REFILE-UPDATE 3-Obama proposes municipal bond tax exemption cap, again

Wed Apr 10, 2013 5:23pm EDT

By Lisa Lambert

WASHINGTON, April 10 (Reuters) - President Barack Obama in his budget on Wednesday revived a proposal to cap the value of the tax exemption for interest paid on municipal bonds, an idea that has rattled the $3.7 trillion municipal bond market for more than a year.

Obama wants to limit the value of tax benefits for the top earners. The budget would limit the tax rate at which high-income taxpayers can reduce their tax liability to a maximum of 28 percent, which would affect the top 3 percent of households in 2014.

If approved, the cap would essentially drive down the appeal of municipal bonds, which are often sold to wealthy investors who are often willing to accept lower interest rates because of the tax exemption. Diminished demand could in turn push up borrowing costs for state and local governments that use the bonds to finance bridges, roads and other capital projects.

A rise in interest rates "will increase the cost of projects financed by municipal bonds as much as 20 percent or prevent vital projects from moving forward," said Marc Jahr, president of the New York City Housing Development Corporation and chairman of the advocacy group Municipal Bonds for America.

Limiting the exemption would undermine infrastructure investment and would risk raising taxes or fees, according to Clarence Anthony, executive director of the National League of Cities.

"We remain frustrated the administration continues to view limiting the exemption as a cost-saving measure, rather than seeing it for what it really is -- a significant cost increase for local governments and our residents," Anthony said in a statement.

AMERICA FAST FORWARD

In his budget, Obama provided details on another idea that has raised alarms about the future of the exemption: launching taxable America Fast Forward Bonds to finance infrastructure. When Obama first suggested the program in February, issuers worried Fast Forward bonds would replace tax-exempt debt.

In the budget, Obama said the program "would be an optional alternative to traditional tax-exempt bonds."

The bonds would be patterned after the 2009 economic stimulus plan's Build America Bonds. When used to finance education construction projects, they would pay issuers federal rebates equal to half the interest costs. For other projects, the rebate rate would be 28 percent.

But the education bonds could only be sold for two years and not be used for refundings, while the lower-subsidy debt would be used for longer and could be sold to refinance other bonds.

In recent years, new debt has been sold for schools at a maximum of $59 billion per year, said Rich Ciccarone, a managing director and the chief research officer at McDonnell Investment Management. Issuers could sell the same amount of the education bonds or more, given that the program is temporary and offers a rich subsidy, putting the U.S. government on the hook for billions of dollars for decades.

"We don't really look like we're budget cutting there. We have a stimulus program going on," he said.

The budget is only a proposal and will likely not become law, leaving Congress to approve separate legislation creating the Fast Forward bonds. That could prove tricky since many Republicans, who control the House of Representatives, criticized BABs as rewarding profligate states.

"If you are a conservative state you are less likely to take advantage of this as a borrower who is frequently in the market," Ciccarone said. "Through the federal subsidy program they would be paying tax dollars for other states' debt."

The Fast Forward bonds offer many benefits, including making investments in infrastructure and creating jobs, and they will likely expand the pool of bond buyers, said Vikram Rai, analyst at Citigroup Global Markets.

But this winter BABs issuers got a cold shock when they learned their rebate payments are subject to the spending cuts known as sequestration. Issuers will be suspicious Fast Forward bonds' rebates could be "exposed to shifting political priorities," he said.

"Can we rely on our federal representatives to do what they told cities, counties and school districts they would do? The answer right now is 'no,'" the mayor of Columbia, South Carolina, Steve Benjamin, said about BABs. "Until we can rely on the promises of the federal government, any other model should be a complementary tool."

With Obama's budget seemingly headed nowhere, the threat to cap the exemption will likely remain just a threat for a while as well. This is the third time Obama has suggested the cap, and members of both parties in Congress have expressed opposition to the limit, including heavy hitters such as Republican House Majority Leader Eric Cantor and Democratic Senator Elizabeth Warren of Massachusetts.

"It doesn't have a very high likelihood of coming to fruition," said Peter Hayes, the head of BlackRock's municipal bonds group.

Still, governors, mayors, and investors are on guard after the cap came up during negotiations on the "fiscal cliff" last year. A coalition of city and county leaders has estimated they would have paid $18.8 billion more in interest over the last decade under Obama's cap.

In fiscal year 2011, the U.S. government missed out on collecting $30 billion in revenues because of the exemption, according to the Congressional Budget Office.

According to Obama's estimates, the U.S. government lost out on $29.3 billion in income tax revenue this fiscal year due to the exclusion of interest on state and local bonds sold for "public purposes," mostly general obligation debt. The foregone amounts could total $202.69 billion over the next five years.

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