Tax Reform and Tax Exempt Status of Municipal Bonds

Last Updated: 11/27/2013

 In 1986, Congress overhauled the federal tax code, purging it of various exemptions, deductions and credits and using the savings to reduce marginal rates on both individuals and firms. It was a significant change, but over the years Congress and presidents of both parties have proceeded to undo the changes by tweaking the tax code 15,000 times over the last quarter-century. Special breaks, large and small, have crept back into the code during this time. 

For the past three years the Senate Finance Committee, under Chairman Max Baucus (D-Mont.), has been assessing the issue, poring over the code in hearings and private meetings, with the goal of writing the first major tax-reform bill since 1986 before the 113th Congress ends and Mr. Baucus retires.  Many believe the effort will collapse under the typical polarization that besets Washington. 

The two leaders of the Senate Finance Committee have approached tax reform with a "blank slate" methodology as a starting point for tax reform.  The approach would begin with a tax code where virtually no tax breaks would be available.  The Senators called on their Senate colleagues to provide suggestions on which tax provisions need to be added back and improved in a reformed tax code. Senators Baucus and Hatch emphasized that any tax provisions should be added back only if they help grow the economy, make the tax code fairer, or effectively promote other important policy objectives. Senators had until July 26 to submit their proposals.

The Senators have indicated that the “blank-slate” is not the end of the discussion. Rather, they both believe that some existing tax expenditures should be preserved in some form. But the tax code is also littered with preferences for special interests. To help inform submissions, the Senators had the nonpartisan Joint Committee on Taxation (JCT) and their staffs analyze the relationship between tax expenditures and the current tax rates if the current level of progressivity is roughly maintained. The amount of rate reduction would depend on how much revenue was reserved for deficit reduction, if any, and from which income groups.  

Policymakers from across the political spectrum have called for fundamental changes to our tax rules. However, tax reform could have significant implications to the City particularly if changes are made to the tax exempt status of municipal bonds and/or Home Mortgage Interest Deductions.  

Tax-exempt municipal bonds 

State and local governments have used tax-exempt municipal bonds to build public infrastructure for more than 200 years. It is the key feature that enables state and local governments to access necessary private investments for critical infrastructure projects, such as the construction or improvement of streets, highways, hospitals, bridges, water and sewer systems, playgrounds, public parks, and other public works. In fact, 75 percent of all national infrastructure projects have been completed using this low-cost, market-driven financing tool.  Over the last decade, municipal bonds were used to finance $1.65 trillion in state and local infrastructure investments.

 Home Mortgage Interest Deduction (HMID) 

The repeal of the HMID and real property tax deduction would affect the finances of nearly every American and would have uncertain impacts on an already volatile housing market. Deductions for mortgage interest have been in place for more than a century as a means of encouraging home ownership. Local communities directly benefit from homeownership, as homeowners are active in the civic and political organizations of the community. Homeownership also promotes stability in the community, which creates positive social benefits and more desirable communities that retain and attract businesses and residents. 

While tax reform is a laudable undertaking, there are potentially serious implications to the City if changes were made to these two deductions in particular.  Reductions in the availability of tax-exempt financing to municipal governments, or increases in the cost of issuing tax-exempt bonds, could impose short and long-term fiscal implications on the City. Changes to HMID could have a distressing effect on the fragile recovery of the housing market, which would likewise impact the City.