* Ongoing debate about federal debt poses concerns
* Local issuers risk higher cost of borrowing
* Tax-free status estimated to cost US Treasury $140 bln
By Lisa Lambert
WASHINGTON, Jan 17 (Reuters) - More than two weeks after U.S. lawmakers reached a budget deal that preserved the tax exemption on the interest paid on municipal bonds, mayors from across the country remain worried the exemption could be at risk.
Muni bonds are critical to local governments, as they are used to fund project ranging from bridges to schools to hospitals.
And with Washington about to take up the debate on the federal debt ceiling and still needing to address spending cuts that the New Year's agreement avoided, the tax treatment of muni bonds is at the forefront of concern for many.
"What isn't really sexy but is incredibly important to us is the tax exempt status of municipal bonds," Scott Smith, the mayor of Mesa, Arizona, said at a press conference on Thursday.
"Remember, municipal bonds aren't just for cities. Our universities, our special districts, our improvement districts, our states rely on this financing technique to fund, if not hundreds of billions, then trillions of dollars of infrastructure," he added.
The tax-free status of municipal bonds costs to the U.S. Treasury around $140 billion a year, according to some estimates.
"We recognize now that we've sort of passed one semi-fiscal cliff ... that there's going to be sort of expeditions looking for other sources of revenue," said Smith.
Since a proposal in February 2012 by President Barack Obama to limit tax breaks for high-income earners on interest paid by municipal bonds, the $3.7 trillion municipal bond market has been on edge about a possible change.
In December, during negotiations to contain the federal budget deficit, the bond market took a big hit on the possibility of a bipartisan agreement over the elimination of the tax exempt status of municipal bonds.
HIGHER COST OF BORROWING
Investors will often accept lower interest payments on muni bonds because of their tax-exempt status, which also keeps borrowing costs down for issuers.
With a cap on how much can be exempted "it becomes more expensive for us to borrow money and lessens the amount of money we have to invest in infrastructure," Philadelphia Mayor Michael Nutter told the same press conference, which kicks off the annual gathering of the U.S. Conference of Mayors.
The mayors this week are taking their concerns to the members of Congress sparring over how to balance the budget. Nutter said he had spoken directly to Vice President Joseph Biden and staff at the White House.
Mayor Joseph Riley, of Charleston, South Carolina, told the conference his city recently sold $54 million in revenue bonds.
"If you adjust the rate down, probably that $54 million would have been $43 million," he said about the impact of a tax exemption limit. "What that is, that's the difference in infrastructure expenditure and investment that a city makes."
Stephen Benjamin, the mayor of Columbia, South Carolina, and a former bond lawyer, said he had pressed his state's delegation in Congress to preserve the current exemption. He said there was significant risk posed in the "several swirling discussions" regarding tax reform, deficit reduction, the debt ceiling and other federal fiscal issues.
"It's important to note that 85 percent of people who invest in municipal bonds earn less than $250,000 a year. This is not a rich man's investment tool," he said.
"You can talk about investment, you can talk about infrastructure and jobs, but the reality is that this is a shift of from the federal government to local governments, and to our taxpayers and to our rate payers," he added. "People who are modest of income will have to bear the brunt of this."