Washington needs to review taxes on municipal bonds

Washington lawmakers who are at the forefront of negotiating the fiscal cliffs should take it slow. According to economists, one wrong move especially when it comes to the issue of municipal bonds could wreck US cities and state budgets and send the US economy falling.

Municipal Bonds and Tax Increases

Municipal bonds is a $4tn-market. They help keep the school districts within the US functioning. These bonds are issued by the state and the cities and are sold to buyers. The proceeds are then used to pay for schools, roads and bridges and a host of other government-sponsored infrastructures. In return, the bonds sold would increase in value overtime making the wise investments by individuals and groups. In fact, about 40% of all municipal bonds are owned by individual investors. If you would consider the mutual funds pertaining to individual investors, you would find that the ownership is actually at 71%.

You would think that banks, pension funds and insurers are the primary buyers of municipal bonds but in fact, they only make up a small number. The primary reason why municipal bonds have so many individuals investors as buyers is because they come without taxes.

Why Municipal Bonds should Remain to be Tax-Free

The Obama Administration has redefined the rich. The new definition would be homes that earn more than $250,000 a year. All of those who buy municipal bonds are the rich and therefore, approximately $30bn a year is lost in supposed federal tax payments because of the exemption that goes to higher-income families.

Tax breaks on higher-income households is something that the Obama administration is strongly campaigning about. However, if the municipal bonds are involved, then that would indirectly mean that government entities (state and local) would also get higher taxes. To economic analysts, that would be like a snake eating its tail.

If this is the scenario, then investors would shy away from the municipal bonds. But since cities and states would need investors to buy their bonds in order to realize infrastructure projects, then the immediate state or city would get seriously wounded. In the words of an analyst from Citigroup, “ losing the tax exemption could wane the appetite of investors for this class of asset.”

Effects of Taxes on Munis

If legislators fail to analyze the bigger picture and push through with the tax non-exemption of municipal bonds then small issuers would most likely have limited access to money. In the long run, this would greatly hurt capital improvements that are needed for the repair of much-needed infrastructures like schools, bridges, and roads and so on.

If this continues, then analysts are afraid that the local city and state economy would get seriously affected. Without the money needed for repairs, roads would ultimately become impassable thereby affecting the on-time delivery of goods. Schools would not be properly equipped to house students and that would affect their education too.

Alternate Routes

Seeing the effects of imposing taxes on municipal bonds, some groups are working on capping the tax break at 28%. This cap would apply to both old and new bonds that have been bought. It is also suggested that the cap should not affect those who have bought municipal bonds but are earning less than $250,000 a year.

The downside to this proposal, though, is that it could make borrowing by states and cities more expensive primarily because of the higher interest rate. Other than that, some municipal bonds could lose anywhere from 2% to 5% of their values making them less desirable.

If the US really has to go through the fiscal cliff, then Washington lawmakers should closely examine every aspect to make sure that it will not lead to a failing economy. The issue of municipal bonds is one of those that need to be cleared out.