More Unintended Consequences

September 16, 2011 Gil Baumgarten

President Obama proposed this week still another way to stick it to “the man”. He wants municipal bond interest to be taxable to investors who earn more than $250,000 annually. What a great concept on the surface. The pool of buyers of muni bonds is relatively small. They typically are savers who depend on the income, or investors who use them as a tool to offset stock risk. The owners of muni bonds have traditionally been America’s wealthiest investors. Anyway, muni bonds are loans to local governments to build roads and schools and water systems, etc. The interest earned on these bonds has been tax-free for over a hundred years.

Political leaders demonstrate a remarkable lack of understanding in the way decisions are made, and how rules are linked, when they propose capricious solutions like this.

The most glaring problem here is that the tax-free nature of muni bond interest does not really benefit the rich. It benefits the municipality.

The reason this is true is because the yields on munis are normally about 20-30% lower than similar taxable bonds. This means that after you consider the tax advantage to the investor, the yields are then about the same. This has been less true recently, since the recent doubling of generous pension benefits for mostly unionized municipal employees seems to be the reason why scores of municipalities are running out of money. The sudden decline in home prices and the resulting tax base has not helped either. Since the risks have increased, muni yields have not fallen as fast as taxable yields, and in some cases pay more than their taxable cousins. This is a short-term freak, and not a long-term condition.

So if you’re a municipal employee cheering the benefits you get to keep because the rich will now be paying even more, please remove your hard hat and sit on it. You’re going to need protection on your back side as this swings around to bite you. As the wealthy begin to unwind their muni bond positions since their slight advantage would then have evaporated, they will be slow to return as buyers when their bonds mature. Muni bonds are sold in auctions as municipalities raise hundreds of millions every month for their various projects. Who will show up? Virtually no one until the yields rise 30%. This will cost the municipalities Billions in additional interest costs over the life of their bond issues. That should just about seal the doom of many municipalities, and set the stage for 12% unemployment and cause Stimulus version 5.