Markets In Action

A Bad Idea That Won’t Die

The infrastructure backbone that supports the American economy-roads, highways, bridges, water systems, electrical grids and more-is in dire need of repair, and funding is short. So why has the Obama administration proposed to make that funding harder to come by?

The administration’s fiscal year 2017 budget document submitted to Congress proposes a partial tax on municipal bond interest, which is currently exempt from federal taxes in most instances. Specifically, the Obama budget proposal would put a 28% cap on the interest exemption for municipal bonds, which would affect all Americans, as investors in municipal bonds and as taxpayers securing the payment of municipal bonds. This cap on the tax-exemption is an effective partial tax on municipal bond interest for investors in tax brackets above 28 percent.

According to a report by the National Association of Counties (NACO), “in 2012 alone, the debt service burden for counties would have risen by $9 billion if municipal bonds were [fully] taxable over the past fifteen years and by about $3.2 billion in case of a 28 percent cap.”

A cap on the interest exemption is a bad idea for several reasons. Municipal bond financing is critical for state and local infrastructure construction and maintenance. The idea would hinder State and local government’s ability to finance vital infrastructure projects at the lowest cost to taxpayers by raising interest costs associated withfinancing those projects . Imposing taxes on investors’ municipal bond interest payments will only make it more difficult to incentivize investors to fund these critical projects, driving up the cost of infrastructure construction and maintenance.

In 2013, the American Society of Civil Engineers (ASCE) rated U.S. infrastructure with a “D+” grade, citing the deteriorating conditions of many of the nation’s transportation systems, utility systems and other vital infrastructure. Most observers agree substantial investment in maintenance and new construction is required to keep pace with population growth and demand.

At the same time, public financing for these projects is tough to come by in a time of declining gas tax revenues, large budget deficits and growing federal debt. That’s why municipal bond financing is so vital-it allows state and local governments to fund large-scale projects using long-term debt sold to private investors at reasonable terms.

But the federal tax exemption on municipal bond interest is a key part of what makes municipal bonds cost-effective and appealing to investors. In a recent op-ed column for The Hill, Washington State Treasurer James McIntire and Oklahoma State Treasurer Ken Miller warned that Obama’s proposal will stifle infrastructure investment:
Every day throughout the nation, infrastructure shortfalls are addressed with financing from tax-exempt municipal bonds. Last year, state and local governments invested $400 billion in public infrastructure. If the tax benefits of municipal bonds are capped as the president proposes, the nation’s mayors – over half of whom cite underinvestment in infrastructure as their greatest challenge – state treasurers and county leaders would have significantly less to invest in infrastructure due to higher interest payments.

McIntire and Miller point toward costs for particular transportation projects in their states would increase by tens of millions of dollars. They conclude:

The American Society of Civil Engineers estimates that more than $3 trillion will be needed to modernize and repair America’s infrastructure by 2020. With so many needs throughout the nation, now is the wrong time to make all these projects more expensive by fundamentally changing this incredibly successful financing program.

This is an argument echoed by SIFMA’s President and CEO Kenneth E. Bentsen, who points to the economic benefits of infrastructure investment, which serves to increase productivity and foster economic growth. Bentsen argues that taxing municipal bond interest “would add further financial burdens to our cash-strapped state and local governments, ultimately discouraging investment in infrastructure projects and stifling job creation.”

The good news is the proposal to limit tax exemptions on municipal bond interest is unlikely to take effect this year. However, proposals to alter the tax-exempt status of municipal bonds have surfaced repeatedly in recent years, as the NACO report emphasizes, and are likely to surface again the future. Advocates for municipal bonds and local infrastructure projects should be prepared to explain to policymakers and the public why this tax idea is wrongheaded and counterproductive.