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WASHINGTON, June 24 (Reuters) - Limiting the tax exemption for the interest paid by U.S. municipal bonds would not only make borrowing more expensive for cities, counties and states, but would also drag on economic growth while driving up unemployment, according to a study released by the U.S. Conference of Mayors on Monday.
As part of his push to limit tax benefits for top earners and raise revenue, President Barack Obama in his budget in April suggested capping the rate at which high-income taxpayers can reduce their tax 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 tax exemption.
Mayors from across the country have warned the diminished demand could in turn push up borrowing costs and force them to cut back on infrastructure projects that require financing. They estimated recently states and localities would have had to pay $173 billion more in interest expenses over the last decade if the cap had been in place.
Reduced capital works, in turn, would slow year-over-year job growth by 20 basis points, according to the study, which the mayors' group commissioned from IHS Global Insight.
For example, in 2012, the unemployment rate would have been 8.3 percent instead of 8.1 percent, the study found. Construction would have had about 122,370 fewer jobs, and in total the economy would have lost 311,736 jobs when sectors such as business services, trade and transportation, and financial services are considered.
Under the cap, real gross domestic product would have been $24.7 billion or 0.2 percent lower that year, the study found.
That could create a hiccup in the economy's recovery from the 2007-09 recession. After the end of the 2009 economic stimulus plan, state and local spending fell so low that it pulled down the country's GDP and led to major job losses. As the spending picked up recently, the economy has improved.
"State and local governments who have been a major drag are now coming to a position where they no longer have to lay off large numbers of workers," said Federal Reserve Chairman Ben Bernanke last week when discussing parts of the economy that "look a little better" and could lead the central bank to pull back its monetary stimulus.
The fate of the tax cap proposal is uncertain. Obama has repeatedly suggested it for three years and the idea has rattled the municipal bond market. But many lawmakers from both parties and both chambers of Congress have advocated for preserving the exemption for municipal bond interest as a way to promote infrastructure spending while protecting tax-free income for retirees.
Groups such as the National Association of State Treasurers are closely following tax reform negotiations in Congress, saying the cap could still be included in a package to overhaul the U.S. tax system which Congress is working to pass by the end of the year.