The multibillion-dollar municipal bond market virtually collapsed yesterday when investors panicked after Senate Finance Committee Chairman Bob Packwood (R-Ore.) proposed a new minimum tax that could hit municipal bond interest that now is tax-exempt.
"For all practical purposes, the market ground to a halt," said Thomas Opdycke, vice president and manager of Bank of America's municipal securities and public finance department.
In response to the turmoil in the market for municipal bonds, several major issues due to be sold this week were postponed, including a $450 million New York City sale.
Municipal bond is a generic term that is used to describe virtually any security whose interest payments are exempt from federal taxation, whether or not it is sold by a municipality. Industrial revenue bonds, for example, are protected from taxation even though they benefit a private party.
The tax-exempt change proposed by Packwood would apply only to those taxpayers with sizable incomes and low tax liabilities under the normal tax rules. Those taxpayers are subject to a "minimum tax" on portions of their income. Packwood would include interest that is tax-exempt in the income that is subject to a 20 percent minimum tax.
Taxpayers who are not subject to the minimum tax still would enjoy the federal tax exemption.
There are no statistics on how many municipal bondholders are subject to the minimum tax, but presumably a large number are. Their willingness to buy municipal bonds could be reduced if the interest were included in the minimum tax. Municipal bonds generally carry lower interest rates than bonds -- such as those sold by corporations or the federal government -- whose interest currently is taxed.
Opdycke said that the tax-exempt status of the interest earned from a municipal bond is a major factor in determining the price of that bond. "When we don't know the value of the tax exemption, we cannot evaluate" the price of the bond, he said.
"For a period of time, I assume there will be no real market for tax-exempt bonds, because people won't know whether they're tax-exempt or not," said David Wright, national tax director for the accounting firm of Coopers & Lybrand.
Even though the proposal is far from enactment, it does not cover every municipal bondholder and it would not become effective until next year, the volatile market reacted sharply to the Packwood proposal, which was revealed Tuesday night as part of the Republican's sweeping tax reform plan.
Municipal bond prices fell sharply yesterday, by about $2.50 to $3.50 for each $100 of face value. But Opdycke said the prices are misleading, because almost no one was willing to buy or sell municipal bonds yesterday.
Some brokers, such as Prudential-Bache Securities, temporarily withdrew from buying or selling tax-exempt securities. But most firms continued to "make a market," although there were almost no investors willing to buy or sell them.
The volatile reaction of the municipal bond market surprised some observers because Packwood has been talking about including some tax-exempt income in the minimum tax for several weeks. But earlier proposals suggested that only newly issued bonds or those that changed hands would be subject to the minimum tax. In the proposal released Tuesday, all tax-exempt income from previously issued or new bonds would be included.