April 25 (Reuters) - State and local groups descended on a U.S. Senate hearing on Wednesday to defend tax exemptions on municipal bonds, as a powerful Senator suggested an overhaul of the tax breaks to benefit a wider range of investors.
The long-standing practice of exempting interest payments allows states, local governments and authorities to offer lower interest rates than they would on taxable bonds.
Because of the country’s graduated tax system, different bond buyers reap different tax benefits, with those who earn the most getting the best break. Senator Max Baucus told a hearing of the finance committee that he chairs that he was interested in alternatives that would benefit more taxpayers.
“For every dollar we spend on infrastructure through a tax exempt bond, twenty cents goes to tax breaks for higher-income taxpayers,” said Senator Max Baucus, chairman of the finance committee. “A uniform subsidy would mean each taxpayer receives the same subsidy regardless of tax bracket.”
Groups representing cities and states did not speak at the committee’s hearing on coordinating state and federal tax codes. They did, however, send letters and submit written testimony to make the case for allowing investors to continue exempting interest paid by municipal bonds from their taxes.
“Without access to this type of financing, the cost to taxpayers for providing schools, libraries, public buildings and hospitals, roads and bridges and sewers and waterways would be much greater,” wrote a coalition of civic groups that included the National League of Cities.
Baucus, though, lauded the Build America Bond program as a model for financing. Municipal bond issuers widely embraced the program during its two years, rushing to sell the taxable bonds that paid them direct federal rebates.
For years, lawmakers have complained about the inefficiency of tax exemptions. But the idea of changing the tax code to lower the amount of exemptions gained momentum last year when President Barack Obama proposed limiting what high earners could exclude in calculating their income taxes, including the interest paid on municipal debt.
The proposal did not make it out of the Senate, but since then the $3.7 trillion municipal bond market has been on watch.
In February, Obama suggested in his fiscal 2013 budget cutting tax breaks for families with incomes over $250,000 by only allowing them to reduce their tax liabilities to 28 percent of income from the current 35 percent.
That attempt, too, will likely not make much progress. Members of Congress and the administration have turned their attention to legislation that appeals more to voters as they draw nearer to the November general election.
Critics of the Obama proposal say it will force issuers to offer higher gross yields.
Senator Orrin Hatch, the most powerful Republican on the committee, summed up the position by asking the hearing witnesses, who were primarily tax and accounting experts, “Does everyone on this panel agree with me that the president’s proposal would raise borrowing costs for state and local governments?”
But Frank Sammartino, assistant director for tax analysis at the Congressional Budget Office, which assesses the financial effects of proposed legislation, did not agree.
“It might just have a minor effect on borrowing costs,” he said. The changes would would not affect tax payers below a 28 percent tax rate, he said and “taxpayers above that, would still be better off buying tax-exempt bonds,” over taxable ones.
He cited one study that estimated ditching the tax exemption would only hurt those with the top 1 percent of incomes.
Sammartino, too, said the direct-pay model used in Build America Bonds “is a more cost-effective way to provide a federal subsidy,” adding that in tax-exempt financing “the loss of federal receipts is greater than the reduction in interest costs for the issuers.”
Sammartino suggested, though, a federal rebate equal to 15 percent of interest costs for direct-pay bonds, compared to the much steeper 35 percent that Build America Bonds paid. By switching to that model from tax-exempt financing, the federal government would shrink its budget deficit by $30.5 billion from 2012 to 2016 and by $142.7 billion from 2012 to 2021, he added.
Still, attempts to bring back the direct-pay model have stalled in Congress and issuers have balked at proposals that would put the subsidy at less than 28 percent of interest costs.