Obama Budget Shakes Up Municipal Bonds

In the new federal budget he proposed on Tuesday (February 13), President Obama wants to reduce the tax breaks enjoyed by high-income earners who buy municipal bonds. But state and local governments believe the move would increase their borrowing costs and complicate financing for capital projects.

Reuters reports that, if approved, the proposal could “rock the $3.7 trillion (municipal bond) market.” States depend on the market to raise cash for transportation infrastructure and a range of other initiatives.

Obama’s budget would reduce tax deductions for municipal bond investors from the current 35 percent of income to 28 percent. The move would apply to the tax-exempt interest earned on municipal bonds and affect individual investors earning more than $200,000 a year or families earning more than $250,000.

But states and localities fear the change would discourage investment in a market they need. Individual investors who buy municipal bonds frequently have high incomes, and one of the debt’s chief selling points is that they can exempt the interest from their federal income taxes,” Reuters explains. “The long-standing practice allows states, local governments and authorities to offer lower interest rates on tax-exempt debt than they would on taxable bonds.”

At the same time, Obama is proposing to offset some of the potential damage to state and local governments from the tax break change by resurrecting the Build America Bonds program, which was part of the 2009 stimulus package and allowed states and localities to issue federally subsidized debt. The popular program expired at the end of 2010, but Obama has sought to permanently extend it.

Some observers saw a contradictory message in Obama’s two proposals. “It still baffles me how the administration can, on the one hand, invest in infrastructure and then impose a tax on the way most of the infrastructure is financed,” Bill Daly, a senior vice president at Bond Dealers of America, tells The Bond Buyer .

Both investors and the states are unlikely to worry too much about Obama’s initiatives, however. The president faces sharp resistance from Republicans on Capitol Hill, just as he does for his overall spending plan. “This entire budget is essentially dead before arrival,” Ken Kies, a former chief of staff of the congressional Joint Committee on Taxation, tells The Bond Buyer.