The $3.5 trillion reconciliation bill being debated by Congress may include a bitter pill for the municipal bond market in the form of a 3% high-income surcharge that applies to tax-exempt income.
The provision would essentially function as a cap on tax-exempt income, a measure long feared by the muni market, said Vikram Rai, the head of Citi’s municipal strategy group, who noted the proposal in a weekly report released yesterday.
Rai said the proposal’s definitions remain unclear – in particular the definition of modified adjusted gross income, or MAGI – but that based on Citi’s interpretation, the 3% surcharge would likely apply to tax-exempt coupon income.
“This is flying under the radar, and it needs to be highlighted,” Rai said. “That 3% surcharge on your income dilutes the power of tax-exempt paper. If it goes through, it’s relatively bearish for munis.”
It’s one of several muni-related provisions featured in the high-profile $3.5 trillion spending package the House is debating before sending it to the Senate. Many of the provisions, such as the restoration of tax-exempt advance refundings and a direct-pay bond program, would benefit the muni market. The proposed tax increases that would pay for the legislation would also be bullish for munis as they would boost demand for tax exemption.
But less friendly is the 3% surcharge. The current provision would impose a tax equal to 3% of a taxpayer’s MAGI in excess of $5 million, or $2.5 million for a married individual filing separately.
The provision is estimated to raise $131.2 billion over 10 years to help pay for the legislation, according to the Tax Foundation.
Citi interprets MAGI as the sum of the adjusted gross income on the federal tax return; nontaxable social security benefits; excluded foreign income; and tax-exempt interest.
“This is our understanding, but the definitions are not clear,” Rai said.
As to the muni-friendly provisions in the reconciliation bill, Rai said he’s skeptical that they will end up passing.
The bill’s $3.5 trillion price tag has become the focus of debate, with key lawmakers like Sen. Joe Manchin, D-W.Va., saying they want to see the cost sliced in half or more. That renders the muni provisions vulnerable, Rai said.
Restoring tax-exempt advance refundings costs an estimated $14.9 billion and the direct-pay bond program around $22 billion.
“Even though we have a very diligent lobby, we have been disappointed with the end result many times in the past and the fairy tale almost never seems to come true,” Rai said.
