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Reduced municipal bond tax benefits could threaten all governmental credit ratings

Senate tax writers say that no tax break is safe in their quest to overhaul the U.S. income tax code.

Municipal-bondsOne credit rating firm, however, says that eliminating or even just reducing the tax exemption for interest paid by municipal bonds could ultimately have negative credit implications for the bonds' issuing jurisdictions.

Standard & Poor's (S&P) Ratings Service, along with the National Association of Counties (NACo) and various bond associations, are concerned about a proposal to cut the value of municipal bond tax breaks for higher income earners. Doing so, they argue, would dramatically and adversely affect the $3.7 trillion municipal bond market.

"Without the tax exemption, municipal borrowers would face higher interest rates with the inevitable result that many state and local governments would need to impose higher taxes, do less capital investment, or some combination of both," S&P said in its report, "Cutting Popular U.S. Tax Programs Could Harm Tax-Exempt Bond Issuers," issued Monday, Aug 19.

Even more worrisome is the suggestion, driven in part by the Senate Finance Committee's "blank slate" approach to tax reform, is that the tax exemption for muni bonds could be eliminated.

Where bonds are used: "In 2012 alone, the debt service burden for counties would have risen by $9 billion if municipal bonds were taxable over the last 15 years and by about $3.2 billion in case of a 28 percent cap," according to NACo's policy paper "Municipal Bonds Build America."

Municipal bonds have been a staple for state and local governments since the 1800s, says NACo, with tax exempt treatment granted when the federal income tax was created in 1913. These instruments finance a variety of large-scale projects, as shown in the table below from NACo's report.

Municipal bond chief projects 2003-2012 Thomson Reueters via NACo

Individual taxpayers would take hit, too: NACo and S&P also argue that it's not just wealthier taxpayers who would suffer if the beneficial tax treatment of muni bonds was changed or erased.

American households hold almost three-quarters of the municipal bond market, for retirement plan diversification and as a way to invest in their communities, according to NACo's report. Any cap or repeal of the tax-exempt status of municipal bond interest would deeply affect Americans' retirement nest eggs.

The resulting higher debt service also would impact counties and other state and local governments' budgets, directly affecting taxpayers.

"If ending the tax exemption for municipal borrowers leads to higher state and local taxes, low-income taxpayers could see their tax bills increase," adds S&P in its report. "This outcome would be at odds with any suggestion that the municipal tax exemption should be ended because it unfairly benefits the wealthy."

S&P's analysis also argues for retention of the mortgage interest and local tax deductions. Changes, says the credit rating firm, would undercut housing demand.

"Any drag on residential purchases - or on the housing market in general - would dampen the rate of economic expansion to some degree. The only debate is by how much," S&P says.

Are municipal bonds part of your investment portfolio? How much would a change in the bonds' tax treatment affect your holdings and asset strategy?

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