No one knows how a new corporate minimum tax will impact demand for tax-exempt municipal bonds, with speculation ranging from grim to merely unhelpful, though most agree the political implications are not encouraging.
President Joe Biden Tuesday signed into law the Inflation Reduction Act, a $740 million climate, health and tax bill that marks a major victory for Biden and Democrats heading into tough midterm elections.
The law's central revenue-generator is a 15% minimum tax applied to the adjusted financial statement income — as opposed to adjusted taxable income — of corporations with three-year average incomes of more than $1 billion. It's projected to generate $222 billion over 10 years.
Municipal bonds typically exempt from taxable income are not exempted from book income. Big corporations that have relied on tax-exempt municipal bonds to help bring down income may find the paper less valuable under the new regime.
Since Sens. Chuck Schumer and Joe Manchin
The Joint Committee on Taxation
Corporate buyers make up just under 27% of muni holdings, according to Federal Reserve data, a number that has risen over the last several years, though many hold taxable as well as tax-exempt munis.
Vikram Rai, the head of Citi's municipal strategy group, warned the new rate will cramp corporate demand, which will mean more volatility and ultimately higher financing costs for state and local governments.
"The market is not paying enough attention to the problem," Rai said. "I have been inundated with corporate buyers telling me it doesn't make sense to buy tax-exempts. Corporate demand is going to be impeded."
Citi estimates the minimum rate will apply to seven life insurance companies, 16 banks and 11 P&C companies that are muni holders, though Rai declined to name the firms.
It's going to hurt the most during outflow cycles, when the muni market's dependence on mutual funds already poses a challenge, Rai said.
Corporate buyers who used to step in during outflow cycles to help set a bottom may now want to see bonds even cheaper. "The safety net moves further away," Rai said.
Most market participants agreed that the new corporate minimum tax rate would hurt during outflow cycles.
"This exacerbates the market's reliance on mutual funds and alternative sources of demand will be fewer," said Municipal Market Analytics' partner Matt Fabian.
But Fabian said he expects the overall impact to only be an "incremental negative," and that the market withstood a much bigger hit with the Tax Cut and Jobs Act in 2017.
Big banks and insurers are probably not relying heavily on tax-exempt municipal bonds as a tax avoidance strategy, Fabian said.
Banks have other reasons for holding muni bonds, including maintaining client relationships that are important to underwriting or lending businesses, he said. "They're not just owning them to get that sweet relief from the 8% tax rate," Fabian said.
Comparing current tax rates to the future AMT rate as well as calculating the role of tax-exempt paper in triggering the minimum rate is key to figuring out impact on muni demand, said BofA Global Research municipal research strategist Yingchen Li.
"The question is, do they hold enough muni bonds to trigger the minimum tax?" Li said. "This is not a simple question, because you have to look at the other preference items" that are included in book income, he said.
"It's quite complicated because there are eight different preference items," Li said, adding that tax-exempt municipal interest appears to be the chief item for many corporations.
Banks hold about 14.7% of muni holdings as of 2022 Q1, according to Fed data.
The large central money banks generally have tax rates between 17% to 20%, while regional bank rates tend to be between 18% to 21% and S&L banks have the highest effective tax rates among the banks, Yi said. Because bank tax rates are already above 15%, the new minimum tax is unlikely to impact them too much, he predicted.
Insurance companies — which hold about 5.3% of muni holdings as of Q1 — appear to have lower effective tax rates and therefore may be closer to triggering the new tax, Yi said.
But even insurance companies that trigger the new rate probably won't have to sell huge amounts of muni bonds, Yi said.
"Clearly it's a negative, but how much is the impact?" Li said. It might prompt corporations to shed some of their muni holdings, "but not enough to impact the normal market operations of sales and trading."
In an Aug. 12
"I'm thinking not necessarily of that smaller percentage of up and down cycles, but what this is going to look like in the ongoing functioning of the market," Kozlik said in an interview. "State and local governments would rather market their securities to a larger number of potential buyers because in theory that's going to help bring down the overall costs, but I don't think that taking out a few potential even large entities is going to reprice what happens in the market day to day."
While the market analyses may differ, most participants agree the inclusion of the tax-exemption as a penalty in the new law may foreshadow future political battles.
"We let lawmakers chip away at the cornerstone tax-exemption without educating them properly," Rai said. "We took our eye off the ball."
Fabian said the municipal market has enjoyed big recent wins with stimulus dollars flowing to issuers, but that the latest measure marks a "chipping away" at the value of the tax-exemption.
"Anytime the value of the tax-exemption is diluted … that's a long-term drag on performance," he said.
It's a reminder that the market needs to maintain focus on preserving the tax exemption itself, which has come under threat repeatedly in Washington, Kozlik said.
"What this reinforces is that organizations and issuer groups need to be educating lawmakers," Kozlik said. "They need to be pounding and delivering the message that tax-exempt municipal bonds are an effective and efficient infrastructure financing tool."
