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A Possible Threat to Municipal Bond Interest Tax Exemption

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Municipal bonds have long been an appealing investment option for high net worth individuals. This has been the case, not only because they provide relatively safe and stable income for investors due to their much lower levels of defaults versus corporate bonds, but also because of their tax-exempt status.

As the federal government’s budget deficit has increased, both parties have been seeking ways to reduce spending and the municipal bond tax exemption is often an item lawmakers target. The 2010 Simpson-Bowles Deficit Reduction Commission recommended to President Obama that the tax code be changed to eliminate the municipal bond tax exemption. In addition, the Obama Administration has recently proposed to tax a portion of tax-exempt interest by capping the tax rate at 28% for high-income earners. The 28% cap would likely apply to bonds that have been already purchased by investors.

Many financial experts believe that any substantial change in municipal bond tax exemptions would decrease demand for municipal bonds and make financing for state and local government more expensive. Removing or limiting the tax exemption would make tax-exempt bonds less attractive compared to other investment options. States and localities would have to raise interest rates to make their bonds more attractive to investor. According to analysis performed by the Securities Industry and Financial Markets Association (or SIFMA), it is estimated that it would have cost state and local governments an additional $173 billion of interest on infrastructure investments if the municipal bond tax exemption limit was implemented from 2003-2012. These additional costs would have resulted in higher taxes or user fees.

Individual investors own about 75% of the nearly $3.7 trillion municipal bond market. A cap or elimination of the tax-exempt status of municipal bond interest would significantly affect high net worth individuals’ investments. And at the same time, higher bond costs would impact state and local governments and other municipal issuers’ budgets, and directly affect taxpayers in the form of higher taxes and user fees.

 
 
 
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