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* Muni bond exemption, state and local tax deduction on agenda
* Neither provision in imminent danger amid increased reform talk
* Both measures deeply embedded, defended vigorously by backers
By Kim Dixon
WASHINGTON, March 18 (Reuters) - A U.S. congressional panel on Tuesday will delve into two major tax breaks - one for state and local tax payments, and one for municipal bond interest. Both highlight the painful choices lawmakers face as they seek to clean up the tax code.
No decisions are expected from the hearing, and the tax breaks likely are not in any imminent danger with lawmakers still deeply divided over fiscal policy. But talk of tax reform has intensified in recent weeks on Capitol Hill.
One of the main reasons for the increased chatter is Dave Camp, the Michigan Republican who chairs the tax-writing Ways and Means Committee of the U.S. House of Representatives.
Camp has held a series of hearings in past months on specific tax topics. He has also divided his committee into study teams, with an eye toward drafting and moving tax-reform legislation this year.
Corporate tax lobbyists are swarming over Camp's teams, but some lawmakers are skeptical that his goal can be achieved this year. Why? Tuesday's hearing may offer some clues.
One of the tax breaks to be examined by the committee is a deduction available to taxpayers who itemize their returns for state and local income, property and sales taxes paid.
The other is an exemption that says investors do not have to pay income tax on interest income from bonds issued by state and local governments, known as municipal, or muni bonds.
Both President Barack Obama, a Democrat, and some Republicans have ideas about how to limit these tax breaks, but the provisions are politically popular, stoutly defended by state and local officials, and deeply embedded in the financial markets.
Just last week, Nebraska Republican Representative Lee Terry and Massachusetts Democrat Richard Neal introduced a resolution to celebrate the history of municipal bonds.
This is not a partisan issue, Terry said. "As we are discussing tax reform, I just want to make it clear, there is support to keep municipal bonds tax free."
Local officials in both parties say the tax breaks are not "loopholes," at least not in the same pejorative sense that some other preferential tax treatments are known.
"Cities and towns are not special interest groups," Steve Benjamin, Democratic mayor of Columbia, South Carolina, said of the muni bond tax break in an interview with Reuters.
Municipal bonds allow localities to tap capital markets more cheaply than private sector borrowers to fund a variety of public projects such as schools and roads.
Both provisions date to the tax code's creation in 1913, which sets them apart from more recent additions to the code. They are also notable for being among the largest tax breaks.
In fiscal year 2011, the U.S. government missed out on about $30 billion in revenues due to the muni-bond interest tax exemption; and about $67 billion due to the state and local tax deduction, the Congressional Budget Office said this month.
That total of nearly $100 billion a year roughly equals the amount of revenue foregone by the government due to another popular tax break - the mortgage interest deduction.
The muni bond tax exemption, in particular, has its critics. Economists say it helps state and local governments less than the revenue Washington gives up for it. Others say the exemption disproportionately helps wealthier investors over others.
"It is a poorly designed way to try to lower states' and localities' borrowing costs," said Alan Viard, an economist with the conservative think tank American Enterprise Institute.
The deduction for state and local taxes presents a dilemma for some Republicans, who back shrinking government.
"In tax theory, you are eliminating a form of double taxation," said Curtis Dubay, an economist at the conservative Heritage Foundation. "However, how this has worked out in practice is expanding the size of state and local governments."
Dubay predicted that Republicans would be more likely to pare the deduction as part of an overall tax revamp.
Obama - who says the wealthy should pay more taxes to shore up federal finances - has proposed capping the value of most deductions and exemptions to 28 percent of an individual's income, curbing tax breaks for those in higher tax brackets.
Mitt Romney, the Republicans' failed candidate for the presidency last year, had a similar proposal.
Such ideas have the municipal bond community - including bankers that underwrite the bonds - on high alert. They say demand for munis would decline if the tax breaks were curbed, which would push up borrowing costs for local governments.