WASHINGTON — Lawmakers on Tuesday moved forward with two legislative efforts to overhaul the U.S. tax code, which would either halt, or threaten, tax-exemption for new muni bonds.
The two tax reform packages, one unveiled as a bill in the Senate and the other as part of a draft fiscal 2012 budget resolution in the House, illustrate there may be growing interest in foregoing tax-exempt interest on new municipal bonds in favor of more efficient alternatives to subsidize state and local debt.
A call to eliminate municipal tax-exempt debt “is clearly on the table” as part of the tax reform debate, said William Daly, senior vice president of government relations for the Bond Dealers of America. This tax reform debate could pose the biggest challenge to the municipal market ever, he and other market participants said.
Daly said that even during the debates on the Tax Reform Act of 1986, “I do not recall people seriously talking about eliminating the tax exemption of municipal bonds and replacing it with a new system.”
In the Senate, Ron Wyden, D-Ore., and Dan Coats, R-Ind., introduced a tax-reform bill that would eliminate tax-exempt interest for new state and local debt in favor of tax-credit bonds, which are taxable. The bill also would eliminate advance refundings for governments and 501(c)(3) nonprofit organizations.
The bill would eliminate the alternative minimum tax and establish three income tax rates of 15%, 25%, and 35% for individuals.
The Wyden-Coats bill is virtually identical to the one Wyden introduced last year with former Sen. Judd Gregg, R-N.H. That bill was vehemently opposed by muni market participants and never gained traction in the Senate.
“We are concerned that this legislation would take away two very important tools that state and local governments use and replace them with products that are not well utilized by issuers nor desired by investors,” said Susan Gaffney, director of the Government Financial Officers Association federal liaison center here.
Separately, Wyden could introduce legislation as early as this week that would create special tax-credit bonds for transportation projects. The measure would provide $50 billion over six years for Transportation and Regional Infrastructure Project tax-credit bonds. The TRIP bonds face the same skepticism from market participants as other tax-credit bonds, which have not been widely used.
House Budget Committee chairman Rep. Paul Ryan, R-Wis., proposed a fiscal 2012 budget resolution calling for tax reform that lowers federal income tax rates, but broadens the tax base.
The budget resolution does not specifically recommend eliminating the tax-exemption for interest earnings on tax-exempt bonds. However, it follows many of the tax proposals recommended last year by the President’s National Commission on Fiscal Responsibility and Reform, which was established to make recommendations for deficit reduction.
The commission’s report, which also called for broadening the tax base, contained an “illustrative proposal” for several sweeping tax-law changes, including the idea of doing away with tax-exempt status for new muni bonds.
By applauding the deficit commission’s recommendations, Ryan appears to be indirectly endorsing the deficit commission’s call to end municipal tax-exempt interest, Daly said.
Market participants pointed out that any tax proposals must be approved by the House Ways and Means Committee, which is chaired by Rep. Dave Camp, R-Mich.
Sources noted that Ryan’s budget would lower the top tax rate for individuals and businesses to 25%. This top rate also has been proposed by Camp, who endorsed Ryan’s budget Tuesday, saying, “We have a tax code that hinders instead of helps job creation.” The path to greater job growth “starts with comprehensive tax reform,” he said in a statement.
However, Ryan’s counterpart in the Senate, Budget Committee chairman Kent Conrad, D-N.D., called the budget resolution “unreasonable and unsustainable.”
Even if both tax-reform proposals end up sparing tax-exempt interest for municipal bonds, the evolving debate on tax reform could bring changes to the market not seen since the 1986 Tax Reform Act, sources said. That law severely curbed the tax law for muni bonds, ushering in broad arbitrage rebate restrictions, the private-activity bond volume cap, and limits on the amount of bonds held by banks. But that law preserved municipal tax-exempt status.
“If you look back at 1986, the tax-exemption was retained but there were a lot of other changes that were made to the municipal market,” Daly said. “You could easily get into a discussion where the exemption is retained,” but there are “other changes to the way municipal finance is treated.”