Tax and Policy Risks for Municipal Investors
We expect that the tax and policy risks municipal bond investors will face in the coming year will result from the impact of two publicly stated federal policy objectives – deficit reduction and economic recovery. In the spirit of fixed income investors, we are thinking of them as short and intermediate duration risks. The impending fiscal cliff and changes in long term tax rates are the short term risks, and tax reform is an intermediate risk.
The Fiscal Cliff
The fiscal cliff refers to a series of events that may occur in 2013, and includes:
- Expiration of the Bush era tax cuts, which would increase marginal tax rates on ordinary income
- An increase in capital gains and dividend tax rates
- Expiration of the payroll tax holiday for Social Security, increasing the tax from 4.2% to 6.2% on income up to $110,000
- An increase in the Medicare surtax from 2.9% to 3.8% on joint incomes greater than $250,000 and extension of the 3.8% tax to all passive and investment income with the exception of municipal bonds
- Roll back of Alternative Minimum Tax levels to 2000 levels
- Automatic sequestration and spending cuts, including the Build America Bonds’ interest rate subsidies, as directed by the Budget Control Act of 2011, which came into being to solve the debt ceiling crisis in the summer of 2011
It is widely understood that this combination of tax increases and spending cuts would have a significant negative impact on US GDP and could send the country back into a recession. Thus, one of the two important policy objectives – ensuring economic recovery – could be jeopardized if the problems posed by the fiscal cliff are not addressed. For municipal bond investors, an increase in the marginal tax rates would make municipals more valuable to current holders. Yet, the reduction in federal government expenditures could have a negative impact on state and local government credit quality, both from a direct transfer of funds (Chart 1) and from a reduction in overall economic activity (Chart 2). Indeed, state and local governments have become more dependent on Federal government revenues over the past 20 years, as shown in Chart 1.
The increases in the federal budget deficit (Chart 3) and the debt (Chart 4), as a percentage of GDP, are widely acknowledged by economists and policy makers as a critical problem that will need to be addressed. The long term fiscal stability of the nation is at stake, as are its bond ratings and its reputation in the international arena. These concerns transcend simple financial issues and potentially have implications on a national security basis. Solving the imbalance between revenues and expenditures requires increasing revenues (either through raising the marginal tax rates or broadening the tax base), reducing expenditures, or economic growth – more likely some combination of all three. This is the heart of the political discussion, and it puts government priorities for programs and spending in the spotlight.
In addition to raising tax rates, there has been renewed interest by both Democrats and Republicans in eliminating certain tax expenditures, preferences and deductions that are used by both broad and narrow constituencies. Many tax expenditures, including the exclusion of employer contributions for medical insurance, deductibility of mortgage interest on owner occupied homes, and 401k plans are used by millions of Americans, while others, such as deferred tax for shipping companies and special rules for certain film and TV production, have much smaller constituencies. The national budget documents list 173 tax expenditures totaling more than $1.1 trillion in 2013, and more than $6.6 trillion from 2013-2017. These are the numbers that both Democrats and Republicans are looking at as they comprise nearly a third of total federal government spending. The top 10 tax expenditures represent 60% of the total amount. See the Appendix for additional detail.
The budget also evaluates all tax expenditures associated with state and local governments, which includes municipal bond interest and deductibility of state and local taxes. Table 5, below, is a summary of the largest tax expenditures that are considered by the Office of Management and Budget (OMB) to be aid to state and local governments. If all expenditures related to state and local governments were eliminated they would represent one of the largest combined categories of expenditures – more than $117 billion in 2013. While it is unlikely that all would be changed, the impact of eliminating these tax expenditures would have significant consequences for state and local issuers. Debt service costs would rise and the economic calculus of living in high tax and low tax areas would change substantially.
Municipal Tax Exemption
Another policy risk is that the municipal tax exemption could be altered in more limited, or surgical, ways. Our September 2011 bulletin described the proposals in the American Jobs Act. While this Act did not pass, there were several lines that were crossed with respect to municipals, including linking exemption to the holder’s income and applying a ceiling on deductibility to both outstanding and newly issued bonds. Going forward, we would expect to see proposals that could, variously: maintain the status quo, with interest exempt at all marginal rates for existing bonds; grandfather existing bonds while reducing the tax benefit for new bonds; or retroactively reduce the tax benefit for new and existing bonds. We could also see a differential in treatment based on use of proceeds, the precedent having been set in the 1986 Tax Act when some categories of bonds became subject to the Alternative Minimum Tax. In fact, in the OMB list of tax expenditures, the individual categories of municipal bonds are already delineated, with separate lines for state and local bonds, and for hospitals, housing and other non-governmental use categories.
The range of issuers of municipal bonds, including state and local governments, airports, transportation facilities, hospitals, universities and many other categories would be the group to present the case for the continuation of tax exemption, based on the lower cost of financing for critical projects in the $3.7 trillion market. Of course, investors could also have a voice in this debate as their interests should be known. In the past, when significant changes to the tax exemption have been proposed, mayors, governors and other state and local officials were able convince Congress that the benefits of tax exemption were crucial. One would expect that this would happen again, but we cannot be certain. We do think this is an intermediate risk – within a year – versus the less-than-two-month fiscal cliff timeframe, because of the complexities and the nuances in the market.
At the time of this writing, the municipal market remains strong and well supported by investors. The overall market movements after the election indicate that investors prefer safety and security to risk, and the municipal market remains the key ‘safety and security’ sector for individual investors. Municipal yields remain above Treasury yields even before adjusting for taxes, so, barring dramatic changes to the tax exemption of existing municipal bonds, the sector remains attractive even if a number of less impactful changes were to occur. The potential for changes to the tax exemption for certain municipal sub-sectors (based upon use of proceeds, for example) exists, but the preliminary nature of the fiscal cliff and tax reform discussions leaves investors with very little information upon which to base decisions. So, in the absence of any clear paths to a solution, investor behavior supports the belief that municipals will broadly retain their value to taxpaying investors and that the current relative pricing environment is fair given the likely and politically feasible outcomes.
Judy Wesalo Temel
Director of Credit Research
November 20, 2012
Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements are now or will prove to be accurate or complete in any way. Certain information herein was obtained from third party sources which we believe to be reliable, but Samson cannot guarantee the veracity of the information.