Proposals to eliminate the tax exemption on municipal bond interest highlight a tension in the present debate about tax reform. Why are we doing this again? Is it to raise revenue or to reform the tax code? It turns out that these are not necessarily the same thing.
Speaker Boehner has reportedly accepted the Obama administration's longstanding proposal to limit exemptions and deductions to 28% as part of a fiscal cliff deal. Earners in brackets above 28% would have to pay taxes on certain currently exempt forms of income such as health insurance and retirement savings. Deductions for home mortgage interest and state and local taxes paid would be less generous, because they could only be calculated at the lower 28% rate.
Municipal bond interest, for the first time in history, would also be subject to income taxes. The exemption would be capped at 28%, meaning that those at a 35% rate would pay 7%. Under current law, they pay nothing. Crucially, existing munis would not be grandfathered in. Those at rates above 28% who bought a 20-year bond 10 years ago will now have to start paying taxes on that interest.
The bondholder is getting a raw deal here. First, he would never have bought the bond had he not assumed that the interest would always be tax exempt. Otherwise, he simply would have purchased a taxable bond with an equivalent, all-in yield. True, there's no constitutional right to the exemption. But it has existed for a century, since the beginning of the federal income tax. It was therefore not recklessly speculative to assume that it would continue to exist.
The muni bond exemption is often thought to benefit mostly high earners because that's the case with all other deductions and exclusions and because only high earners own muni bonds. In fact, munis are different. 80% of the value of the tax expenditure goes to state and local governments (in the form of reduced borrowing costs) and only 20% to high earners.
A better reform would be to allow all existing bonds to remain tax exempt, and then either (a) totally eliminate the exemption going forward, (b) cut it back more drastically or (c) change it into a credit. This would amount to a much more substantial reform than the Obama proposal. After all, a 28% exemption would still amount to a very significant tax expenditure and preserve incentives for state and local governments to over borrow, and other inefficiencies.
The problem is that allowing all existing issues to remain tax exempt wouldn't raise any revenue. Savings would accrue very slowly. And the deficit was the main motivation behind the 28% cap to begin with.
Revenue vs. reform considerations are also relevant to the home mortgage interest deduction, a far larger tax expenditure than the muni bond exemption ($110 billion vs. $36 billion for "public purpose" bonds). Why not simply make it completely unavailable to future home purchases, instead of cutting the benefit for people who have been relying on it for decades? Assuming that a complete elimination is not on the table, a deeper prospective cut is better than a shallow retroactive cut.
This is the tax reformer's dilemma. On the one hand, times of high debt and deficits create opportune political conditions for tax reform, because it's a way to generate revenues without raising rates. Ideally, tax reform would be revenue neutral. Special interest loopholes would be narrowed or closed to finance a rate reduction for all. But Democrats probably won't countenance lower rates anytime soon. If the Obama administration's 28% cap proposal goes through, the tax code will be at least somewhat more neutral. Perhaps the tax reformer should take what he can get.
On the other hand, there are cases in which revenue demands may simultaneously make tax reform politically possible and weaken its substance. This is clearly so in the case of the muni bond and mortgage interest deductions. From a true tax reform perspective, who cares about retroactivity? The markets have already been distorted and capital misallocated. But from a revenue perspective, the elimination of the muni bond exemption is only worth doing if it's done retroactively.