Market Commentary: Is Municipal Bond Tax-Exemption in the Crosshairs?

By Gayl Mileszko

Is Municipal Bond Tax-Exemption in the Crosshairs?

Yes. But it is part of a broad array of possible options for a cut or trim. Do not panic. Instead, stock up on high caliber bullet points and fire up your iPhones. 

Along with countless others across the nation, we at HJ Sims believe that tax-exempt municipal bonds are critical to America’s infrastructure and to a well-functioning U.S. economy. In our view, the national interest is advanced by providing incentives for infrastructure investment by keeping state, local and non-profit borrowing costs low. But for the first time in more than 40 years, Washington’s newly elected officials and their enthusiastic staffers are on an aggressive hunt for ways to pay for tax cut extensions and reduce the overall size and scope of government. Fueled by the voter mandates of 2024, they have already marked several programs and operations for elimination, and have since been supplied by Members of Congress and others with a wide array of other plump targets for analysis. This is not the first such effort to be undertaken, nor will it be the last. But “draining the swamp” is one of the incoming Administration’s Top 15 priorities. And the ambitious goals touted by two prominent American entrepreneurs are receiving are receiving worldwide attention. The pressure is on for a series of quick wins and workable blueprints for smaller, more efficient government. The mission and commitment must be taken very seriously by all. 

The “Manhattan Project” of Our Time

Consider: the FY24 federal budget totaled $6.75 trillion and had thousands upon thousands of line items. The details of the FY25 budget take up 1,298 pages. The number of pages in the tax code total about 6,871. Elon Musk and Vivek Ramaswamy have been charged by President-Elect Trump to pour through all these numbers and come up with recommendations to cut federal regulations, spending and headcounts. Unlike the 1982 Grace Commission which was  led by a group of 150 business leaders who toiled in 36 task forces and produced nearly 2,500 specific proposals that were never implemented, the incoming 47^th President refers to the current effort as the “The Manhattan Project of our time”. His project leaders plan to identify and carve out $2 trillion of government bloat between now and nation’s 250^th birthday.  They are aggressively tackling their assignment with a team of volunteers staffing the unofficial Department of Government Efficiency. DOGE is scouring the federal books and preparing to make recommendations to the President and to Congress on how to root out programs, activities and people that are not necessary, or much less necessary than others, given our dire financial condition and the need to reprioritize government spending. At the outset, the hunt to find offsets for the 2017 tax cut extensions is high on the list.  Everything is said to be on the table.

Below, we begin a dialogue with our readers as we explore some of the key issues. It is not intended to encompass all aspects of the debate, but to encourage outreach and advocacy.

Why go after the municipal bond tax-exemption?

Some see it as “low hanging fruit” in the offset hunt. Every $40 billion counts.

• Although the exemption of interest on state and local bonds was codified in the Revenue Act of 1913, it is not protected by the Constitution. In a 1988 ruling, the Supreme Court stated that Congress could tax interest income on municipal bonds if it so desired.
• In the array of options available to DOGE and Congress, the elimination of special interest exemptions and closing of loopholes seem like no-brainers to those outside of “Gucci Gulch ²”. There may not be enough room in the halls of Congress to accommodate the lobbyists who will camp out until their loopholes are deemed safe.
• Although state, local and nonprofit issuers sold $505 billion of municipal bonds last year, only about four percent or 9 million of 160.6 million individual taxpayers claim tax-exempt interest income.
• Municipal bond tax-exemption is seen as “low hanging fruit” with an exact price tag (technically a “tax expenditure”) annually calculated by the U.S. Treasury Office of Tax Analysis. The “cost” of the program is projected to be $32 to $42 billion a year, or $371 billion, through FY33. It could be much more in a high tax environment, or much less if the exemption disappears.
• The muni tax-exemption for public purpose state and local bonds¹ alone is the 18^th largest federal tax expenditure. The 17 larger tax expenditures have much broader appeal, including employer contributions for medical insurance, deductibility of mortgage interest and charitable contributions.
• From an efficiency perspective, removing the exemption would reduce tax code complexity as well as the administrative and regulatory costs of the IRS bureaucracy.
• The Tax Foundation and American Enterprise Institute, among others, argue that the tax treatment of municipal bond interest is an inefficient subsidy: that the federal government loses more than then beneficiaries of state, local and nonprofits gain.
• The exemption has expanded over time to include many new projects with questionable public return on investment, including sports stadiums, entertainment venues, and green energy; some contend that it has also produced a redundant, highly paid industry of lawyers, consultants, accountants and lobbyists.
• Some small government advocates view the exemption as inhibiting privatization efforts and, in fact, encouraging excessive government borrowing. inducing public ownership of projects that should be privately undertaken, or at least limiting opportunities for public-private partnership. The exemption implies that state and local governments are fundamentally more creditworthy than private entities.
• National security hawks who see the U.S. continuing to borrow money from China, other adversaries and foreign sources contend that we should not waste our precious capital on funding activities for less than national purposes.
• There is outrage from many corners of America over private colleges with weak leadership, and attention to hospitals, housing, and airports posting significant profits, as well as ESG projects able to access lower interest rates than are available to many essential public service providers and productive American businesses.
• The municipal bond “lobby” is perceived by some as weak, having lost various fights over numerous private activities, BABs, sequestration, advance refunding, and arbitrage.
• The two extraordinarily wealthy DOGE leaders have no exigent need for tax-exempt interest income. Many Members of Congress, new and long-serving, may not invest in, or even understand, municipal bonds.

But could the municipal bond tax-exemption survive intact or mostly intact in 2025 tax reform negotiations?

Yes. This is what we expect. But we take nothing for granted.

 The federal government has recognized the exemption to fund local infrastructure since 1913 and the National League of Cities estimates that approximately 75% of critical U.S. infrastructure has been “built by bonds.”

• The American Society of Civil Engineers has reported that there is a $2.5 trillion underfunded needs gap with a $4.59 trillion investment required by 2025. This cannot be met through the private sector alone, and many important project financings may not be viable if the only financing options were local banks, taxable bonds, or private placements.
• There are about 50,000 separate municipal bond issuers and they cannot possibly rely on state and federal earmarks and grants, subject to the uncertainties of the annual appropriations process, or impose higher user fees or taxes to fund critical infrastructure construction and repair projects.
• Proposals to eliminate the exemption have arisen in every debate over tax reform. There is colorful history going back to 1942, most recently in the early 2010s, throughout the Obama Administration, and again in 2017. Pressure on Members of Congress from state and local officials in each congressional district has always come to overwhelm and quash most debate.
• Projected savings from eliminating tax-exemption would hardly make a dent in the $2 trillion federal budget deficit and the $36.3 trillion national debt.
• The elimination of the tax-exempt financing option would have a negative impact on most local and regional economies and restrict the freedom of local communities to manage their finances. In many counties, cities, and rural areas, the largest employers are schools and hospitals, almost always built, expanded and renovated with tax-exempt bond proceeds.

 What are the odds of a significant change? 

 Heraclitus said back in 500 BCE that the only constant is change: everything changes and nothing remains still. That certainly still applies to our financial markets and legislative process.

• There have been numerous proposals to substitute tax-credit bonds, interest subsidies, or grants for tax-exempt bonds over time. Laws enacted in the late 1960s, 1986, and 2017 placed new restrictions on the use of tax-exempt bonds. So the trend has been to chip away at the exemption and it is highly unlikely to reverse. This year, tax-exemption is again on the line alongside the AMT, the SALT cap, and much more. The effective term of the new tax reform provisions has not yet determined but, as always, after enactment interim “technical corrections” and other amendments are always possible.
• If elimination is seriously considered, Congress would most likely adopt transition relief for existing bonds, “grandfathering” in outstanding tax-exempts, perhaps those with forward settlements, reimbursement resolutions, or other declarations acceptable to the Treasury.
• There is almost no hope of restoring advance refunding this time. In 2017, it was seen, and it is still likely seen, as a “double dip”.
• Every market is bound to be impacted by new federal tax and spending policies and the change will be driven by politics. The decision over the vehicle(s) used to effect policy change may be significant. It is unclear at present whether tax reform will be attempted alongside immigration reform, energy, and the debt ceiling extension in a single reconciliation bill or as a separate measure. In the melee of lobbying for attention and protection, or horse trading over SALT, EVs, or corporate taxes, the muni tax-exemption could be lost.
• Last month, the Congressional Budget Office estimated $43.1 billion of savings between 2025 and 2034 from the elimination of the exemption for new qualified private activity bonds. It is just one of 76 cited CBO policy options for reducing the deficit, but the fact that it was listed less than one month ago is cause for some concern.
• There is a strong chance that attention will indeed turn to specific private activity bonds. For example, bonds issued for colleges with very large endowments and “woke” policies that fail to protect free speech, prevent discrimination, and ensure student safety on campus. Other PABs, such as those benefiting for-profits, ESG projects, sports stadiums, or toll roads owned by foreign companies, may also be singled out.
• Municipal market strategists at some of the nation’s largest bond buyers and dealers have opined on the subject and, as expected, differ. Nuveen sees elimination as “highly unlikely”. The CIO for municipal bonds at Alliance Bernstein wrote that wholesale elimination of tax-exemption isn’t likely, but certain types of muni bonds could be targets.   In a Bloomberg interview on December 18, the head of municipal markets strategy at Wells Fargo said he believes the risk is not zero but low, but the head of municipal research and strategy at Barclay’s said he considers it one of his biggest worries. Hilltop Securities sees this as a “unique threat” amid the political shift and fiscal deterioration; the head of municipal strategy estimated that “there is a 50% or greater chance  that the municipal bond tax exemption will be significantly curtailed or even completely eliminated in 2025.”

 What would happen if tax-exemption were eliminated in the worst case?

 Of course, the municipal bond market would dramatically change. But it would survive.

• Recall how the market evolved after the shocking loss of advance refundings in the Tax Cuts and Jobs Act of 2017.
• The muni buyer base would again change, likely seeing expanded demand from corporations, insurers, and foreign investors.
• Grandfathered tax-exempt bonds would become extremely valuable.
• In the window between enactment of tax reform and the effective date of elimination, the muni market would see an explosion of issuance. Perhaps as much as $745 billion or more.  Partial eliminations would produce extremely heavy issuance in the sectors affected.
• Many of the 511 muni bond mutual funds and 111 muni ETFs would close for lack of product or else require approval from investors to change the asset allocations. New taxable muni funds would emerge.
• Higher grade credits will always find willing lenders. Banks, private equity and other lenders may become more active in the muni sector.
• Some states will continue to allow exemption of interest income on bonds from in-state issuers, so these bonds remain attractive to investors in high tax states including New York, California, Massachusetts and New Jersey.
• New state bond banks may be created to consolidate smaller local issues into a single pooled financing to help eligible borrowers obtain lower rates than in standalone sales.
• Many state, local and non-profit borrowers would come to market with taxable bond financings that investors would measure in terms of credit quality against corporate bonds and Treasury bonds. Some would get much better rates than high grade corporate bonds and a few could see rates on top of or better than comparable U.S. Treasuries.
• The cost of borrowing would increase dramatically for non-rated and below investment grade credits, rendering some if not most projects not viable.
• Rating agencies would develop new metrics for evaluating credits given the higher costs of borrowing.
• Property, sales, and other local taxes would likely increase. The public could see reductions in some essential services.

 How to help save the muni tax-exemption

All non-profits pay heed!

• Consider this a good time to start providing ammunition to your U.S. Members of Congress, their staffs, and all the other state local, and nonprofit organizations³ who have their ears. Those who toil in drafting rooms, or vote in committees, need to hear from you. They may need to have specific examples of essential purpose infrastructure projects in your state that would not have been made possible except for tax-exempt financing ..  and those critical projects in the pipeline still in need of funding.
• Bloomberg counts approximately 929,000 outstanding CUSIPs from muni borrowers. Many come from vocal advocates at the national, state and local level. As Hilltop’s head of municipal strategy said, “I think the municipal bond tax exemption has a target on its back. It’s likely to be used as a pay-for in 2025 unless public entities and state and local governments vigorously advocate and defend it.” Non-profits pay heed!
• The NLC and GFOA have launched the #BuiltByBonds campaign, to illustrate the vast impact of tax-exempt municipal bonds in every congressional district and community in America. Local officials can help educate Congress on this issue by populating this mapusing this form with at least one project that has been partially or fully funded through tax-exempt municipal bonds.  
• Non-profits, their sponsors, patients, residents, students and beneficiaries, can invite their elected federal representatives to visit the schools, senior living communities, hospitals, student dormitories, intergenerational and affordable housing, and economic development projects only made possible through the sale of tax-exempt bonds to investors both local and nationwide who see the essentiality of use as well as credit value in these vital projects
• As always, there will be horse trading, colorful words, and dramatic fights played out on the airwaves before the dust clears and — as Nancy Pelosi once quipped — “we can find out what is in the bill” at last. Negotiators move things along at the speed of light once agreements in the back room are reached so the goal is to weigh in before the House/Senate conference committee backroom.
• The uncertainty that may prevail, possibly through year-end, will make things volatile for bankers, traders, underwriters, portfolio managers, and investors. Newspapers sell better on bad news. And trade associations, press, and some market strategists have reason to elevate the panic level in order to get members and readers engaged or directed toward other products. As always there will be great opportunities and reason for pause. Your HJ Sim representative is on call to guide you through 2025 and the years to follow.

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