The dizzying speed at which the new administration is proposing and acting on changes to the budget and finding ways to generate additional revenue has now included the idea of marginalizing the tax-exemption of municipal-bond interest. Recently, certain factions within the Donald Trump administration have suggested the taxation of municipal-bond interest as another source of revenue.
This threat to the tax-exemption of municipal-bond interest is not new and often follows a regime change in Washington, D.C. An advisor to President Trump recently floated the idea of taxing municipal bonds, and the topic caught the attention of the media outlets and investors. Following through on this, however, would be a herculean effort and yet not likely to reap the benefits that its current proponents expect. That’s why many believe a change to the tax-exempt status of munis is unlikely; let’s discuss the specifics.
The most recent comprehensive tax reform happened after the passage of the Tax Cuts and Jobs Act, which took effect Jan. 1, 2018, during Trump’s first term. This legislation was the first such comprehensive tax reform since 1986, although various suggestions to eliminate or reduce municipal bonds’ tax-exempt status have since made their way to the fore without any real threat. The TCJA made sweeping changes to both individual and corporate tax structures. It temporarily reduced tax rates across most brackets, raised the standard deduction, capped state and local tax deductions, and reduced the mortgage interest deduction. Municipals still retained their tax-exempt status, but it eliminated a provision that allows municipalities to refinance its outstanding debt early without issuing taxable debt. The TCJA is set to expire at the end of 2025. However, just last week, a Senate budget resolution proposed to make these tax cuts permanent.
Implications for Eliminating the Municipal Bonds’ Tax-Exemption Extends Beyond Investors
Support against eliminating the tax-exemption measure is strong. The logic to maintain the tax-exemption makes economic sense and is consistent with a pro-growth agenda, given the massive infrastructure needs of the country, which include maintaining roads, utilities, water and sewer systems, and public buildings throughout the country. A MacKay Municipal Managers report estimates that the United States has a $3.7 trillion infrastructure deficit. Meeting this need will require government entities to invest in these projects, which is most often done through municipal-bond issuance.
Any change to the tax-exempt status of municipalities would not only be unpopular for the municipalities that issue debt, but according to some studies, the impact on the broader fiscal budget deficit would also not be material. According to the Public Finance Network, an organization formed to preserve the tax-exemption of municipal bonds, estimates that the elimination of the municipal-bond tax-exemption would result in more than $800 billion in higher interest costs for issuing municipalities over the next 10 years, most of which would fall upon the Americans who are repaying the debt through higher taxes.
That said, it seems that every possible solution for the US government to increase revenue and pay for future income tax cuts is on the table at the moment. The simple math may result in higher revenues to the federal government, but higher financing costs to back such projects will mostly fall to a municipality’s constituents, who are servicing the debt as part of their tax payments.
From an investment perspective, the municipal-bond tax-exemption, while often providing the greatest benefit to investors in higher tax brackets, is necessary to fund the infrastructure required to manage our states, cities, schools, and transportation systems, among others. The tax-exempt yields at which these municipalities borrow are typically lower than comparably rated corporate bonds and US Treasuries. This keeps the cost of funding infrastructure projects lower and therefore requires less support from residents and constituents of the respective municipalities to service that debt. More practically, any material change to the tax code would severely limit the ability for smaller municipalities to access capital markets. For example, the issuer of a $20 million school bond would likely not only pay a higher taxable interest rate on those bonds but would also pay an even higher yield because of the relative lack of liquidity for smaller issuers in the market.
Aside from municipalities wanting to keep interest costs for public projects low, multiple other interested parties are not on board with any legislation that materially affects the tax-exemption of municipal bonds. Many believe changing the tax-exemption would be politically challenging. In addition, municipal markets reacted mildly to the issue when it first arose, indicating that it’s not a serious threat for the time being.
There are many logical reasons that the tax-exemption of municipal bonds will remain, and it’s seemingly been relegated to the back burner after the tariff events of the past week. For now, any change to the tax-exemption on municipal-bond interest appears unlikely, but the current US administration has shown that it’s willing to go against the historical norms, and the talk of municipal-bond reform will likely persist.