U.S. Treasury stands behind cap on municipal bond exemption

WASHINGTON, June 25 Tue Jun 25, 2013 1:37pm EDT

WASHINGTON, June 25 (Reuters) - President Barack Obama's administration is still pursuing his proposal to limit the tax exemption for interest paid by municipal bonds, with a top U.S. Treasury official on Tuesday saying the agency hopes new debt programs will allow state and local governments to continue financing public works.

As part of his push to balance the federal budget, Obama has repeatedly suggested limiting the rate at which high-income taxpayers can reduce their liability at 28 percent.

If approved, the cap would essentially drive down the appeal of municipal bonds, which are often sold to wealthy investors willing to accept lower interest rates because of the exemption. The suggestion has rattled both buyers and sellers in the $3.7 trillion bond market.

Mary John Miller, under secretary for domestic finance at the U.S. Treasury, told a conference convened by a group of economists and political leaders that other "sacred cows" would also be capped under the proposal, including the mortgage interest deduction.

With the economy recovering, the U.S. government must look into cutting spending and raising revenue, she told the meeting of the State Budget Crisis Task Force, headed by former Federal Reserve Chairman Paul Volcker and former New York Lieutenant Governor Richard Ravitch.

"The idea is if we are going to pursue any sort of comprehensive reform of our fiscal balance we're going to have to make a lot of choices and we're going to have to consider everything," Miller said.

She called tax-exempt muni bonds "perhaps not the most efficient way to help the issuers of the debt," citing disproportionate benefits to investors while issuers fail to reap their full benefit of the tax subsidy.

Miller said the issue bears discussing while considering Obama's proposal for new taxable bonds, "and to try to introduce another mechanism for helping issuers who are trying to fund infrastructure."

In his budget in April, Obama proposed selling taxable America Fast Forward bonds that would offer federal rebates equal to 50 percent of their interest costs when sold for capital works at public schools and universities and equal to 28 percent of interest costs when issued for other projects.

The program is based on the wildly popular Build America Bonds, which paid rebates equal to 35 percent of interest costs and were part of the 2009 economic stimulus plan. They expired when the plan ended. Under the federal budget cuts that began in March, their rebates have been lowered and the unexpected reductions have made states, cities and counties cool to Fast Forward and other ideas for rebate bonds.

Mayors, governors, state lawmakers and county commissioners have stood shoulder-to-shoulder with bond investors and dealers to support the bond exemption since the cap was first broached three years ago. They warn that a limit would raise borrowing costs for governments, forcing them to shrink the number of infrastructure projects and slow down the economy. Meanwhile, they say a cap would threaten the tax-free income of many retirees.

The fate of the cap proposal is uncertain. It would have to be part of a larger overhaul the tax system currently working through the politically fractured Congress. Lawmakers from both parties have voiced support for maintaining the bond interest exemption.

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