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Davis Brown Tax Law Blog

Tax Law Blog: Attacks on the Exemption for Municipal-Bond Interest and Why it is Important to the Average Taxpayer - December 17, 2012

Tax reform is a big topic in today’s news and much of the presidential campaign and debates were centered on how to get our nation out of debt and back on track.  One of the proposed cuts in President Obama’s budget for 2013 is a limit on the municipal bond income tax exemption.

For those entities that qualify to issue tax-exempt municipal bonds, the importance of the tax-exemption is that it allows them to borrow money at a lower interest rate and the cost of borrowing is much lower than in a taxable deal. The exemption for the use of tax-exempt bond proceeds is limited to certain entities, including, but not limited to, municipalities, airports, certain non-profits, hospitals, and colleges.

The argument for taking away this exemption or limiting it is that the interest would become taxable and would help eliminate the deficit.  However, there are some serious flaws in this analysis as well as some increased costs this would have on all taxpayers in other ways.  

If the cost of borrowing is increased for cities and other qualifying issuers, there is a greater likelihood that there will be a reduction in infrastructure (which would impede economic growth, job creation and deficit reduction).  Also, individuals that would no longer qualify for the tax exemption on municipal bonds would have an incentive to move their funds to other investments where they would receive favorable tax treatment.  This would ultimately result in a smaller market for municipal bonds and may not have the anticipated effect of helping to raise revenues to get out of our nation’s debt.

The alternative is for cities, hospitals, airports and colleges to issue bonds at a higher interest rate (which results in a greater cost of borrowing) and then pass the cost onto taxpayers through increased fees or taxes.  

The ultimate effect of eliminating or reducing the exemption for municipal bond interest is that it will shrink the market for tax-exempt bonds, increase the cost of borrowing to cities and other issuers of these bonds, increase fees and taxes for all taxpayers in order to pass on the increased costs of borrowing and impede economic growth.