Tomato, Tomahto: Why Obama, Simpson-Bowles and Others Miss the Point on Munis
When it comes to eliminating or modifying the tax-exempt status of municipal bonds, everyone seems to have an opinion these days.
Regrettably, amidst the politicking over whose proposal is more sensible, we are losing sight of the bigger and more important question: what is the best way to subsidize infrastructure spending in the US?
After all, that is the very purpose of the tax-exempt status.
We believe that while it may not be perfect, the muni tax exemption is the most cost-effective, easy-to-implement solution for subsidizing infrastructure spending.
Limiting the Exemption Would Cost State and Local Governments
The job of financial markets is to help move funds from lenders to borrowers. On this count, the muni market is working well. According to the Government Finance Officers Association, 75% of infrastructure in the US is built and maintained by state and local governments. Their primary source of financing is municipal bonds.
There are roughly 50,000 different municipal issuers, ranging from states to local school districts. All told, they have $3.7 trillion in debt. Another $2.2 trillion in infrastructure investment is needed over the next five years, according to the American Society of Civil Engineers. Hurricane Sandy was a devastating reminder that a functioning economy depends on bridges, roads and electrical grids that work.
The tax exemption for muni bonds isn’t free—but it’s not expensive. The Office of Management and Budget estimated that it cost the government $36 billion last year, about 1% of federal spending. Supporting 75% of our nation’s infrastructure with 1% of our budget? That sounds like a bargain.
What would happen if the subsidy went away? Eliminating—or even limiting—tax exemption would increase financing costs for state and local governments, pushing them to raise taxes or cut costs by eliminating jobs and putting off maintenance.
Tax Exemption Is a Market-Based Solution That Works Well
Critics of federal tax exemption for municipal-bond interest argue that it’s an inefficient subsidy. Their rationale: it’s not given directly to the issuer, but earned by investors who stand to profit from the subsidy. This is especially true, the critics say, for wealthy investors subject to the highest tax bracket, because tax-exempt interest is worth more to them than to investors subject to lower tax brackets.
Let’s take a closer look at this argument. The market determines interest rates. If the subsidy is efficient in this framework, muni bonds should have about the same yield after taxes as comparable bonds subject to federal taxation. This is the case for short-term munis: yields for high-grade municipal bonds maturing in two years have averaged 68% of high-grade corporate bond yields over the last 10 years (based on two-year, AAA-rated yields from Municipal Market Data Corp. and LIBOR swap yields from Bloomberg).
This means investors subject to the top tax bracket would have come out roughly the same whether they bought a muni bond or a corporate bond.
The same isn’t true for longer-maturity municipal bonds. Over the last 10 years, the yields of munis maturing in 10 years averaged 78% of comparable corporate bond yields, suggesting that investors subject to federal tax rates above 22% profited from the tax-exempt subsidy (based on 10-year, AAA-rated yields from Municipal Market Data Corp. and LIBOR swap yields from Bloomberg).
Why the higher relative yield for longer maturities?
A big part of the difference is uncertainty about future tax rates. Municipal bond investors bear the risk of potential changes in the federal tax treatment of muni bond interest, which could hurt their investments.
Sure, tax exemption is an indirect subsidy, but it isn’t necessarily inefficient. And capping the benefit of tax exemption will not improve the efficiency of the subsidy, but will raise financing costs for state and local governments.
A Direct Subsidy Makes Financing Costs Less Predictable
Since the crux of the matter is how best to subsidize infrastructure spending, many have called for a direct federal subsidy—as was done in the 2009 Build America Bonds program. While a direct subsidy is more transparent, the problem is that it puts state and local governments at greater risk of absorbing changes in the level of federal support.
In fact, while issuers have fixed obligations with Build America Bonds, their federal subsidy will be cut if we go off the fiscal cliff. With tax-exempt municipal bonds, state and local governments’ financing costs are fixed—their current obligations won’t change with federal budget negotiations and the tax code.
In sum, to paraphrase Winston Churchill’s famous speech that democracy is the worst form of government…except for all other forms that have been tried: the tax exemption of municipal interest remains the best tool we have to stimulate investment in US infrastructure.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Guy Davidson is Director of Municipal Investments at AllianceBernstein.