The Muni Bond Tax Break Is a Tempting Reform Target

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Prominent mayors and municipal officials called the President last week to urge him to preserve tax breaks which benefit cities amidst talk of federal tax increases. The President listened but apparently gave them no assurances about one of their greatest concerns, allowing holders of municipal bonds to continue to receive their interest tax-free.

It's not surprising that ending or narrowing the federal exemption on municipal bond interest, which dates back to the origination of the income tax code in 1913, might be on the table now. It's a bi-partisan target. President Obama has twice proposed, including in his budget for fiscal 2013, limiting the deduction of municipal bond interest to 28 percent for families with adjusted gross income of $250,000 and single filers with $200,000 in income. These taxpayers receive about half of all the benefits from the muni exemption and so are on the President's radar screen as part of his plans to raise taxes on upper income taxpayers.

At the same time, Republicans in Washington have increasingly worried about the levels of debt that states and cities are accumulating. Some blame the muni-bond exemption for helping to enable a barrage of new muni issues, and these critics wouldn't mind seeing the exemption limited or erased as part of a fiscal cliff deal. House Budget Committee Chair Paul Ryan's alternate GOP budget set the framework earlier this year by proposing to eliminate the special tax treatment of interest on municipal bonds. The bi-partisan Simpson-Bowles commission also called for eliminating the deduction as part of reform that would have saved money in order to lower tax rates for all Americans.

Concerns about growing state and local debt are hardly confined to Republican fiscal hawks these days. The States Project, a joint venture of Harvard's Institute of Politics and the Fels Institute of Government at the University of Pennsylvania, recently estimated that total state and local liabilities now amount to about $7.3 trillion, counting retiree obligations that haven't been funded as well as traditional debt. This is well beyond what is commonly understood to be the level of state debt, because "states do not account to citizens in ways that are transparent, timely or accessible," the group noted in a report.

Outstanding bond debt is certainly part of that worsening picture. It has risen from $1.047 trillion in 1995 to $2.895 trillion today. Much of that growth is recent. From 1995 through 2000, state and local debt rose just $151 billion, or 15 percent. But since then state and local debt outstanding has increased by one and a half times, or $1.78 trillion. One reason is that our states and cities aren't paying off their debt; instead they've taken advantage of low interest rates to refinance debt at longer terms, while adding new obligations.

Local elected officials will defend the tax exemption, which allows them to issue debt at lower interest rates than taxable bonds, because they say munis are essential to helping municipalities raise money cheaply for building and maintaining America's ‘infrastructure.' But while that word conjures up images of the national highway system and bridges and tunnels, increasingly states and cities have used tax-free debt to finance economic development projects that are often speculative in nature, including everything from sports arenas and stadiums to museums and convention centers.

The taxpayers of South Florida, for instance, are groaning under $500 million in debt floated to build the Miami Marlins baseball team a new stadium. The city of Harrisburg, capital of Pennsylvania, is insolvent in large part because it floated hundreds of millions of dollars in debt to build a Civil War museum, a minor league baseball stadium and a municipal incinerator using speculative new technologies that never produced the anticipated revenues.

Some of the rise in debt is also attributable to states and localities using borrowing to boost budget spending, what the Harvard/University of Pennsylvania study labeled ‘accounting tricks.' "California," the study noted, "has been particularly guilty of using debt to cover deficits." The problem with that, of course, is that borrowed money builds in higher levels of spending on government budgets that's not supported by regular tax revenues. It's another way of living beyond our means.

Part of what makes state and local borrowing so worrying is that it comes amid a stark rise in other liabilities, notably in retirement promises to government workers. In a 1995 report the U.S. General Accounting Office estimated state and local pensions had accumulated $200 billion in unfunded liabilities, or about $300 billion in today's dollars. The recent Harvard/University of Pennsylvania study, however, estimates that unfunded liabilities are now at a whopping $3.4 trillion, plus another $1.2 trillion in promised health care benefits for retirees that haven't been funded. That's well more than a 10-fold increase in these obligations. Most state fiscal analysts, including Wall Street ratings agencies, now consider pension debt along with traditional bonded debt when evaluating the health of state and local budgets. Under that scenario, the total liabilities of some states are far higher than once thought.

Some defenders of the tax break for munis will argue that eliminating it will only make states' efforts to dig themselves out of their financial problems even more difficult because it would raise the cost of borrowing. Munis have powerful defenders in Congress, too, because many representatives are politically allied back in their home districts with mayors and local council officials who rely on tax-free borrowing.

But some elected officials have also demonstrated a notorious inability to restrain themselves when it comes to using borrowed money instead of tax revenues for new spending or to fund their pension systems, plunging taxpayers further into debt. That's why a tax reform in Washington that both raises more revenue to close the federal deficit, while making excessive borrowing less attractive to local government, is suddenly looking far more inviting to policy makers.


Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

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