Wednesday, August 15, 2012

Muni Bond Exemption Benefits Issuers, Not Buyers

Brookings has an analysis of Romney's tax plan that asserts it won't consider the possibility of exempting the muni bond tax exemption because Romney has proposed to expand tax incentives on savings and investment. The assumption is that muni bond tax exemptions are obviously incentives for savings and investment, so Romney can't simultaneously say he's for savings and investment while proposing to cut the muni bond tax exemption.

It's hard to take serious a document that uses the phrase 'tax expenditure' vastly more frequently than 'tax revenue', but this claim that the muni bond tax exemption is consistent with helping savers is ludicrous. As muni bonds are a minor portion of total assets held by savers, the tax break does not go to the buyers but rather the sellers. In equilibrium, the expected return to investors--after tax--is equal among assets, so it doesn't create a deal for investors. That is, the adjustment in equilibrium is on the borrower side, in that they don't have to pay as much. The buyer gets the same after tax return.

 So much for savings, how about investment? Does anyone think states are not borrowing enough in the secular sense? I would think that most states have too much accumulated debt coming from perpetual deficits. If anything, dad needs to apply some tough love and tear up their credit card. Unfortunately, the Federal government is not so much like an adult dad, but rather, a teen mom from a dysfunctional reality show hoping to emulate Snooki's improbable payoff for being unapologetically stupid. We need more investment in stuff that increases productivity, not the redistribution (eg, payoffs to underfunded pensions) that dominates state expenditures.


Troy Peterson said...

You are correct that the tax exemption benefits muni issuers, not buyers. In fact, there is no precedent for the federal government having any authority to tax independent states or state agencies.

Your argument seems to be: Since states tend to waste money on pensions, etc., that gives the federal government to interfere in state issues (non-interstate commerce) and grab more money from citizens.

The problem with that argument is that the federal government is notoriously more wasteful and bureaucratic than the average state government. Meaningful exceptions to that statement include states like Illinois, but as a whole it is local governments that create the most value for citizens with accountability for roads, schools, and public safety.

Making it more difficult for municipalities to fund these critical activities (in order to fund more federal govt largesse and overseas wars) will accomplish little public good, in my opinion.

Eric Falkenstein said...

I too am pessimistic on the productivity of federal spending, but I think taxes should be as simple and unvarying as possible, because this minimizes rent-seeking. An argument for lower tax rates should be separate from selective exemptions that lower tax rates when considered in isolation.

JWO said...

One thing sure to get me yelling at the TV is a news story that says some millionaire pays no taxes and it turns out that it is because he has all his more invested in municipal bonds. In effect by buying municipal bonds one opts to pay taxes at a slightly lower rate to state and local governments in place of paying the income tax.

Max said...

Not all the tax break goes to the issuer. However, the portion that flows to top bracket buyers is a risk premium (for illiquidity), so it's not equivalent to a tax cut. It's a cost to taxpayers but not a benefit to anyone.

Mercury said...

Actually in my experience muni bonds have been a *major* portion of total assets held by savers in the smart and rich category. This may not be the case going forward now that all kinds of disaster scenarios are on the table but traditionally, from say 1945-2008 it was generally the case that you only needed to get rich once. Having a lot of your money socked away in state and fed tax free bonds gave you a lot of breathing room to position yourself in the tax bracket of your choice and better manage any other (taxable) income streams. If you eeked out a decent gain over inflation well, so much the better. Hell, Florida has been full of successful, wealthy old people, living large on barely detectable taxable incomes for decades. We should all be so lucky. Sure, treasuries have delivered a great, total return over the last 30 or so years too but at the time you didn’t know what would happen with your fed tax liability year to year. Munis had more certainty in that regard and that’s worth something.

You need/needed to do more homework with munis of course (see: smart AND rich) and generally avoid shenanigans like muni bond insurance but I’ve seen too many muni-laden portfolios positively correlated with the right-hand side of the bell curve to dismiss the whole asset class as a sleight of hand trick. It depends on your circumstances but from a capital preservation standpoint (aka ‘saving’) it looks like munis have provided some pretty good opportunitiesn to me.

Besides, there has to be/have been more opportunity to derive alpha within an asset class like munis (vs. say, equities) which have many thousands of issues, are comparatively illiquid and aren’t whipped around by index derivatives. That's attractive too. On average all women are a ‘5’ too but that doesn’t mean you shouldn’t try and play the hand you’ve been dealt as best you can and try for better, especially if (as with munis) you’re looking to buy and hold.