After the Cedar River overflowed and caused extensive damage to Linn County, Iowa, five years ago, county supervisors floated about $20 million in tax-exempt municipal bonds to repair the devastation and minimize the impact of future floods.

Today, Supervisor Linda Langston worries that proposals to eliminate or cap the tax-free status of municipal bonds could significantly limit the ability of state and local governments to raise capital for similar disasters. Without the tax-free bonds, governments could not meet emergencies, improve the safety of roads and bridges, treat water and sewage or build new schools and municipal facilities, she says.

“It would definitely have cost more to rebuild after the flood and would have handed the bill to local taxpayers,” she says. “When you can’t do the borrowing, it means you don’t have the same capacity to make the improvements.”

President Barack Obama’s Fiscal Year 2014 budget proposal to cap the interest exemption for municipal bonds at 28 percent for higher income taxpayers has prompted local leaders to rally around a provision as old as the tax code itself. Those leaders argue that the nation’s already deteriorating infrastructure would suffer further damage if local governments were forced to pay hundreds of billion of dollars more to float their bonds at rates now paid by the private sector.

The proposal also has provided a forum for tax experts who contend the current system unnecessarily benefits the wealthy and, in some cases, business. They also claim that it shifts the burden of local borrowing to federal taxpayers and induces borrowing beyond prudent levels, simply because bonds are so inexpensive.

“The thought of losing this provision sends local officials into a panic frenzy,” says Scott Hodge of the Tax Foundation, a nonpartisan tax think tank, that advocates eliminating the provision completely for new bonds. “People want what appears to be free. They don’t want you to mess with it.”

Moneypenny – proposals also affecting municipal wallets

Local government leaders disagree with that assessment but concede that they have to be flexible in working with Congress. They admit that they might have to accept some limitation on passing their favorable tax treatment to private corporations, even if the money is used for public benefit. They caution that other proposals before Congress would damage local government and also merit vigilance.

“This is one issue,” says Philadelphia Mayor and president of the Conference of Mayors Michael Nutter. “We need to pay attention to what’s happening in other quarters, pay attention to a lot of issues. We are players in a vast arena.”

The municipal bond controversy is tied to proposals to eliminate tax loopholes in the bloated federal tax code, an effort that has a great deal of support among Democrats and Republicans in both the Senate and House of Representatives. Both tax-writing committees are working on tax code reform, but prospects for passage of a bill that reaches the President’s desk remain unclear, considering the current legislative stalemate.

 Public sector officials are taking no chances. They have been actively sending letters and visiting local representatives to persuade Congress to leave municipal bond interest untouched. They have been somewhat encouraged by House Majority Leader Eric Cantor’s recent comments as well as a letter sent to the President from a group of Senators, all saying they do not support limiting the deduction.

But local leaders are not convinced that the battle is won. “We are taking this very seriously,” says Matthew Chase, executive director of the National Association of Counties. “We’re hearing mixed messages from Congress.”

Public officials have mobilized so strongly to protect the tax status of municipal bonds, because they are the primary source of funding for infrastructure projects for communities of all sizes. According to a report that was prepared for a coalition of public sector groups, state and local governments financed more than $1.65 trillion in infrastructure investment using tax-exempt bonds in the last decade – nearly all in six categories:

• $514 billion in primary and secondary schools;
• $288 billion in hospitals;
• $258 billion in water and sewer facilities;
• $178 billion in roads, highways and streets;
• $147 billion in public power projects; and
• $106 billion in mass transit.

If the proposed 28-percent cap had been in effect during that time, the report says borrowing costs to states and localities of these bonds would have increased by $173 billion, and by $495 billion if eliminated entirely. In 2012 alone, more than 6,600 tax-exempt municipal bonds financed more than $179 billion worth of infrastructure projects. The report also contends that capping the tax benefit would raise the interest rate on municipal bonds by 0.7 percent or, for example, from 2 percent to 2.7 percent.

High-income taxpayers accept a lower interest rate on municipal bonds because the interest they earn on the bonds is not taxed — a significant benefit. For example, if a taxpayer in the 35 percent tax bracket received $100,000 in interest, they would save $35,000 in taxes. If the benefit were capped at 28 percent, they would save only $28,000, amounting to a tax increase of $7,000. Eliminating the tax benefit entirely would increase their taxes by the full $35,000.

Because most of the money raised through the bonds repair and expand the nation’s infrastructure, increasing the cost of projects doesn’t make sense, says Lars Etzkorn, who heads federal relations for the National League of Cities. “There are decades and decades of deferred maintenance and the federal government doesn’t have the capacity to take care of it,” he says. “It’s a disconnect to talk about retarding a program that’s key to the local effort.”

A Gentlemen’s Disagreement

The arguments to reform the taxation of municipal bonds come in two varieties. One group contends that Congress should end the tax-free status of the bonds altogether, so that they are treated on the same level playing field as private sector bonds. This group includes the National Commission on Fiscal Responsibility and Reform, known as the Simpson-Bowles Commission, and the Rivlin-Domenici Debt Reduction Task Force, among others.

“There shouldn’t be a disparity in borrowing in the private sector and the rates that cities and counties have to pay,” says Hodge of the Tax Foundation, who testified on the subject before a recent hearing of the U.S. House Ways and Means Committee.

Hodge labels the argument that the discount for bond interest gives local governments the ability to build out infrastructure as a “red herring.”  “If cities and counties had to pay a higher rate, it would only make them be smarter and more prudent borrowers,” he says. “They are demanding federal responsibility for what is inherently a local function. They just need to find a way to provide them through the local tax base.”

He also contends that the money raised through municipal borrowing has not been tied directly to infrastructure improvements. “The level of borrowing has rocketed to record levels, but where has the money gone?” he asks. “Much of it has gone to nonessential spending.”

Hodge argues the result is that local governments have borrowed too much. “Lower rates allow them to overuse their borrowing authority, in many respects,” he says. “Governments pay more than $100 billion on $1.7 trillion in debt. That’s more than they pay for police services, twice what they pay for fire services. The debt has run up far beyond their means.”

The second argument supports the tax-exempt status of municipal bonds, but limits their cost to the federal treasury by reducing their value to higher-income taxpayers. President Obama caps the deduction at 28 percent for all $3.7 trillion of outstanding bonds and new bonds.

The theory behind these proposals, explains John L. Buckley, professor of taxation at Georgetown University and former chief Democratic counsel to the House Ways and Means Committee, is that the difference between the lower tax exempt rate and taxable rate reflects the marginal rates of the lower income investors whose volume of purchases are required to sell the bonds.

By offering the rate at the highest bracket, the Treasury Department contends, the government is providing an unnecessary windfall. Buckley doesn’t take a position on that argument and instead prefers selling special bonds that don’t offer a tax benefit but make a direct payment to the government issuer, similar to the Build America Bonds program that was part of the stimulus plan.

Other proposals would also significantly change the treatment of municipal bonds. The budget proposal of Rep. Paul Ryan (R-Wis.) would effectively do away with the special treatment of municipal bond interest by eliminating taxes on all interest, capital gains, dividends and estates.

A bill sponsored by Sen. Ron Wyden (D-Ore.) and Sen. Dan Coats (R-Ind.) seeks to spread the benefits of owning municipal bonds equally to all taxpayers, regardless of adjusted gross income. That proposal would replace the tax exemption of municipal bond interest with a federal tax credit for bondholders equal to 25 percent of the interest earned.

Some government leaders don’t like any of the proposals. Columbia, S.C. Mayor Stephen Benjamin says that the system has worked well and does not need to change. “This tool has been effective for 100 years,” he says. “It’s supported the vast majority of our infrastructure. It works well to the benefit of our citizens.”

He dismisses the contention that infrastructure is entirely the responsibility of local government. “I just had a $500 million water and sewer infrastructure build-out under the watchful eye of the Environmental Protection Agency,” he says. “We’re committed to clean water and we are also required to do it. But we need to access the bond market at a reduced cost of capital.”

Benjamin says that local officials have been making their case in the most direct language possible.

“Disrupting this market will bring potential devastating effects on communities across the country,” he says.
In addition, he says that local governments have already shared in the sacrifice needed to bring the nation’s finances in line. “American cities for the last several years have taken significant cuts,” he says, pointing to reductions in block grants and support for law enforcement, as examples. “We have sacrificed every step of the way. We are doing our part of getting the federal government on track. But all of that would pale in comparison to what this would mean to our constituents. It would hit them directly in the pocketbook.”

Langston, from Linn County, adds that capping the rate would shake the markets and raise the specter of future changes. That would hurt many elderly investors who buy municipal bonds for their security and steady retirement income, even if their income is in the lower tax brackets.

“Once they do that, it would open the door for further restrictions, further legislation,” she says, noting that some Wall Street advisors already see some effects on rates communities are paying simply because of the prospect of the change.

However, Langston concedes that the public sector may have to accept some limitation on certain bonds that are floated by a community but whose proceeds are passed to a private sector company, often to undertake a public benefit. “Some legislators are focused on closing loopholes,” she says.

While acknowledging the importance of maintaining the tax exemption for local government bonds, Nutter also urges his colleagues to remain vigilant on a whole gamut of issues and continue to work with the administration.  

“It’s my opinion that neither the President nor the administration wants to do something that messes up the important municipal bond market,” he says. “They continue to support funding for the infrastructure. We need to see this as one item in a mixture of 100 different things that we need to look at. As important as the municipal bond issue is, we have to be flexible, nimble.”