If passed, what effect will the Treasury's tax reform proposals have on the tax-exempt municipal bond market? The Treasury has been trying for years to repeal the tax-exempt status of state and local government issues. It also has attempted to restrict the issuance of tax-exempt revenue bonds for at least 15 years.
Although there are major implications for the muni market in the tax reform proposals, whether or not these various proposals will be passed is certainly questionable in light of the municipal industry's ability to ward off most of the Treasury's previous attacks.
Jim Capra, an economist from Shearson Lehman Brothers in New York, has approached this problem from a supply-demand viewpoint. The Treasury in its tax reform proposal is attempting to do away with "private purpose" bond financings. These are securities that are issued by state and local entities but whose proceeds may be used by private business, certain tax-exempt organizations, homeowners and students.
The Treasury also wants to eliminate "advance refunding" bonds. Many bond issues were sold during periods of much higher interest rates and generally cannot be "called" or retired for 10 years. With interest rates having declined drastically, bond issuers will sell a new bond issue at a much lower interest cost, with the proceeds being placed in U.S. treasuries and earmarked for the retirement of the first issue in 10 years.
The supply of both the "private purpose" and the "advance refunding" bonds constituted 60 percent of all tax-exempt bonds issued with maturities longer than a year in 1983, and 63 percent in 1984. Of the $43 billion in long munis issued so far in 1985, $11.4 billion are refunding bonds. The bottom line is that if the Treasury is able to obtain all of its proposals in this area, about 60 percent of the supply of a $100 billion-a-year new issue market would vanish. But analysts such as Capra believe the actual reduction will be only about $35 billion to $40 billion.
From the demand side, there are three primary purchasers of munis: commercial banks, property and casualty insurance companies, and individuals. The former two use tax-exempts to shelter their profits from taxation, with their participation being guided by their level of profits. Individuals, on the other hand, invest in tax-exempts to obtain a higher after-tax return on tax-exempts than on taxable issues.
Commercial banks, who own one-third of all outstanding municipal bonds, currently are able to deduct from their taxable income 80 percent of the interest expense they may incur in order to own or to carry a municipal bond. Furthermore, the interest income derived from the muni bond is not included in the taxable income. The Treasury's new tax plan proposes that the entire interest rate expense may not be used as a deduction from taxable income. If this proposal carries, it will effectively eliminate the demand for munis by commercial banks.
From the demand standpoint, as far as individuals are concerned, the lowering of the marginal tax rates to 35, 25 and 15 percent is the key factor. The break-even point between taxable and tax-exempt securities will depend on the investor's marginal tax bracket. In particular, equivalent after-tax income is obtained from taxable and tax-exempt securities when the ratio of the yield (tax-exempt to taxable) equals 1.0 (or 100 percent) minus the investor's marginal tax rate. Therefore, an individual in the 35 percent bracket would be indifferent to a choice between a taxable security and a tax-exempt security with a yield that is .65 (1.00-35 percent=.65) of the taxable yield. The lower the marginal tax rate, the higher the tax-exempt yield must be relative to the taxable yield for an investor to receive an equivalent after-tax return.
Therefore, given the change to lower marginal tax brackets, tax-exempt yields will more than likely have to rise so that the ratio of tax-exempt yields to taxable yields is at least .67 to .75 to attract both 35 percent and 25 percent marginal tax bracket investors.
Munis from one to eight years have traditionally had a .50 to .55 ratio of tax-exempt/Treasury yields. This maturity range is traditionally purchased by banks and corporations. With an eye to the possibility of lower marginal rates along with faster declining Treasury rates, the ratios in the one-year area already have risen to .62.