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How taxing muni bonds would hurt cities

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(MoneyWatch) To raise more revenue from wealthy Americans, various proposals have been made regarding the taxation of municipal bonds. It seems like an area ripe with opportunity, since it's estimated that the federal government forgoes about $32 billion a year in taxes by exempting municipal bonds.

However, such a move could ultimately end up hurting the cities and states issuing the bonds.

There are several proposals on the table. One proposal involves taxing all municipal bond income. Another involves only taking the exemption away from municipal bonds that raise money for business -- still allowing it for bonds that finance public works. A third involves allowing the exemption only up to 28 percent.

Warren Buffett, among others, has expressed outrage that loopholes, such as the tax exemption for municipal debt, allow high-income earners to pay lower effective tax rates than people in the middle and working class. However, that viewpoint shows a lack of understanding of how markets work. It fails to recognize that there's an effective tax on municipal bonds already, coming in the form of lower interest rates than would be available if the bonds were taxed.

The only reason municipal bond yields have historically traded at a discount to Treasury bonds of the same maturity has been their tax exemption. Without the tax exemption, investors would demand significantly higher rates on municipal bonds, because they entail credit risk and are less liquid investments (thus, more expensive to trade). Investors demand to be compensated for taking these risks. Consider the following example.

If a 10-year Treasury yielded 2 percent, a AAA-rated municipal bond might yield just 1.6 percent, or 80 percent of the Treasury yield. You might ask why if the tax rate on the highest bracket investors was 35 percent, why it wouldn't trade at 1.3 percent (65 percent of 2 percent). The answer is that municipals have the aforementioned two incremental risks. If municipal bonds were taxed, the yield that municipalities would have to pay would rise.

To see how much they might rise, we can look at the yields on corporate bonds. For example, the yield on the 10-year Treasury note is now at about 1.9 percent, 10-year AA-rated municipal bonds are yielding about 2 percent and 10-year AA-rated corporate bonds are yielding about 2.7 percent. As you can see, assuming the risks of AA-rated municipals and corporate bonds are similar (and the rating agencies have unified their rating systems so they should be roughly equivalent), investors in municipal bonds are paying an effective tax of about 25 percent (not zero).

There's one more point that we need to make. Historically, the tax exemption has meant that municipal bond yields have traded at significant discounts to Treasury yields. Depending on the maturity, the discount has typically been between about 15 and 35 percent (the shorter the maturity, the larger the discount has been).

Yet today we see that 10-year AA-rated municipal bonds are actually yielding more than the 10-year Treasury. One reason is that the market is pricing in the significant risk that even existing municipal bonds could be taxed. So municipalities are currently paying higher rates simply because of the threat of their debt being taxed. If this threat didn't exist, the AA-rated, 10-year municipal bond yield might be much closer to 1.7 percent than its current yield of about 2.0 percent.

The bottom line is that taxing municipal bonds means municipalities would have to pay higher rates on their debt. While the federal government would collect more revenue, municipal finances would take a hit. We can only wonder how many people believe that a shift in revenue from local governments to the federal government is a good idea. And, of course there's the risk that current valuations of municipal bonds would suffer if they're not grandfathered. How much would depend on what change was made.

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