Looming tax cliff puts municipal bond tax exemption back in play

Bonds

They’re calling next year the Super Bowl of federal tax policy, and everything, including the municipal market’s prized tax exemption, will be in the game.

Congress is gearing up for a potentially major tax overhaul post-election as provisions in the 2017 Tax Cuts and Jobs Act, the largest tax overhaul since 1986, are set to expire next December. The growing federal deficit makes the hunt for revenue more urgent.

But as is the case whenever Congress creates a tax vehicle, it brings risks and creates an opening for the muni market to win passage of its priorities.

“Given that we have a unique group of circumstances coming together in 2025, it represents an opportunity for the municipal market to make its case in terms of what it does for communities and providing infrastructure and to expand its capabilities,” said Edwin Oswald, a tax partner at Orrick Herrington & Sutcliffe in Washington D.C.

The danger, Oswald warned, comes as “people are looking to spend more or extend some of the tax cuts that are expiring. With the national debt now playing more of a role, they’ll always look for revenue offsets, and tax-exempt bonds will be part of that conversation.”

Ed Oswald, a tax partner at Orrick Herrington & Sutcliffe in Washington D.C., said next year will bring opportunities and risks for the municipal bond market.

Burwell Photography – John Burwe

The TCJA was estimated to cost around $1.5 trillion over 10 years, and Republicans, who passed the bill through the reconciliation process to avoid a Democrat filibuster, added the 2025 sunset to help reduce costs. A full extension of the law’s expiring provisions, which includes all the individual tax policies, is now estimated to cost between $4 trillion and $5.2 trillion, according to various estimates, including the Joint Committee on Taxation.

Meanwhile, the Congressional Budget Office in a budget update released Tuesday estimated that the 2024 fiscal year, ending Sept. 30, will end with a $1.9 trillion deficit, 27% higher than the CBO predicted in February. Federal debt is expected to total $28.2 trillion by the end of the year. In comparison, federal debt totaled $14.7 trillion at the end of fiscal 2017.

“If next year is about looking at the federal deficit and the amount of federal Treasury debt, it could be a year of serious deficit reduction,” said Micah Green, senior counsel at Steptoe LLP. “But also there’s all these expiring provisions from TCJA, so it’s going to be about tax reform. It’s a convergence of historical proportion that requires every sector in the economy, but particularly state and local governments, to make sure their members of Congress are fully engaged and educated about how policies will affect their own communities.”

The Joint Committee on Taxation most recently estimated the cost of the tax exemption at $181 billion from 2022 to 2026, or $40 billion annually. The Bond Dealers of America noted in a February Bond Buyer column the tax exemption faced the threat of elimination or significant haircuts with “deficit proposals advanced by then Ways and Means Committee Chairman Dave Camp in the early 2010s and throughout the Obama era.”

President Joe Biden has dubbed himself the infrastructure president, but the importance of the tax exemption remains cloudy as the Treasury Department’s Green Book has failed to mention the tool for the last two years. And Treasury has been without a specialist on muni finance tax issues since John Cross, who served as associate tax legislative counsel at the Office of Tax Policy, left in 2019.

A March report from the American Enterprise Institute, which caught the muni market’s uneasy attention, argues for eliminating the tax exemption, dubbing it an “inefficient” way for local and state governments to finance infrastructure.

Permanent TCJA measures that affect the market will also be in play next year. That includes the elimination of tax-exempt advance refunding and the corporate tax reduction to 21%, which some said reduced muni demand. Allowing individual tax cuts to expire would likely increase demand for muni paper.

A controversial $10,000 cap on state and local taxes, which high-tax state lawmakers have tried several times to overturn, will sunset next year without action. That’s also the case for the reduced alternative minimum tax, which, if allowed to expire, could reduce demand for AMT paper issued by airports and other muni issuers.

An early version of the bill pushed by House Republicans eliminated new qualified private activity bonds, Oswald noted. The Senate later stripped out the provision, but PABs represent another popular financing tool that could be on the chopping block next year.

The Inflation Reduction Act’s clean energy tax credits, extended for the first time to state and local governments, will also be under scrutiny.

“An essential component of how one might view this is how the election results pencil out in November,” Oswald said. “In broad strokes, if the Democrats have a clean sweep, I think the municipal market would generally be in better shape versus if the Republicans got a clean sweep,” he said. “Then I think tax cuts are front and center and then perhaps municipal bonds have more at risk in terms of being used as a pay-for.”

Though the outcome of November election remains uncertain, lawmakers have started to lay out their positions. The Biden administration has said it would extend the individual tax cuts for households making less than $400,000, increase taxes on the very wealthy and raise the corporate income tax to 28% from the TCJA-set 21%, which reduced it from 35%.

Republicans have said they would fast-track a tax/budget bill that extends TCJA through the reconciliation process if they sweep in November. But recent reports have noted that some GOPers are backing off the idea of a full extension, saying any new tax bill would need manage the growing federal debt.

The House Ways and Means Committee, where all tax legislation originates, has created tax teams to address a key TCJA provision that’s set to expire, and launched its debate with an April 11 hearing on the TCJA.

“This is the beginning of what we are going to see over the next 20 months with the expiration of $4.3 trillion worth of tax cuts on all Americans,” said committee Chair Rep. Jason Smith, R-Mo. “So we have a lot of work before us.”

Senate Democrats held their first meeting Thursday to begin to prepare for the tax cliff, and Senate Finance Committee Chairman Sen. Ron Wyden, D-Ore., told local reporters that they agree on higher taxes for wealthy individuals and multinational corporations.

Wyden named affordable child care and housing — including low-income tax credits — as top priorities, and said the Democrats are putting together a “menu” of proposals to raise revenue, according to reports. “We’re coming up with smart, cost-effective ways to close loopholes,” Wyden was quoted as saying.

For investors, it remains too early to make portfolio moves based on possible post-election policy changes, according to Jennifer Johnston, director of research, municipal bonds, at Franklin Templeton Fixed Income.

Among clients’ top concerns, “the tax-exemption question comes up regularly,” Johnston said in an email. “We view the elimination of the tax-exempt benefit as extremely unlikely,” Johnston added. “In regards to tax-exempt advance refunding and those types of policies, we are watching what the ultimately make-up of Congress will be after the November election. Will we have a divided Congress where passing legislation is going to be challenging?”

Johnston said tax rate changes in general can shift investor appetite. “This could in turn impact market technicals,” she said. “An increase in demand without a commensurate increase in supply could push prices up on a relative basis. The opposite could happen if demand slows.”

Steptoe’s Green, who started his public finance career the year after the 1986 tax overhaul, in which the municipal market “got creamed,” said educating lawmakers about the need for the tax exemption will be key.

“The tax exemption isn’t a break for wealthy investor, it really does reduce the cost of borrowing for state and local governments and saves money for local taxpayers,” Green said. “It may come with a revenue score, but if it reduces the cost of state and local borrowing, that’s an important fiscal responsibility.”

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