’s how they pulled it off.

But that’s not all it does.

Because investors know they won’t have to pay federal taxes on the interest they earn on their municipal bond investments, they’re willing to accept a slightly lower rate of return on that investment.

This means that it costs less for states and municipalities to finance infrastructure projects than it would otherwise. 

In fact, a 2014 study found that the tax-exempt status of muni bonds has saved governments an estimated $714 billion in extra interest payments from 2000 to 2014. That’s $51 billion per year in taxpayer savings—much more than what the federal government gives up in revenue.