Inside the Tax Cuts and Jobs Act: The Muni Market Perspective

The Tax Cuts:Impact: What's Ahead for the Muni Investor
Personal Income RatesThe new bill preserves the existence of seven individual tax rates in current law but slightly modifies the brackets and lowers each rate modestly. The top tax rate is reduced from 39.6% to 37% and starts at US$500,000 for single and at US$600,000 for joint; other marginal rates are 10%, 12%, 22%, 24%, 32%, and 35%. Individual cuts sunset at the end of 2025. Because the proposed reductions in marginal rates aren’t very large, demand for municipals from individual investors should remain strong.
Corporate RatesThe corporate tax rate is slashed, from 35% to 21%. It's permanent. This reduction in the corporate tax rate will reduce demand for municipals by corporations such as banks and insurers. These institutions traditionally buy high-grade municipal bonds and hold about 30% of outstanding municipal debt.
Other Provisions:
State and Local Tax
(SALT) Deductions
SALT deductions are reduced to a US$10,000 limit that individuals can divide across income, property and sales taxes. The shrinking of SALT deductions is likely to increase the cost of investing in out-of-state municipal bonds, thereby increasing the demand for in-state municipal bonds—especially in high-tax states. In the short run, bonds from high-tax states should perform relatively well. However, repealing SALT could negatively affect those states’ economies over the longer term. The after-tax income in more heavily populated, high-tax states with many high-income taxpayers, such as California and New York, may decline.
Alternative Minimum Tax
The AMT is repealed for corporations and curtailed for individuals. Individuals now see their income exemption amounts increase to US$70,300 for single filers and US$109,400 for joint filers. The phase-out of these exemptions starts at income levels of US$500,000 for single filers and US$1 million for joint filers. The individual reduction ends after 2025, while the corporate repeal of the AMT is permanent. The changes to the AMT would benefit private activity bonds. Currently, AMT bonds offer investors a 0.20% yield advantage versus non-AMT-subject munis. This spread could narrow as these bonds rally, with investors reaching for extra yield.
Advance Refunding BondsAdvance refunding bonds are bonds issued 90 days or more ahead of the redemption date of bonds already outstanding. Advance refunding helps issuers reduce costs when interest rates fall and outstanding bonds are not callable. Under current law, government and not-for-profit issuers can advance refund once per issue. The elimination of advance refunding bonds beginning in 2018 would modestly reduce the overall volume of muni bonds outstanding over time. Over the near term, their pending elimination has been driving heavy supply as issuers rush to take advantage of the closing issuance window.

As of December 18, 2017
Source: Urban-Brookings Tax Policy Center
and AllianceBernstein(AB)

Following a reconciliation of the variant bills behind closed doors, final tax reform legislation has been delivered and will very likely make its way to the president’s desk before the end of the week. We’ve kept score, assessing the likely impact on the muni market, from tax cuts to the reduction of state and local tax deductions.

What’s the most important response for a muni investor? Make sure your manager has the flexibility to invest dynamically as conditions change. The ability to use taxable bonds opportunistically can help preserve capital during volatile periods. Above all, don’t be passive.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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