November 15, 2017 / 11:09 PM / in a month

U.S. tax reform poses more risks for states, local governments

CHICAGO/NEW YORK, Nov 15 (Reuters) - States and local governments face additional revenue risks under U.S. House and Senate Republican tax reform bills from a potential loss of a federal subsidy and increases in standard taxpayer deductions that would cut cash to some state coffers.

Eliminating or capping the ability of taxpayers to deduct state and local income, sales and property taxes from their federal tax bills under the legislation poses revenue raising problems for some governments.

Now, the U.S. House of Representatives bill, which was unveiled Nov. 2, could knock out a federal subsidy applied to billions of dollars of bonds sold by states and local governments in the aftermath of the Great Recession, analysts said on Wednesday.

The threat to the subsidy came to light in correspondence this week between the Congressional Budget Office and U.S. Representative Steny Hoyer, who was seeking more details about the effects of the House tax bill.

These bonds, known as Build America Bonds (BABs), were created under an economic stimulus law. It allowed municipal issuers to sell for a limited time taxable debt with the federal government contributing 35 percent of interest costs. Between April 2009 and the end of December 2010, $181.5 billion of BABs were sold in 2,351 issues.

The future federal subsidy on the $13.5 billion of BABs sold by California, the biggest issuer of the debt, is $6.7 billion, according to the state treasurer’s office.

The U.S. government’s payment on BABs became subject to federal across-the-board spending cuts known as sequestration, resulting in subsidy cuts that ranged from 8.7 percent in 2013 to 6.6 percent in the current fiscal year, according to the Internal Revenue Service.

The Congressional Budget Office said this week that the estimated $1.5 trillion increase over 10 years in the federal budget deficit under the House tax bill would, in fiscal 2018, trigger larger cuts to programs subject to sequestration under federal law.

As a result, all of the money earmarked for BABs and other programs would be sequestered, leaving BABs issuers without a federal subsidy, according to Bill Daly, the National Association of Bond Lawyers’ governmental affairs director.

“It would be unfortunate,” said David Erdman, capital finance director for Wisconsin, which issued just over $1 billion of BABs.

Erdman added that Wisconsin likely would not have sold BABs had it known the federal subsidy would be reduced or possibly eliminated in the future.

There were others in the market, however, who said the situation was not so dire. Philip Fischer, municipal research strategist at Bank of America Merrill Lynch, said the potential subsidy loss did not impact BABs trading in the U.S. municipal market.

“Seems to us it’s entirely a budgeting problem and all the Congress has to do is say the deficit will not be subject to sequestration,” he said. “If they don’t do anything, it’s a big deal.”

So far in 2017, BABs have notched total returns of 7.17 percent, outpacing other fixed income classes including U.S. Treasuries and corporate bonds, according to Bank of America Merrill Lynch indices.

Big increases in federal standard deductions in both the House and Senate bills could cause revenue problems for eight states unless they take preemptive legislative action.

For Colorado, Idaho, Minnesota, Missouri, North Dakota, South Carolina, Utah, and Vermont a rise in the federal deduction would automatically increase the state deduction, decreasing tax collections, according to Ron Alt, senior manager of research at the Federation of Tax Administrators. (Reporting By Karen Pierog in Chicago and Laila Kearney in New York, additional reporting by Stephanie Kelly in New York; Editing by Daniel Bases and Grant McCool)

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