WASHINGTON – Advocates for maintaining the tax-exempt status of municipal bonds are firing back after a Tax Foundation report last week concluded lawmakers should consider limiting, reforming or eliminating the muni exemption.
The report, called "Reexaming the Tax Exemption of Municipal Bond Interest," was released by the Tax Foundation on Thursday. It argued that the tax-exempt status of munis can encourage municipalities to over-invest in infrastructure and can unfairly benefit taxpayers in higher income brackets.
The over-investment, the foundation said, can come in part from federal subsidies that can make a project seem more lucrative than it really is. That drew immediate opposition from several muni advocates.
"This is a classic woolly-headed, ivory tower analysis," said Chuck Samuels, a member of Mintz, Levin, Cohn, Ferris, Govsky and Popeo. "Tax exempts might cause state and local governments to over-invest in infrastructure? Does anyone feel like their pot holed, overcrowded roads, mass transit and airports are over-invested? Does the author think D.C. potholes, Metro fires and the crowded National Airport are suffering from infrastructure over-investment?"
Scott Greenberg, the Tax Foundation analyst who authored the report, said that the tax-exempt standing of munis can potentially cause state and local governments to over-invest in infrastructure, especially when the tax onus is placed on nonresidents.
An example he cited was a $10 million highway project that that will only provide $9 million in economic benefits. A $1.5 million federal government subsidy could make the project appear to be economically beneficial, despite what may be what he called a "socially wasteful investment," the report said.
John Vahey, director of federal policy for Bond Dealers of America, also disagreed with the opinion that municipalities may be prone to overinvesting in infrastructure.
"We think the notion that there is an overinvestment in infrastructure in the U.S. generally right now is a fallacy," Vahey said. "You just need to point to the glaring need to rebuild roads and bridges as well as grades and reports by engineering organizations that analyze the condition of infrastructure."
Vahey said the BDA – which told The Bond Buyer last week that limiting the muni exemption could increase infrastructure costs to state and local governments by more than 10% -- has had some internal discussions about the report, but has not yet seen significant member engagement about its suggestions.
The Tax Foundation report doesn't make any recommendations to lawmakers considering potential tax legislation, though it does suggest they consider the "flaws and drawbacks" of the muni exemption that make it an unideal policy design for subsidizing state and local debt.
The "most compelling case" for muni exemption inefficiency, the report said, is that for every dollar of revenue the federal government forgoes because of the muni exemption, state and local governments receive less than a dollar in lower borrowing costs, making it "inefficient."
It added that according to the Treasury Department, the federal government will forgo as much as $617 billion in revenue over the next decade by excluding interest on munis.
The 12-page report says that the current exemption provides larger benefits for those in higher income brackets and smaller benefits for taxpayers in smaller brackets, while effectively shutting out some investors, including those who do not pay taxes, foreign investors and pension funds. Greenberg said that the Washington-based think tank routinely compiles reports on parts of the tax code it feels have not been thoroughly discussed, including the muni exemption.
Kathleen Nilles, a partner at Holland & Knight in Washington, said she disagreed with some of the report's basic premises. She said, however, that it was "quite interesting" and raised several valid points, in particular concerning, "the inefficiency of the subsidy in lowering interest rates for government borrowers commensurate with the tax benefits made available to taxable bondholders."
Still, Nilles disagreed with the conclusion that local government infrastructure doesn't need to be subsidized at the federal level and that tax subsidies could lead to overspending.
"I look forward to giving further thought to how the supposed inefficiencies of the exclusion could be remedied," she said. "Personally, I doubt that transforming the exclusion into a tax credit is going to be a panacea."
The report was issued less than a month after the release of the GOP blueprint for tax reform, which calls for limiting or eliminating unnamed deductions, exclusions and credits.
Though the GOP plan doesn't mention munis directly, muni groups are concerned that their tax-exempt status may be in jeopardy as the plan is amended before the formal tax legislation is drafted. Republican lawmakers hope to introduce the proposal in 2017.
Because of the cost-effective financing it provides state and local governments for financing infrastructure projects such as road, water and sewer improvements, protecting the tax-exempt status of munis has been a common cause among lawmakers.
In March, Reps. Randy Hultgren, R-Ill., and Dutch Ruppersberger, D-Md., announced the launch of a bipartisan Municipal Finance Caucus that would work to protect the muni exemption and advocate for state and local governments' ability to independently finance infrastructure projects.
Rep. Jim Renacci, R-Ohio, also released a tax reform plan earlier this month that would replace the corporate income tax with a consumption tax, while maintaining the muni exemption.
