* Critics say muni exemption inefficient, rewards debt
* Localities say cap could force local taxes, utility rates up
WASHINGTON, Feb 27 (Reuters) - Changes to the federal tax treatment of U.S. municipal bonds could cost state and local governments tens of billions of dollars per year, cities and counties warned on Wednesday as they escalated their fight to defend the bonds’ tax exemption.
The interest income that bondholders receive on the $3.7 trillion municipal bond market is not subject to federal income tax, allowing local issuers to tap capital markets more cheaply.
For more than two years, President Barack Obama has suggested limiting that exemption to increase federal tax revenues. The idea gained traction at the end of 2012, when the “fiscal cliff” crisis sent the U.S. government scrambling to bring in money without raising taxes.
Even though the deal in December on averting the “fiscal cliff” did not include capping the exemption and one of the most powerful Republicans in the House of Representatives, Dave Camp, has said he would not support a cap, those who sell the debt across the country are now taking their fight to the public. They say that any change will make funding of infrastructure more expensive.
“The focus has been that somehow this is some great tax dodge when in reality it is a great financing mechanism,” said Scott Smith, mayor of Mesa, Arizona, at a media briefing Wednesday.
“Frankly we’re concerned that it’s coming from all sides because of the search for an easy solution to satisfy the demand for more revenue.”
Civic officials visited lawmakers on Capitol Hill, members of Obama’s administration and Treasury officials to press their point Wednesday. They also released studies of the costs of limiting the exemption, saying higher interest payments would ultimately hurt taxpayers and utility customers and could slow down construction on projects that provide jobs.
From 2003 through 2012, $1.65 trillion in municipal bonds were sold for infrastructure projects. If the exemption did not exist, issuers would have paid $495.3 billion more in interest, according to the National Association of Counties.
Buyers in the U.S. municipal bond market are usually willing to take lower interest payments because they will not have to pay taxes. That keeps financing costs low for the cities, states, and authorities who sell the bonds to pay for road, school, airport, transit, sewer, utility, housing and hospital construction.
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 or couples above $250,000, down from 35 percent currently. Some in the markets feared that the tax-exemption could be eliminated altogether as a way to boost federal revenues.
In 2012 alone the increased interest payments would have totaled $53.8 billion if the tax exemption were totally removed, according to the U.S. Conference of Mayors. Interest costs would rise $18.8 billion if the exemption were capped at 28 percent.
Without the exemption, Chicago, for example, would have paid 42 percent more in interest in 2012. Virginia’s Fairfax County paid $98.1 million in interest last year. It would have paid $14.6 million more under the cap and $41.8 million if the exemption were eliminated, the mayors’ report.
The tax exemption for municipal bonds has been in existence as long as the federal income tax - 100 years. Critics of the exemption say it is inefficient and rewards states and local governments for racking up debt while lowering revenues for the U.S. Treasury.
A subsidy for states and localities, the muni exemption cost U.S. taxpayers about $26.2 billion in 2011.
Moreover, they say it benefits the highest earners the most, essentially giving large tax breaks to those in the top income brackets.
But local government officials dispute that notion. “This is not about the person at the top of the chain. It’s about the people at the lower part of the chain,” said Chris Rodgers, a commissioner of Douglas County, Nebraska.
Higher interest costs could force utility customers to pay more in rates or fees or could even lead to higher local taxes, he said, forcing lower earners to pay more.
City Controller Ronald Green of Houston said the threat to the tax exemption has not been made “tangible” for many citizens. He said that if his city had to make higher interest payments it would undertake fewer infrastructure projects, which in turn would lead to fewer jobs in the city. It would also have fewer funds available for basic services, he said.
The Chief Administrative Officer of Maryland’s Montgomery County Timothy Firestine, meanwhile, contended the tax exemption is not a tax break for the wealthy. Most bondholders are over the age of 65, and using fixed income investments to fund their retirement, he said. Meanwhile, 52 percent of individual municipal bond holders make less than $250,000, and only 30 percent of the debt is held by large institutional investors, he said.