Once again congressional staff members are attacking the bond markets in general and the municipal bond market in particular by including in the House version of the budget reconciliation bill (HR 3545) a provision requiring bond investors to accrue "market discount" on an annual basis, this amount then being subject to the ordinary income tax rate.
Staffers estimate that this will bring in $447 million over the next three years.
What congressional staffers never seem to understand is that the United States operates on a capitalistic system that depends on smoothly working financial markets to make the economy work efficiently and effectively. With the government seeking any means to increase revenue, the staffers are formulating unpalatable schemes that threaten the viability of all of the bond markets for the relatively paltry sum of $447 million.
In actuality, this proposal does not raise new revenues; it simply accelerates their payment. The municipal market is particularly affected because of the large amount of tax swapping that is carried on in discount bonds.
To put the matter in perspective, bond issues may sell at a discount to their par value ($900 on a $1,000 bond), at a premium to their par value ($1,110 on a $1,000 bond) or simply at a bond's par value when the its price is $1,000.
Through the years price and yield spread relationships have emerged between discounts, currents and premium bonds. Now, for the sake of gleaning a pittance of revenue, the staffers would fracture the discount sector of the bond markets and disrupt the existing yield and price relationships with other sectors of the market. Their approach is similar to a person with a jackhammer performing brain surgery.
The staffers have continued their relentless pillaging of the tax-exempt market. The Tax Reform Act of 1986 emasculated the municipal market to the extent that the new-issue volume has been cut in half from the 1985 high of $206 billion. With the margins and the underwriting volume having been drastically reduced, one of the largest underwriters, Salomon Brothers, has closed its muni unit, while another top dealer, Kidder Peabody, has reduced its operation.
When the large players begin to exit or to reduce their operations, the liquidity, breadth and viability of the municipal market comes into question.
The shortsightedness of these attacks has become all the more evident during recent years, when federal financial support to state and local governments has been curtailed. This leaves the municipal market as a primary way in which to raise capital to build schools, roads, etc., but the congressional staffs respond by slowly attempting to dismantle it.
As to the "market discount" issue, at best the expense and problems that will be created will be tremendous -- not only for the individuals who buy discounted bonds, but for mutual funds and trust departments that must track and report on the discount bonds they have purchased for clients, and also for the brokerage community who must report the discount bonds sold to their clients. If the private sector is forced to do this, then the IRS must set up a complex system to receive all of this "valuable" information, probably at a cost of $447 million a year or more.
This provision, if passed, will affect all bond buyers, not just wealthy investors or institutions. The most prudent action taxpayers, states, municipalities and financial institutions can take is to quickly and emphatically let our lawmakers understand that we want this constant tampering with the financial mechanisms stopped, once and for all. Common sense tells you that if you keep changing the rules every year, chaos in the financial markets eventually will emerge. In a market-driven system, that's not what it's all about.
The Treasury will offer a five-year note on Tuesday in $1,000 minimums. They should return 8.30 percent.