"Right now I give Sen. Bob Packwood's tax-reform program a 60 percent chance of going all the way, especially if he can protect the plan against revenue-losing amendments," said Peter Davis, Prudential-Bache's political analyst in Washington. The complete reversal in the fate of the plan, as well as the radical changes made in the plan, have surprised most of Capitol Hill and the financial markets as well. How the plan, approved last week by the Senate Finance Committee, will survive its journey through the Senate, and its final form after going through the House-Senate conference committee is, at best, unclear.
The feeling from the Hill, according to Davis is "that Rep. Dan Rostenkowski (D-Ill.) chairman of the Ways and Means Committee also wants to see a tax-reform bill passed, and if it is not accomplished in the current session, members will be called back to pass it in a lame duck session."
The Senate committee's version certainly would have its impact on the fixed-income markets, especially with only two tax brackets, a 15 percent bracket and a maximum individual rate of 27 percent. It is estimated that 80 percent of the taxpayers will be in the 15 percent bracket, 14 percent in the 27 percent bracket, and with 6 percent paying no taxes.
This would mean that tax-exempt yields will have to increase for two reasons in order to lure investors to purchase municipal bonds.
First, to arrive at a taxable equivalent yield for a specific tax-exempt yield, the simple formula is: The tax-exempt yield divided by one minus the marginal tax rate. To illustrate, assume in all cases a 6 percent tax-exempt yield. Currently, with a 50 percent maximum tax rate, the taxable equivalent would be 12 percent (6 divided by 50). Under the House's tax-reform bill, HR 3838, the maximum individual tax rate would be 37 percent.
Therefore, the taxable equivalent under HR 3838 would be 9.52 percent (6 divided by 0.63). Under the Packwood program, with a top bracket of 27 percent, the taxable equivalent would be 8.21 percent (6 divided by 0.73). The situation is even more dramatic when the 15 percent tax bracket is considered, for the taxable equivalent falls to 7.05 percent (6 divided by 0.85).
In other words, as a person's tax bracket falls, the value of tax-exempt yield also declines. Consequently, tax-exempt yields will have to rise to be meaningful enough to attract investors to purchase them. This can be further shown by taking the taxable equivalent and working backwards to find the tax-exempt yield necessary to produce the taxable equivalent at a certain marginal tax rate.
Using the 9.52 percent taxable equivalent, and assuming the 27 percent bracket of the Senate's version is final, we arrive at a tax-exempt return (9.52 percent multiplied by 0.73) of 6.95 percent. Under the Packwood version, it will now take a tax-exempt yield of 6.95 percent to produce a taxable equivalent of 9.52 percent, instead of the former tax-exempt yield of 6 percent.
The second factor that will cause tax-exempt yields to rise is that for the volume of new municipals that are sold each year, it will be necessary to attract investors from the 15 percent tax bracket, which will consist of 80 percent of all taxpayers. In the 15 percent bracket, the tax-exempt yield would have to rise to 8.09 percent (9.52 multiplied by 0.85) to produce a taxable equivalent of 9.52 percent.
Another aspect of the Packwood tax-overhaul program is that it would eliminate IRA's for those individuals who are already covered by a company's pension plan.
But the interest earned on those IRA's will remain tax free until it is withdrawn from the plan. If this feature passes, it would certainly favor the mathematical compounding magic of the high-yield (junk-bond) funds in which to have one's IRA invested. The quality aspect is another consideration, but the sheer force of the interest compounding factor would favor those types of funds. The problem now is to see what the final tax law will actually be.