Last Wednesday, millions of investors in tax-exempt bonds and the entire tax-exempt bond industry were upset with Sen. Bob Packwood's (R-Ore.) proposal to make the interest received on tax-exempt securites subject to the "alternative minimum tax" that is paid by taxpayers who would otherwise escape taxation.

If accepted, Packwood's proposal to his Senate Finance Committee could make tax-exempt income taxable for millions of investors who have purchased municipal securities with the understanding they would earn tax-free income.

The proposal recommended that all tax-exempt interest on all outstanding municipals be subject to alternative minimum tax. The municipal market was thrown into a state of disorder, raising indignation among those who labor in the industry.

Jack Merritt, the president of Vam Kampen Merritt Inc., a large purveyor of unit-investment trusts, said that "what the Senate Finance Committee has recommended has created chaos in what was an orderly and professional market."

Last week, several new issues were either delayed or canceled as underwriters found it impossible to issue new bonds without clarification of whether the new issues would be wholly or partly tax exempt, or not at all. Trading and underwriting evaporated.

The crux of the problem is the idea of tax exemption. Tax exemption arose from the "reciprocal immunity doctrine" of the U.S. Constitution. Basically, this doctrine holds that the federal government will not tax the state and local governments, nor will the state and local governments tax the federal government.

This concept was upheld in several Supreme Court rulings and written into the Internal Revenue Code in 1954; it serves as the basis for the issuance of tax-exempt securities by state and local governments.

But in the last 10 years, events have led the Treasury to covet this tax-exempt interest. There has been explosive growth of tax-exempt financing. Total long-term financings have burgeoned from $34 billion in 1976, to $47 billion in 1980, to $102 billion in 1984, and finally $173 billion in 1985.

By the end of 1985, there were $725 billion in tax-exempt securities outstanding. Much of this growth came in bonds issued for projects that were not in the original purview of municipal financing. These new underwritings, known as "private purpose" bonds or "nongovernmental issues," began to swell the total financings. These issues include industrial revenue bonds and economic development bonds issued through local governments to private businesses. They finance home mortgages, student loans, new factories, shopping centers, even fast-food outlets. In recent years, these nongovernmental bond issues accounted for as much as 60 percent of the long-term new-issue volume. Clearly, the number of borrowers has grown way out of hand and should be curtailed. Legislation in 1982 and recent tax-reform legislation took aim at curtailing these "private purpose" bond issues.

A second factor has surfaced since the late 1970s that has perplexed Congress and has made tax revenue all the more important -- the enormous growth of the federal budget deficits.

From 1976 through 1985, the federal government has piled up $1.113 trillion dollars in deficits. During this same period, the outstanding federal debt jumped from $632 billion to $1.828 trillion. The need for tax revenue became overwhelming, and with tax-exempt interest being paid on some $725 billion of municipals, the obvious target for that needed tax revenue was tax-exempt bonds.

These two factors account for the constant effort by the Treasury and Congress to capture tax-exempt income. They lead to what holders of tax-exempt bonds regard as the threat of a "breach-of-faith" by Congress.

But there is another side to the equation -- the threat to the legitimate issuers of municipal securities and ultimately to all taxpayers. The ability of states and local governments to issue tax-exempt securities allows them to borrow money at lower interest rates. If these securities become partially or totally taxable, higher interest rates will be needed to attract buyers. This would require higher taxes, in order to pay the higher interest on the municipal issues.

The disruption of the municipal market is another unsettling effect of the Packwood proposal. Peter Gordon, who is in charge of the T. Rowe Price tax-exempt funds, points out, "the greatest concern I have is that for each of our four funds, we have an obligation to determine the fair value of the securities daily so that investors can buy or sell shares in our funds."

Gordon notes that many other funds were unable to put a price on their securities Wednesday because of the uncertainty in the marketplace. "This could scare the public to death, and lead to redemptions" of tax-exempt mutual funds. This would force the fund managers to sell large amounts of securities in a weak market, probably at losses, in order to redeem investors shares. As a result, investors would suffer losses if the market remains unsettled because someone wants to change the rules of the game in mid-session.

Gordon also notes that "you can't manage money or make investment decisions based on every proposal that floats around the halls of Congress. You must look at the fundamentals and decide on how to take advantage of them and then make your investments."

The best lesson that can be learned from these events is that tax exemption should once and for all be established or eliminated. Private purpose, nongovernmental issues should be eliminated so the municipal bond world can return to the business it was originally created for -- raising funds to facilitate the growth and needs of our states and local governments by providing tax-exempt income as an inducement for purchases of such financial instruments by the American people.

The Treasury will offer, in $1,000 denominations, a 4-year note on Wednesday and a 7-year note on Thursday. They should return 7.35 percent and 7.65 respectively.

In retrospect, one cannot help but wonder if the federal government begins to tax state and local securities, will not the states be lawfully correct in taxing U.S. Treasury issues. Perhaps this whole situation needs to be rethought more clearly.