Changing tax exemption for municipal bonds faces stiff opposition

Federal policymakers looking for ways to raise revenue while reforming policies that they see as subsidizing the affluent are eyeing proposals to limit the tax exemption for interest paid by municipal bonds.

But the proposals, like similar ones to limit tax deductions for mortgage interest and charitable donations, are running into determined opposition from those who say the policies — which have the backing of the Obama administration — would have unintended consequences.

In the case of the municipal bond deductions, advocates for local governments say limiting tax deductions on bond interest would hurt struggling state and local governments while hindering economic growth.

A recent study sponsored jointly by the U.S. Conference of Mayors and the National League of Cities said the reduction or elimination of the tax deduction would raise the financing cost of badly needed infrastructure projects. That, in turn, would reduce the number of projects, putting a damper on job growth.

The mayors’ study estimated that if the tax deduction had been capped at 28 percent in 2012, it would have reduced economic activity in the nation’s cities by nearly $25 billion.

“Changing the tax-exempt status of municipal bonds is simply a bad idea,” said Philadelphia Mayor Michael Nutter, past president of the U.S. Conference of Mayors. “If the goal is to help cities recover from the economic downturn and spur job growth, then this just doesn’t make sense.”

The mayors also are pushing back against further reductions in the $3 billion federal Community Development Block Grant program. The program, already trimmed by the across-the-board federal budget cuts known as sequestration, is now the target of a House proposal that would reduce funding by nearly 50 percent.

The block-grant funding supports a wide range of social service programs as well as economic development projects — some of which have been criticized as having marginal benefits for low-income people.

Members of Congress leading a broad effort aimed at rewriting the nation’s sprawling tax code for the first time in nearly three decades have said they are taking a “blank slate” approach to their task. They plan to scrutinize each tax break, from those subsidizing mortgages and charitable donations to those that help parents pay college tuition. The plan is to eliminate the breaks that cannot be justified.

Overall, the breaks to corporations and individuals cost $1 trillion in fiscal 2011, according to the federal government. The tax breaks that flow to individuals — including those supporting municipal bonds — mostly go to those who are already relatively well-off.

The Obama administration has repeatedly proposed a 28 percent cap on exemptions, including municipal bonds, as a way of raising badly needed revenue and limiting tax breaks for high-income earners.

The proposal has provoked a strong reaction from state and local governments, as well as from lawmakers in both parties who say it will not happen. But with a major effort at tax reform looming, some say they worry that the proposals can quickly gain momentum as part of a larger compromise.

“Our general sense is that it is not a proposal that would have a groundswell of support. This is the third time it has been proposed, and it hasn’t gotten traction to date,” said Jeff Westergaard, director of municipal analytics for Morningstar. “This is essentially something that would functionally shift the financial burden [of bonds] from the federal government to state and local government. It is hard to see how this is beneficial to citizens of our country.”

Michael A. Fletcher is a national economics correspondent, writing about unemployment, state and municipal debt, the evolving job market and the auto industry.
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