The US public debt currently totals $14.9 trillion and now exceeds our nation’s gross domestic product (GDP) with a debt-to-GDP ratio of 101.1 percent. That ratio has climbed to a post-World War II high and is rapidly approaching 120 percent, a threshold which economists Carmen Reinhart and Kenneth Rogoff associate with civil unrest and economic turmoil.
Although the European sovereign-debt crisis dominates the headlines, the US domestic debt burden is a major cause of the tectonic shifts underway in the political landscape. At this point, every option for debt reduction seems to be on the table.
Municipal Bond Tax Exemption
One item up for review is the tax exemption on interest paid by municipal bonds.
Municipal bonds achieved tax-exempt status in 1895 when the US Supreme Court ruled that the federal government didn’t have the constitutional authority to tax such bonds. Although the court reversed this ruling about 100 years later, Congress has yet to change the rules.
But because some policymakers view municipal bonds as a tax shelter for wealthy investors, municipal bonds’ tax-exempt status could soon be adjusted. As part of a jobs bill, the Obama administration recently proposed a cap on the amount of municipal bond interest that’s eligible for tax exemption. Although the jobs bill is currently stuck in Congress, many analysts believe that the muni tax exemption remains vulnerable to elimination in 2012 because presidential campaign politics could frame municipal bonds as a tax break for the rich.
Let’s hope that the truth wins out over such demagoguery. More than 40 percent of municipal bonds on the market are owned by retail investors, so municipal bonds are not solely the province of the wealthy. In fact, the middle class would most likely be the hardest hit should municipal bonds become taxable.
Additionally, such a shift in tax policy could hurt municipalities themselves. Most municipalities enjoy lower costs of capital than even AAA-rated corporate borrowers because investors are willing to accept
Without a tax exemption to sweeten the deal, investors would demand municipalities compensate them with higher rates on their bonds.
Although municipal balance sheets have improved as a result of spending cuts and a stabilizing economy, municipalities can ill afford an increase in borrowing costs while property values and their associated tax receipts remain stagnant.
Keep Municipal Bonds Tax-Free
Our nation’s budget needs to be balanced, but policymakers who pursue punitive tax reform could harm some of the very entities they claim to care about most.