**The President's Advisory Panel on Federal Tax Reform**

**Statement of\
\
The Bond Market Association\
\
Submitted by\
\
John R. Vogt\
Executive Vice President\
(202) 434-8400\
\
June 9, 2005**

**\
**

![](media/image1.png){width="0.9895833333333334in"
height="0.9895833333333334in"}

***Tax Reform and State and Local Government Finance***

The Bond Market Association (TBMA) appreciates the opportunity to
present our views on federal income tax reform and its potential effects
on the finances of state and local governments to the President's
Advisory Panel on Federal Tax Reform. TBMA, with offices in New York,
Washington, D.C. and London, represents securities firms and banks that
underwrite, trade and sell debt securities, both domestically and
internationally. These securities include bonds issued by state and
local governments to finance public projects, bonds issued by
government-sponsored enterprises to reduce the cost of home mortgages,
bonds issued by the federal government to ensure the lowest cost of
servicing the national debt, and bonds issued by corporations to finance
business expansion and capital investment.

The mandate assigned the Tax Reform Panel does not articulate specific
tax policies, but rather focuses on a fairer and more broadly based tax
code that promotes long-run economic growth. These are noble goals and
the types of tax code changes that promise to benefit the broader
economy. Most tax reform discussions in recent years have included
proposals to reduce or eliminate taxes on savings and investment---a
policy administration officials have supported and one with potentially
huge benefits for the economy overall. The promotion of savings and
investment is important for our economy, but eliminating taxes on
savings and investment would also have implications for the municipal
bond market and for the finances of state and local governments. The
effects of tax reform on this market are discussed in more detail below
as are the implications of eliminating the federal income tax deduction
for state and local taxes, a change policymakers reportedly are
considering.

The area of particular concern to the Association is how tax reform
would affect the finances of state and local governments, specifically
the tax-exempt bond market. It is widely recognized that the transition
to a new tax system represents perhaps the most serious challenge in the
debate. Policymakers must consider whether the economic and social
benefits of a simpler and more streamlined tax code will outweigh the
difficulties that some will face in moving from the current to the new
system. With regard to the bond markets, this question rests to a
significant degree on whether a new tax system---one where potentially
municipal bonds no longer receive a tax preference or state and local
taxes are no longer deductible for individuals---will result in the
level of economic benefits that are hoped.

***Effects of Tax Reform on the Municipal Bond Markets***

The bulk of responsibility for financing, building and maintaining our
nation\'s infrastructure has traditionally fallen to state and local
governments. Most of the nation\'s secondary roads, bridges, water and
sewer systems, airports, public schools and other projects that come
under the definition of infrastructure, were planned, financed and built
by states and localities.

The most important tool states and localities have in financing
infrastructure investment is the tax-exempt bond market. The interest on
state and local government bonds issued to finance public projects is
generally exempt from federal income taxation for most investors.
Investors, therefore, accept a lower rate of return on securities issued
by states and localities than they would if the interest were taxed, and
state and local governments, in turn, pay a lower interest rate on their
borrowing. The federal government forgoes tax revenue on state and local
government bond interest in order to provide financing assistance to
states and localities and to encourage public investment. The
tax-exemption for municipal bonds is one of the most important sources
of federal assistance for state and local governments.

As noted above, municipal bonds finance a variety of public projects.
Which specific projects receive municipal bond financing is a decision
appropriately made at the state or local level, often by voters
themselves through referenda or by political bodies--- state or local
legislatures. The process provides a sort of political test to judge the
importance of the project to the community. This is a solely local test
that does not rely on input from or the approval of the federal
government. The result is efficient federal assistance with
decentralized decision making and minimal federal bureaucracy. In
addition, because bond investors must ultimately decide whether, and at
what price, state and local bonds are purchased, the municipal bond
market imposes a market test of investment projects on states and
localities.

One way to measure the benefit of the tax-exemption to state and local
governments is to look at the difference in yields on a municipal bond
and comparable taxable bond. To take an example, a highly rated
tax-exempt municipal bond that matures in 10 years was priced to yield
3.67 percent on May 6, 2005, while a highly rated corporate bond was
priced at a 4.95 percent yield the same day. The difference of 128 basis
points, or 1.28 percent, represents a lower borrowing cost for the
tax-exempt issuer. The yield differential means that a typical municipal
issuer would bear \$12.80 less in annual interest costs on every \$1,000
bond than a similar corporate issuer if both were to issue bonds at
those rates. With \$360 billion in municipal bonds issued in 2004, this
\$12.80 per \$1,000 bond adds up to billions of dollars in savings. A
decade ago, when tax reform was on the congressional agenda, the yields
on municipal bonds rose relative to taxable bonds. This reflected
investor concern over the effects of tax reform on the municipal market
and increased the cost of borrowing for state and local governments.

Bond prices move inversely to yields, so as investors bid down municipal
bond prices, yields---or interest rates paid by state and local
governments---rise. The increase in yields in that period relative to
taxable bonds was based on a concern that the benefit of the tax
exemption could be lost, not because municipal bonds would become
taxable, but because all other investment income might become
tax-exempt. The tax preference on municipal securities is a key factor
in determining interest rates paid by state and local governments, and
expectations regarding the future tax status of municipal bonds are a
vital determinant of investor demand. Faced with the growing likelihood
of tax reform in 1995, investors demanded a higher return on municipal
bonds relative to other investment alternatives because of the risk
municipal bonds would lose their preference under a new tax system.

**Municipal and Taxable Yields**

Several approaches to comprehensive federal tax reform would exempt most
or all investment income from taxation. Under such an approach, the
capital markets would price municipal bonds similarly to other
comparable assets. Municipal bonds would no longer be tax-preferred
investments. The most important question for municipal bond issuers in
the context of tax reform is what effect the elimination of the tax
preference for municipal bond interest would have on the borrowing costs
of state and local bond issuers.  Would the yields on comparable taxable
bonds fall to the level of municipal yields? Would municipal yields rise
to equal taxable bonds? Or, would yields simply meet in the middle? For
several reasons, tax-exempt yields are more likely to rise than
comparable taxable yields are to fall. The municipal bond market is
considerably less liquid than the corporate market and the millions of
municipal issues are, on average, much smaller in size than corporate
issues. In 2004, the average corporate bond transaction was \$711
million while the average municipal transaction was just \$25 million.
Even large municipal bond issues tend to be sold with "serial"
maturities, where a single issue is actually composed of a series of
distinct, sequential maturities, each relatively small in size. These
small issue sizes generally do not appeal to the investment needs of
large institutional investors such as pension funds and banks. And
smaller communities, who make up the vast majority of municipal issuers,
typically issue in amounts far lower than the average. Also, financial
reporting among state and local governments is less uniform than among
corporate bond issuers. Varied disclosure makes it more difficult for
investors to analyze the financial performance of municipal issuers.

The composition of the investor base of municipal bonds also suggests
eliminating taxes on other investments would cause municipal yields to
rise. Currently, the market is dominated by individuals, acting either
directly or through mutual or money-market funds or trust accounts. At
the end of 2005, individuals held, directly or indirectly, about \$1.33
trillion, or 70 percent, of all outstanding municipal bonds. Problems
associated with a market so dependent on a single source of demand
became apparent in 1995, when the tax reform debate made individual
investors skittish about the potential effect on tax-exempt investments.
The prices of municipal bonds were bid down causing yields---state and
local borrowing costs---to rise.

It is true that if Congress were to equalize the tax treatment for all
bonds it would broaden the pool of potential municipal bond investors.
It would not, however, introduce a level of new demand significant
enough to keep municipal yields down. A large proportion of investor
demand in the taxable capital markets is already tax-indifferent.
Consider the U.S. Treasury securities market. At the end of 2004, there
were approximately \$3.943 trillion of Treasury securities held by the
public. Of this amount, at least \$3.036 trillion, or approximately 77
percent, were held by investors that are not subject to federal income
tax. These investors include foreign central banks and other foreign
investors, the Federal Reserve as well as state and local governments
and pension funds. None of these investors would significantly increase
their demand for bonds and similar instruments if the tax code were
amended to eliminate the taxation of investment income.

Under an income tax system where all investment income was tax-exempt, a
relatively small number of investors, including individuals and mutual
funds---especially those individuals in high-tax states where there
might still exist a tax preference for in-state bonds---commercial banks
and property and casualty companies would continue to buy municipal
securities. The issuance structures in the current market, however,
would tend to keep large institutional investors away.

The effective loss of tax preference for municipal bonds raises another
issue: the fate of the existing holdings of municipal bond investors. If
municipal bond yields were to rise under such a circumstance as
anticipated, the price of outstanding municipal bonds would fall as
price and yield move inversely. This would translate into at least a
\"paper\" capital loss for investors that cannot be attributed to
market, interest rate or credit risk---all of which investors bear
knowingly. For investors who sold their bonds before maturity, these
paper losses would become actual losses. Crafting a grandfather or
transition provision designed to mitigate these losses could inject
significant complexity to the tax treatment of outstanding tax-exempt
bonds.

**Effects on State and Local Finance**

 

While the Bush Administration has not publicly endorsed eliminating the
current deduction for state and local property and income taxes, news
reports from earlier this year suggested it is under consideration. It
is important to note that such a policy would hurt the ability of state
and local governments to raise revenues. The true cost of state and
local taxes would rise for taxpayers absent the ability to deduct the
levy under the federal income tax. Local resistance to property and
income tax increases would become more intense under these
circumstances, putting further pressure on an important revenue source
for local governments. Proponents of such a policy can argue the federal
government should not subsidize the taxes of state and local
governments, and that the benefits of the deduction go
disproportionately and unjustifiably to high-tax jurisdictions. On the
other hand, eliminating the deduction would result in the federal
government's taxing income that has already been paid in taxes to a
state or local government---effectively double taxation.

In addition, many state and local income tax systems are based directly
or indirectly on the federal system, and radical change at the federal
level could have unforeseen consequences for states and localities. The
income tax systems in many states are so closely linked to the federal
system that certain changes could effectively shrink the state or local
income tax base. Eliminating investment income as a component of
adjusted gross income (AGI), for example, would lower tax revenue for
those states that use the federal definition of AGI.

The combined effects of eliminating taxes on investment income and the
deduction for state and local taxes would have a negative effect on
municipal finance. Higher yields in the municipal market would lead to
higher borrowing costs for states and localities seeking to finance new
public projects. State and local government finances would also be
constrained by the increased pressure to keep taxes as low as possible.
At the same time that an increase in financing costs for states and
localities under tax reform would create a need for higher revenues to
meet the principal and interest payments on municipal bonds, the ability
to actually generate new fee or tax revenue would be facing new
pressure. Together, these policies would lead to less investment in
public infrastructure by state and local governments.

***Transition Issues***

If the tax policy changes discussed above are put in place, the issue of
transition to the new system would be of primary importance to the
municipal bond market. In the capital markets, the perceived effect of a
pending policy change is priced into the value of securities virtually
immediately. Rumors of pending changes---as noted above was the case in
1995---could cause investor losses that may not be recoverable. Making
the transition to a new tax system should be as clear, transparent and
gradual as possible to assure the value of municipal bonds under current
law is maintained.

 

***Summary***

The Association is encouraged by the efforts of the Bush Administration
and the Tax Reform Panel to create a fairer tax system. The potential
benefits for our nation's economy are tremendous. At the same time, some
of the policies under discussion as part of tax reform have the
potential to drive up the cost of municipal finance and discourage
investment in public infrastructure. Any policy recommendations offered
by the Tax Reform Panel should consider both the long- and short-term
effect on municipal finance.