In 2003 only Utah specifically changed the way its tax laws treat municipal bonds held by individuals by requiring them to pay taxes on the interest earned on bonds issued out of state, unless that state doesn't tax interest on Utah bonds.
But because residents of Utah aren't big buyers of municipal debt, the change isn't expected to significantly affect the municipal market, said Martin Mauro, a senior economist at Merrill Lynch & Co. in New York. The impact would have been far greater had a state with a large muni-buying population, like California, altered its tax treatment of bonds, Mauro added.
On a state level, the change means that muni buyers in Utah will probably be less inclined to buy out-of-state bonds, he said.
Kimball Young, a co-manager of the Aquila Group of Funds' tax-free Utah fund in Salt Lake City, agreed that the change "makes Utah paper more attractive to Utahns." But he cautioned that it's impossible to measure just how much of a competitive edge the new law lends in-state bonds because investment decisions are so often influenced by other factors such as bond ratings.
The change does mean that state-specific Utah municipal bond mutual funds now enjoy a 20-basis-point yield advantage over non-Utah specific competitors on an after-tax basis. That's one of the reasons Young said his firm supported the measure.
State tax revenue rose by 1.7% in fiscal 2003, marking it the second-weakest year of tax revenue growth in more than a decade, according to a report released earlier this month by the Nelson A. Rockefeller Institute of Government in Albany.
The 1.7% increase in 2003 came after state tax revenues dipped by 5.7% in fiscal 2002, which was the first time in 11 years that tax revenues fell. But the 1.7% rise is still small compared to increases of 4.7%, 8.7%, and 5.7%, in fiscal 2001, 2000, and 1999, respectively, the report said.
When the stock market bubble burst, many states saw revenue from capital gains taxes unexpectedly dry up, Nicholas W. Jenny, author of the Rockefeller Institute report and a senior policy analyst with the think tank's fiscal studies program, said in a telephone interview.
Some states have responded by raising personal income taxes.
The top tax bracket in Connecticut was raised to 5.0% in fiscal 2003 from 4.5% in fiscal 2002. Tax rates in Nebraska for 2003 were raised to a range of 2.56% to 6.84% from a range of 2.51% to 6.68% in 2002. In New York, the maximum tax rate rose to 7.70% from 6.85% in fiscal 2002 for individuals with income of over $500,000, and new tax brackets were added for individuals with incomes over $100,000.
Michigan reduced its tax rate to 4.0% in fiscal 2003 from 4.1% in 2002, and the maximum tax rate in New Mexico was also cut to 7.7%, from 8.2%.
But the changes weren't big enough to affect the demand for municipals, Mauro said. He pointed out that when states have fiscal problems, supply can increase as they issue debt to raise money.
In fiscal 2003, the top federal tax rate was cut to 35% from 38.6% in 2002. Because the drop wasn't large enough to significantly diminish the after-tax benefit municipal bonds can provide to many investors, the demand for them was only marginally affected.
Mauro stressed that municipal bonds provided individuals with relatively high total returns in 2003.
