UPDATE 3-Obama seeks to cut municipal bond tax breaks

Mon Feb 13, 2012 2:43pm EST

* Cuts for families with incomes of more than $250,000

* Build America Bonds revival suggested again

* Budget would allow bigger pool of debt to be refunded

By Lisa Lambert

WASHINGTON, Feb 13 (Reuters) - U.S. President Barack Obama on Monday proposed limiting tax breaks given to high-income earners on the interest paid by municipal bonds, a change that could rock the $3.7 trillion market if approved.

In his fiscal 2013 budget, Obama reiterated his desire to cut tax breaks for families with incomes over $250,000, saying they should only be allowed to reduce their tax liabilities to 28 percent of income from the current 35 percent.

"It is very unfortunate that investors who bought tax-exempt muni bonds in good faith under the premise that they would be tax-exempt would be subject to at least a 7 percent tax under the proposed budget," said Chris Mier, a managing director at Loop Capital Markets.

Among the list of breaks, Obama included tax-exempt interest, the payments made by U.S. municipal bonds. Obama made a similar suggestion in legislation in September, and many of his proposals that could impact the municipal bond market have surfaced previously.

"The budget contains what looks like a number of recycled muni provisions," said Chris Mauro, director of municipal bond research at RBC Capital Markets. "There's no expectation that any of this gets passed in an election year. At best, it keeps the tax reform conversation going."

Individual investors who buy municipal bonds frequently have high incomes, and one of the debt's chief selling points is that they can exempt the interest from their federal income taxes. The long-standing practice allows states, local governments and authorities to offer lower interest rates on tax-exempt debt than they would on taxable bonds.

Investors buying a 10-year muni bond rated AA would need more than 80 basis points more in yield to get the same taxable equivalent as a 10-year AA-rated corporate bond using a top tax rate of 28 percent, said Richard Ciccarone, a managing director and chief research officer at McDonnell Investment Management.

"This could raise borrowing costs (for municipal issuers) because you have to make up for the tax equivalent cost," Ciccarone said.

By the middle of the day, the municipal bond market largely shrugged off the proposal, with many noting the budget must wend its way through a politically fractured Congress.

"I think everybody assumes it's dead on arrival," said Parker Colvin, managing director at Stone & Youngberg in San Francisco.

In the budget, Obama also proposed "an expanded and permanent extension" of the taxable Build America Bonds program created in the 2009 economic stimulus plan. But the Bond Dealers of America group said cities and states still "need a strong tax-exempt program."

The budget advocated allowing a wider universe of bonds, including BABs, to be refunded, as well.

"State and local bond programs have varied in the extent to which they expressly allow or treat refinancings," according to budget documents. Granting "a general authorization for refundings of state and local bonds not currently covered by specific refunding authority would promote greater uniformity, tax certainty, and borrowing cost savings."

Under Obama's plan, issuers would have only two restrictions on refunding bonds. They could not issue refinancing bonds with greater principal amounts than the original bonds, and the new bonds could not have average maturities greater than the debt being refunded.

This will be the third year in a row Obama has tried to make the BABs program, which expired in December 2010, permanent.

Republicans and Tea Party conservatives criticized the program, which paid issuers a federal rebate equal to 35 percent of interest costs, as rewarding profligate states while funneling taxpayer dollars to Wall Street underwriters. Over the last year, hopes for a revival of the program have all but died.

Obama proposed operating the BABs program for two years with a subsidy of 30 percent and then "extend it permanently thereafter at a subsidy rate of 28 percent."

Cities, states, schools and other issuers sold $181.5 billion of BABs from April 2009 through the end of December 2010, according to Thomson Reuters data.

"(I am) not sure how likely it is that any program related to the Recovery Act, no matter how good it is or was, is going to be re-instituted," said Thomas Kozlik, director and municipal credit analyst at Janney Capital Markets.

MOST STATE, LOCAL OUTLAYS FOR HEALTHCARE

Currently, 28 states owe more than $37 billion to the federal government for unemployment benefit loans and businesses in states with outstanding balances are facing a federal tax hike. The budget proposed suspending interest on the loans while postponing the tax hike for two years.

Obama's budget would "also raise the minimum level of wages subject to unemployment taxes in 2015," it said. "The higher wage base will be offset by lower tax rates to avoid a federal tax increase."

As the sweeping healthcare overhaul comes on-line, fewer people will lack health insurance, according to the budget. Obama would cut $18.1 billion through 2020 in "Disportionate Share Hospital" payments intended to support hospitals that treat low-income and uninsured patients.

Altogether, the budget "provides $623.7 billion in outlays for state and local governments in 2013, an increase of $20.2 billion from 2012."

Nearly half would go to healthcare, according to budget documents, with 17 percent for income security programs, 15 percent for education and social services, and 13 percent for transportation.

While Obama would keep the Community Development Block Grants used to combat blight and other urban problems, he would put only $3 billion into the program. The grants were nearly eliminated under his predecessor, President George W. Bush, and when he took office Obama pressed to take them back up to a little more than $4 billion.