1861 Capital: Municipal Arbitrage Losses and Gains

1861 Capital Municipal Arbitrage Gains and Losses

WASHINGTON — Senior White House economic advisors have told state and local officials that tax- exempt bond interest is “off the table” and will not be part of the administration’s proposed 28% cap on the value of exclusions, deductions and other tax preferences for wealthy taxpayers, according to those familiar with the discussions.

“There is nobody at the White House who understands state and local financing,” said a market participant who did not want to be identified. “It was not a proposal put together by people at the Treasury who understand municipal bonds.”

The White House backed away from the proposal because the advisers who crafted it didn’t fully understand the consequences to state and local governments, several knowledgeable sources said.

In the American Jobs Act that President Obama sent to Congress in September, he proposed to limit the value of tax- exempt interest from muni bonds, as well as other tax expenditures and deductions, to 28% for all individuals with

$200,000 or more of taxable income and married couples with $250,000 or more.

The cap would have decreased demand for munis and raised borrowing rates for state and local governments and could have destroyed the tax-exempt bond market because of the uncertainty it would create about the value of tax-exempt interest for investors, market analysts said.

The $447 billion job-creation package of tax cuts and new government spending failed to gain traction in Congress even after Democrats split up sections of the package into separate bills. But muni bond market participants feared the cap on tax- exempt interest still might be in play as the administration looked for ways to trim the budget deficit.

However, since the initial proposal, White House staff have said, in several meetings with municipal officials, that they did not intend for the cap to hurt state and local governments and that they are no longer considering applying the cap to tax-exempt bond interest, according to market participants. A White House spokesperson could not be reached for comment.

Matt Fabian, a managing director at Municipal Market Advisors, said state and local issuers would pay higher borrowing costs.

“It’s definitely a negative factor,” he said. “In the current market conditions it’s hard to see this type of tax reform triggering a catastrophic end to muni bond demand. There are other forms of tax reform, including total repeal of tax- exemption, that would have an enormous and negative impact to munis.”

The officials who were briefed at the White House were pleased that the administration recognizes the proposal’s high cost to state and local economies, sources said. However, they expressed worry that even though the White House is not pursuing the cap, the proposal could resurface in the coming year as Congress seeks bipartisan avenues for deficit reduction and tax reform.

Two bipartisan groups of former lawmakers and administration officials have each recommended the curtailment or elimination of tax-exemption as a means of cutting the federal deficit. Sources warned that the muni market is “not out of the woods yet.”

The President’s National Commission on Fiscal Responsibility and Reform, led by Democrat Erskine Bowles, former chief of staff to President Bill Clinton, and former Republican senator Alan Simpson from Wyoming, made recommendations for deficit reduction in 65-page report called “The Moment of Truth.”

It contained an “illustrative individual tax-reform plan” recommending that there be no tax-exemption for new muni bonds.

Before that, the Bipartisan Policy Center’s debt-reduction task force issued a 137-page report called “Restoring America’s Future” that urged there be no tax-exemption for any new private-activity bonds, including bonds for single- and multifamily housing, airports, water and sewer facilities, hospitals and small manufacturing facilities.

That task force was led by Alice Rivlin, a senior fellow at Brookings Institution, as well as former Sen. Pete Domenici from New Mexico, now a senior fellow at the Bipartisan Policy Center. Rivlin helped found the Congressional Budget Office and formerly headed the Office of Management and Budget. She also was vice chair of the Federal Reserve Board. Domenici formerly chaired the Senate Budget Committee.

One representative of local governments expressed concern that other entities, including some Republican presidential candidates, may embrace the recommendations from those groups or even the president’s cap proposal. Last week, GOP hopeful Mitt Romney suggested he would use the Bowles-Simpson deficit commission report as a framework for tax reform.

Meanwhile, members of the tax-exempt bond community are awaiting the president’s fiscal 2013 budget plan, due out on Feb. 13, and hoping it does not pose any new threats to tax- exemption.

Copyright 2012 The Bond Buyer. All rights Reserved.

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