In the face of potential broad sweeping tax reform, a bi-partisan Municipal Finance Caucus has been formed in the House of Representatives in order to assist states and municipalities with their infrastructure and other municipal finance needs.

Some in the public finance community worry about comprehensive tax reform, along the lines of the 1986 Tax Reform Act, which fundamentally changing the “rules of the road” for states and local governments. This is a legitimate concern, in that nothing in the 1984 Treasury Department Study that led to the process beginning in January 1985 led anyone to expect either change to already-issued notes and bonds (affecting both issuers and investors) nor wholesale elimination of categories of tax-exempt financing as of January 1, 1987, such as for commercial office facilities and pollution control industrial revenue bond transactions. So anyone involved in public finance in 1984-1986 certainly worries about the “last war” happening again.

A more significant reason for the formation of the caucus, however, is the introduction of many measures that individually would harm issuers, investors and/or projects, often for reasons of “raising revenue” to offset other tax changes, such as a lowering of corporate and/or individual marginal tax rates.

One example is the potential “cap” at 28% for the value of tax-exemption introduced in the last several Presidential budgets, which would get revenue based on the higher marginal rates of certain taxpayers. The purpose of setting this limit would be to make a percentage of the interest income into taxable income in that tax year for that taxpayer. This has been judged to gain significant revenue, in part because in the proposal there is no “grand-fathering” for outstanding tax-exempt bonds, which may have up to forty years to maturity. The Bond Dealers Association, SIFMA and other trade associations have all said this would significantly harm the market, in that it would dramatically reduce demand by higher tax bracket investors, both directly and indirectly (such as by means of funds and unit investment trusts).

If existing securities were at a fixed rate, their drop in value would be a loss to existing Bondholders were they to sell prior to maturity, as all potential investors would re-adjust their offers to gain the same after-tax yield they seek to obtain under current law.

For bonds with an interest rate which re-sets, for example weekly or quarterly, the Remarketing Agent would have to offer the bonds at higher yields/higher interest rates for the same reason, which would impose the loss going forward on issuers, just as in the case of newly issued Bonds. That greater additional cost to issuers is why coalitions of states and cities such as the National League of Cities, oppose such a “cap” on the value of the tax exemption.

Former House Ways and Means Committee Chairman Dave Camp offered a tax reform plan with a 10% surtax for certain higher-income taxpayers, including interest on municipal bonds. The Council of Development Finance Agencies (CDFA) and others pointed out that this plan could make certain tax-exempt industrial revenue bonds, already subject to the alternative minimum tax, as or more heavily taxed than ordinary corporate bonds, and accordingly opposed the idea as taking a key element of the “economic development tool-box” away from states and localities.

Although as many as fifty million investors hold municipal bonds, either directly, indirectly, or because a pension plan on their behalf holds such investments, the key tax-exempt bond provisions are far less well-known to ordinary voters than the mortgage interest deduction or charitable itemized deduction many individual taxpayers take on their Form 1040 Schedule A each year. So the goal of the caucus is to make sure that before any such provisions are modified or eliminated, whether to achieve tax simplification or other reform, a full discussion of the value of tax-exempt bonds in terms of state and local finance, especially the funding of infrastructure, is part of the overall approach.

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