1. MARKET UPDATE
Rethinking Municipal Interest Deductibility:
Perception vs. Reality
Anthony Tanner, CFA®
, Senior Investment Manager May 17, 2013
Bryan D. Austin CFA®
, CIMA ®
, Director, Financial Planning, Abbot Downing
The big economic news this week is that the U.S. budget deficit for the financial year ending in
September is likely to be much smaller than had been expected. The Congressional Budget Office
lowered its estimates for the deficit to $642 billion—the first time it has fallen below $1 trillion since
before the Great Recession. While this news calls into question the recent emphasis on deficit
reduction and the likelihood that Congress will enact comprehensive budget reform this year, many
investors remain concerned about provisions contained within President Obama’s preliminary
budget. These provisions would potentially reduce the value of itemized deductions, including the
deduction for state and local municipal bond interest income for some taxpayers. In this Quick
Market Update, we explore the implications of this proposed measure while underscoring the
importance of maintaining a long-term perspective toward your investments.
President Obama’s budget proposal: provisions and summary
On April 10, 2013, the Obama administration released its proposed fiscal budget for 2014,
including deficit-reducing spending cuts, new funding for a variety of programs, and roughly $580
billion in new taxes that would primarily affect the highest-income taxpayers and corporations.1
The specific items in the administration’s proposal that would affect upper-income taxpayers
include:
Reducing the value of itemized deductions and other tax preferences to 28 percent of
income for households currently in the 33, 35, and 39.6 percent tax brackets. The proposal
would limit the tax rate at which high-income taxpayers can reduce their tax liability to a
maximum of 28 percent. This limit would affect approximately the top three percent of
households in 2014, and would apply to:
– All itemized deductions, including charitable contributions
– Foreign-excluded income
– Tax-exempt state and local municipal bond interest income
– Employer-sponsored health insurance
– Retirement contributions; and
– Specific above-the line deductions.
Incorporating the Buffett Rule. The Administration also proposed to incorporate the Buffett
Rule, requiring that wealthy taxpayers pay no less than a 30 percent tax rate on their
1
These proposed changes are described in the Treasury Department’s “General Explanations of the Administration’s Fiscal Year
2014 Revenue Proposals” (commonly referred to as the “Green Book”).
2. 2
Adjusted Gross Income (AGI) after charitable contributions. This proposal likely would
apply to taxpayers with AGI levels exceeding $1,000,000 for Married Filing Jointly and
$500,000 for single filers.
We anticipate the probability of Congress passing a budget that reduces the value of itemized
deductions, including municipal bond interest, is low, but not out of the question. As a result, we
think it is worth considering what the long-term impact on the potential value of municipal bonds
would be, should such a reduction be approved.
Impact at current market yields
We believe the long-term impact on municipal bond prices and demand from a reduced tax
exemption for municipal bond interest income likely would be negligible and, that municipal bonds
still will offer tax advantages to many high-net-worth investors. Our view is based on the
composition of municipal bond investors, the current level of municipal bond yields vs. those of
taxable securities, and the lessons of history.
First, let’s review the holders of municipal bonds. A number of measures indicate that a majority of
municipal bond owners are either not in the highest federal tax bracket, or are institutions not
subject to individual income taxes. For example:
Only 45 percent of the $3.7 trillion municipal market is held directly by individual investors.
Twenty-eight percent of the municipal market is held by mutual funds, which tend to be
owned by retail investors. Almost 30 percent of the market is owned by institutions that the
proposed limitations would not impact.
Source: Federal Reserve, May 2013
High-income, high-tax-bracket households are a small minority of all mutual fund holders.
In fact, the 33 percent tax rate comes into play at $183,251 for most household filers.
Source: ICI and U.S. Census Bureau, May 2012
Table 1: Holders of U.S. Municipal Securities ($ Billions) Year-End 2012
Holder Amount Percent
Individuals $1,678.8 45%
Mutual Funds $1,062.8 28%
Insurance Companies $450.0 12%
Banking Institutions $392.3 11%
Other $130.7 4%
Table 2: Percent of Households Owning Mutual Funds
Household Income Percent
$200,000 or more 8%
$100,000-$199,999 31%
$50,000-$99,999 39%
Less than $50,000 22%
3. 3
Fifty-five percent of tax-exempt interest income was earned by taxpayers with an annual
gross income of under $250,000 in 2011, representing 83 percent of all returns filed by
taxpayers.
Source: IRS, January 2013. (For tax year 2011)
If the legislation were to pass in its current form, we would expect long-run net redemptions by
mutual funds, and sales by high-net-worth investors, to be minimal and, therefore, to have little
impact on bond prices. Individual investors holding these assets who are in relatively low (up to 28
percent) tax brackets likely will be unaffected by the proposals for a 28 percent deduction limit on
high-income taxpayers. For individuals in higher tax brackets, the value found in the municipal
interest exemption is primarily a function of the ratio of tax-exempt yields to other comparable
taxable alternatives. Presently, municipal bonds yield nearly the same as those of their high-quality
taxable counterparts across most of the yield curve. While a limit on the deductibility of interest
income would lead to additional taxes owed by higher-tax-bracket municipal bond investors, they
are unlikely to find suitable taxable replacements for their municipal holdings that offer an equal
amount of income net of taxes.
The value of patience
We agree that a limit on the tax deductibility of municipal bond interest may create short-term
displacement and some volatility-induced selling; however, this outcome can be viewed as an
opportunity for municipal investors with a longer-term view. Attempting to time the market by
reducing municipal holdings before any potential imposition of a tax-deductibility limit with the
intent to reenter the market at cheaper levels is a form of market timing that is likely to upset a
well-developed asset allocation strategy, and create negative consequences for the portfolio.
History—Lessons learned and potential impacts (This time it’s the same)
The administration’s budget proposal could potentially create a modest reduction in the after-tax
value of the municipal interest an investor receives. However, there are also several proposed
measures that would raise the overall level of taxable income for investors and could presumably
increase the value of and demand for tax-free municipal bond interest. A similar set of tax-code
changes occurred when the Tax Reform Act of 1986 was enacted in October of that year. It
reduced the highest marginal federal income tax rate from 50 percent to 28 percent. At the time,
many analysts postulated that a substantial reduction in the relative tax benefits of municipal
securities would lead to a significant drop in demand for municipal bonds, resulting in falling prices
and rising yields. As it turned out, the tax rate reductions were coupled with a decrease in the
number and types of deductions (including interest paid on consumer loans and credit card debt)
Table 3: Tax Returns and Tax-exempt Interest Reported
Bracket Count Percent Amount Percent
Under $100,000 3,231,753 54% 20,725 31%
$100,000 to $200,000 1,436,023 24% 12,831 19%
$200,001 to $250,000 306,474 5% 3,363 5%
$250,001 or more 981,196 17% 29,720 45%
5,955,446 100% 66,639 100%
Tax-exempt Interest
Reported
Returns Filed
4. 4
while several tax shelters that were once available to investors had become severely restricted or
eliminated. The net long-term impact on municipal bond values was virtually undetectable, as
illustrated in the ratio of municipal and taxable bond yields before and after the tax-code changes.
(See table 4).
Source: FactSet, 5/16/2013. *Yields as of end of September each year.
Although municipal interest was less valuable on a tax-equivalent basis, it remained one of the few
options for investors in high tax brackets to generate attractive after-tax income. We believe it is
unlikely that the proposed 28 percent tax cap on the municipal bond interest exemption would
occur in isolation and that any additional tax policies (such as a reduction in tax deductions) might
actually benefit the holders of municipal debt.
It is also important to consider the negative impact on the issuers of municipal debt, as state and
local governments would face an increased cost of capital as a result of this legislation. Many of
these issuers are still struggling to overcome significantly reduced tax receipts as a result of the
Great Recession in 2008 and have a strong incentive (and lobbying groups) to keep their debt-
issuance costs low. The municipal interest exemption has been in place since the income tax was
introduced in 1913. It emanates from the doctrine of “municipal reciprocity”—the federal
government does not levy taxes on municipal debt and municipalities reciprocate by not taxing
federal debt securities. Countering the spirit of this doctrine could potentially prompt local
governments to tax interest income on federal debt securities held by their residents.
Conclusion
It is unclear whether the proposed measure to reduce the deductibility of municipal bond interest
income will pass. While the budget process in Washington bears monitoring throughout the year,
we believe the optimum approach for investors who hold municipal bonds within their portfolios is
to stay committed to a well-diversified asset allocation strategy. In light of the potential tax
implications on municipal bond interest, we recommend that investors:
Continue to hold and invest in municipal bonds
Be active in the selection of municipal bonds in terms of structure, credit, sector and curve
positioning—working together with an investment professional to understand the choices
Don’t try to time the market, but rather, take advantage of potential market mispricing
and/or imbalances.
Table 4: Changing Rates and Yields
Year of Change
30-Year U.S.
Treasury Yield (A)
Bond Buyer 40
Index Yield (B)
Ratio (B/A)
1985 10.55 9.8 0.93
1986 7.59 7.56 0.99
1987 9.74 8.87 0.91
1988 9.05 7.86 0.87
1989 8.23 7.47 0.91
