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By Kim Dixon and Patrick Temple-West
WASHINGTON, Dec 14 (Reuters) - The tax break that U.S. states, cities and counties get on the bonds they issue is in growing jeopardy now that Republicans, in addition to Democrats, are considering limits on the exemption.
As part of the "fiscal cliff" negotiations to raise more federal government tax revenue, Republican lawmakers have joined Democrats in reevaluating the costly tax break, said Republican congressional aides and lobbyists.
Municipal bonds issued by states and localities are a $3.7 trillion U.S. market underpinned by a law that exempts their interest income from taxation. This allows states and localities to tap capital markets more cheaply than private-sector borrowers such as banks and corporations.
"The muni bond exemption is on the table, not only during tax reform, but also during the 'fiscal cliff,'" said Mike Nicholas of the Bond Dealers of America, a lobbying group for fixed-income securities dealers and banks.
That the tax break - deeply embedded in the economy and vital to state and local governments - would draw the interest of Republicans shows how far Washington has come in a short time in considering potentially dramatic tax-and-spending changes.
As the United States grapples with a huge budget deficit and a complex tax code that has not been revamped in 26 years, even once politically untouchable tax breaks are being questioned.
The "fiscal cliff" refers to sharp tax increases and spending cuts that take effect in 18 days unless Congress intervenes soon.
Some lawmakers from both parties are calling for a comprehensive tax code overhaul in 2013 and groups concerned with the muni bond exemption are worried.
"We have not felt this threat level being this real in a long time," said David Parkhurst, legislative director with the National Governors Association, which represents the leaders of U.S. states that rely heavily on the muni bond tax exemption.
The exemption benefits bond investors on one side of the market and state and local governments on the other. Effectively a subsidy for states and localities, the muni exemption cost U.S. taxpayers about $26.2 billion in 2011.
President Barack Obama in 2011 included the exemption among items subject to his proposed 28-percent cap on deductions and other tax breaks for individuals earning more than $200,000.
That proposal alarmed muni bond issuers and investors, who were already on edge because of a proposal to kill the exemption entirely in 2010's Simpson-Bowles deficit reduction plan.
Now, Republicans are rethinking their traditional reluctance to tinker with muni bonds, largely because they want to find ways to increase federal revenues without raising tax rates.
Phasing out the muni bond tax break for individual taxpayers earning more than $200,000 could raise about $10 billion a year - or about $100 billion over a decade - Republican aides said.
In the fight over the "fiscal cliff," Republicans hope to refute Obama's argument that real deficit reduction cannot be achieved without raising tax rates on high-income Americans.
Senator Orrin Hatch, the top Republican on the Senate Finance Committee, said tax breaks of all sorts need to be weighed in the effort to raise revenue and cut the deficit, but that "they are not easy to get rid of."
New issuance of tax-exempt bonds is expected to hit about $400 billion in 2013, up from about $370 billion this year, according to investment bank Loop Capital Markets LLC.
Jurisdictions that issue tax-exempt bonds range from states to cities, counties and school districts. They defend the bonds as vital to transportation, infrastructure and other public projects, which would be threatened by an exemption roll-back.
"It certainly couldn't come at a worse time," New York State Comptroller Thomas DiNapoli told Reuters last week, referring to the devastation the region suffered during Hurricane Sandy.
"Even before the storm, we had tremendous infrastructure needs that localities were trying to address and now we're going to have even more."
It is unclear exactly what sort of limitations Republicans have in mind. The Obama proposal would apply to all bond issues.
Citigroup Inc muni bond strategist George Friedlander has estimated that Obama's cap, if enacted, would raise state and local government borrowing costs.
The "fiscal cliff" talks and a possible tax code overhaul next year pose "a clear and present danger" for muni bond issuers and investors, Friedlander said in a recent research report.