Bye-Bye Tax Free Munis?

There's been a lot of buzz in the media that President Obama might try to confiscate privately held retirement plans, or at least end tax deferral for them.

Anything is possible in the current financial crisis, but there's another initiative underway right now, and that's received scant media attention.  And that's the impending elimination—or at least scaling back—of tax-free interest payments from municipal bonds. 

For more than 60 years—ever since the Roosevelt administration—presidents have tried to tax interest payments from municipal bonds without success.  However, the economic crisis has now provided Obama with a way to do just that. 

At the outset, it's important to remember the central operating tenet of the Obama administration: “A crisis is a terrible thing to waste.”  That aphorism comes from Obama's Chief of Staff, Rahm Emanuel, Obama's right-hand-man.   And this economic crisis has given the government the opportunity to take over partial responsibility for financing state and local government operations, via so-called "Build America Bonds," or BABs.

The Bush administration's TARP legislation authorized BABs as a "temporary" government initiative.  Unlike ordinary muni bonds, BABs are taxable, but offer a higher return than ordinary munis—up to 7% or more.  BABs can pay higher returns because the federal government subsidizes 35% of the interest.  Moreover, due to the federal government subsidy, many investors believe they're safer than ordinary munis. 

To date, BABs have had a relatively minor impact in the market, with only US$14 billion or so sold.  But sales are growing quickly, and the combination of higher yields and federal subsidies have led some analysts to predict that sales will grow to US$150 billion or more annually.

If you were Rahm Emanuel, what opportunities would you see in this development?  Here's what I would be thinking if I shared his mindset:

• First, introduce legislation to extend the "temporary" authorization for BABs from year-end 2010 for another five years.
• Second, propose beefing up Treasury supervision of BABs so that, in effect, the federal government effectively decides which state and local projects receive funding.  This essentially ends state or local control over funding decisions, especially in states like California with low credit ratings for many traditional munis.
• Third, begin issuing press releases from the White House pointing out how "unfair" it is that high-income investors reap most of the tax benefit from traditional munis.  Surely the mandarins in Obama's Treasury have notified Mr. "Waste no Crisis" Emanuel that U.S. taxpayers earn US$72 billion in tax-free income each year (2006 figures).  And, they've certainly let him know that households earning over US$500,000/annually account for more than US$30 billion of that amount.

I suspect that it will be impossible to eliminate tax-free munis all at once.  But several interim steps leading to possible elimination are also possible:

• First, phase out the exemption for alternative minimum tax (AMT) for high-income muni investors.  President Obama has already made it clear that anyone who earns more than US$250,000 annually will pay more in tax under his tax reform plans.  And what better way to do it than to target an investment primarily used by the wealthy?  Plus, there's a precedent: investors are already subject to AMT on interest paid by munis issued by not-for-profit 501(c)(3) organizations and other “private activity” issuers such as airports and certain housing agencies.
• Next, tighten the regulations on the use of muni proceeds.  The U.S. Tax Code already prohibits using munis to finance racetracks, massage parlors, golf courses and other privately owned projects.  The Obama administration could always propose legislation to extend these restrictions.  It could even mandate that any traditional muni offering pass a Treasury cost-benefit analysis or pass a similar hurdle. 
• Finally, prohibit bailout money from being used to pay interest on munis.  Congress and the Obama administration already are telling corporations how much they can pay their executives and placing unsecured creditors ahead of secured ones in federal bankruptcy proceedings.  So why shouldn't it screw muni bondholders too, particularly if they're "rich?"

No less an authority that PIMCO's Bill Gross, perhaps the world's most prominent bond investor, says "Don’t turn your back on the government when it comes to your investments."  That's good advice if I ever heard it.

Copyright © 2009 by Mark Nestmann