US Representative David Camp (R-MI), the current chairman of the House Ways and Means Committee, released a comprehensive tax reform proposal that, among many other changes, would reduce the tax exemptions that make municipal bonds so attractive to investors. Even if this bill does get out of committee, some of the ideas that are being introduced could find their way into future tax reform legislation and are still worth analyzing.

Dave Camp Tax Reform

Tax reform a ‘shot across the bow’: Friedlander

“We believe that state and local issuers should view this highly detailed proposal as a ‘shot across the bow’ with a number of provisions—and inherent flaws—that are likely to be reintroduced in the future when and if Tax Reform is undertaken in earnest,” writes Citi analyst George Friedlander.

One of the big changes in the Camp proposal is that high-income individuals (those currently in the 39.6% bracket) would pay a 35% tax rate, including a 10% surtax. Tax-free interest income, and many other forms of deductions, wouldn’t count against the 10% surtax, meaning that income from tax free bond payments essentially get hit with a 10% tax.

The bill would get rid of private activity bonds’ (PAB) tax exempt status, arguing that the government shouldn’t be subsidizing private companies’ borrowing costs, but Friedlander notes that PABs are often used by non-profits such as universities and hospitals, and that when for-profit entities use equivalent financing tools they would still get to deduct interest expense.

Investors would also have to pay taxes on accrued market discount in the year it is earned, instead of paying in the year the bond matures or when the bond is sold, and a number of smaller exemptions that together reduce muni borrowing costs would be eliminated.

Blah, blah, blah: Boehner

It would be difficult to calculate the full impact of such broad changes to the tax code, and Friedlander doesn’t attempt it since he doesn’t think it has any chance of passing, but he points out that one of the major qualitative changes would be to save money at the federal level by increasing borrowing costs at the state and local level.

No one expects this bill to pass (when asked about the bill, Speaker of the House John Boehner responded “Blah, blah, blah, blah,” reports Steven Pearlstein at The Washington Post), but municipalities and bond holders should still be aware of an approach that might resurface.