Income Investor Perspectives

Should Muni Bond Interest Be Taxable?

That is the question asked in a new research report published today by The Tax Foundation.

Here are a few quotes from the paper, with my editorial comments:

The strongest economic justification for the tax exemption of municipal bonds is that it encourages state and local governments to invest in infrastructure projects that create benefits for nonresidents. On the other hand, there is also reason to believe that the tax exemption will cause municipalities to overinvest in infrastructure, particularly if states and localities are also able to shift their tax burdens onto nonresidents. (Key Findings, page 1)

My comment: “will cause municipalities to overinvest in infrastructure”? Really? It seems that a constant reality in our country is the absolute need for more investment in infrastructure: water and sewer systems, bridges, roads, tunnels, airports, etc., etc., etc. And by the way, if there is “over investment,” then by definition, those projects would be uneconomic and unable to service the debt. The market has been very efficient at recognizing non-economic bond issues (also known as non-investment grade, or speculative).

Most importantly, there is a compelling case that the current tax treatment of municipal bond interest is inefficient. For every dollar that the federal government forgoes due to the provision, state and local governments receive less than a dollar in lower borrowing costs; the remainder goes largely to high-income households. (Key Findings, page 1.)

Inefficient? Proposing that financings of local projects should be routed through Washington D.C. seems to create a much greater likelihood of inefficiency. Wasn’t it temporary tax incentives created by Congress that started Puerto Rico down the path to insolvency? If you were not familiar with that, see Adventures in Muniland, by Comes, Kotok and Mousseau. (The book is on my all-season recommended list.) I quote from their chapter on Puerto Rico:

In 2006, tax policy changes removed certain incentives for businesses to locate production in the Commonwealth. Assessing their options, companies began to relocate, taking jobs with them. (Page 198.)

Federal tax policy created the artificial (i.e., non-market driven) demand for locating jobs in Puerto Rico–that’s ok as a policy, but it can be destructive when policies are changed. As jobs moved into Puerto Rico, money was borrowed to finance needed infrastructure that became unsupportable after the tax incentive was changed and jobs moved away from the island. (THIS is an example of “encouraging overinvestment in infrastructure,” and it started in Washington.) I could go on, and I have in the past, so if you’d like more on this part of the topic, see my short essay, The Reverse Midas Effect.

Voters love to hear politicians talk about tax-simplification. Replacing the tax exemption of munis with a Federal tax credit sounds to me like tax complexification (sorry if that is not a word, but it sure should be).

I know, I’m a “muni guy,” so I’m biased. But I am also a citizen, taxpayer, voter and father. I have a vested interest in efficient government not only now, but for the decades ahead. Low cost financing for essential and sustainable governmental infrastructure projects increases the ability to complete needed projects. Muni bonds have being filling that need for well over a hundred years. (And by the way, why is it that any dollar not collected by the Federal government is considered “forgone tax revenue”?)

So should muni bond investors be worried? It is impossible to handicap what could happen to the tax exemption if the new Congress and new President decide to re-work the tax code. But there is some margin of safety right now in that in many cases, muni yields are higher than taxable yields. I encourage you to read the report and form your own opinions. I’ll delve more into the relative yields in next week’s complete Catchup.

Thanks for reading! Let me know if you have any questions and have a great weekend.

Pat

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This is not investment advice. The opinions expressed and the information contained herein are based on sources believed to be reliable, but accuracy or appropriateness is not guaranteed. Past performance is interesting but is not a guarantee of future results. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Indices are not available for direct investment, although in some cases, there may be ETFs available designed to track some of the indices shown. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Additional information available upon request.
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