While there are many unknowns and uncertainties surrounding President Trump’s proposed tax reforms, below is a brief review of three of his proposals that could have an impact on the municipal bond market.
Lower Individual and Corporate Income Tax Rates
President Trump would like to reduce tax rates by cutting the top individual tax rate from 39.6 percent to 35 percent and reducing the number of total tax rates from seven (currently 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent, and 39.6 percent) to three (i.e., 10 percent, 25 percent, and 35 percent). He would also like to reduce the top tax rate for all businesses to 15 percent. The reduction in individual and corporate income tax rates could weaken demand for municipal bonds as the tax exemption would be seen as less valuable by investors. Many wealthy individual investors seek out tax-exempt municipal bonds because the interest on such bonds is exempt from federal taxes. However, with a reduction in individual rates, individual investors may not see quite the same benefit in the tax exemption for municipal bond interest and choose to make other investments. Demand for municipal bonds may also weaken as corporate tax rates decline as large buyers of municipal bonds, such as banks and insurance companies, could choose other investments as the value of the municipal bond tax-exemption weakens.
Elimination of State and Local Tax Deduction
Another proposal removes the provision in the federal tax code allowing for the deduction of state and local taxes from federally taxable income. This provision is particularly important for residents of states with high income taxes and property values such as California, New York, and New Jersey. These deductions would be eliminated in order to help make up for the revenue lost from the reduction in the individual and corporate tax rates discussed above. However, the removal of the state and local tax deduction could have a mixed impact on municipal bonds. It may be more difficult for states and local governments to raise taxes if there is not a deduction for such taxes at the federal level. Without the ability to effectively raise taxes, states and local governments may look to issue more revenue bonds where the sources of payment are not tied to the general obligation credit or taxing power of the issuer. The removal of the state and local tax deduction could also have a positive impact on bond yields. For example, in high tax states like California, New York, and New Jersey, residents may face an increase in their effective tax rate that may actually cause demand for tax-exempt municipal bonds to increase in those states, in turn driving down bond yields.
Elimination of the Alternative Minimum Tax
A third Trump proposal repeals the alternative minimum tax (AMT). Such a repeal could have a potentially positive impact on municipal bonds that are subject to the AMT, as these bonds typically pay yields that are roughly 50 basis points higher than traditional tax-exempt municipal bonds because the interest is subject to the AMT. If Congress successfully repeals the AMT, municipal bonds subject to the AMT may begin trading closer to general tax-exempt levels. In addition, the repeal of the AMT and a corresponding reduction in yields might cause an increase in the issuance of tax-exempt municipal bonds to finance, among others, airports, seaports, and certain housing developments that are currently subject to the AMT.
While the impacts of any possible tax reform to the municipal bond market are still at least several months off, President Trump’s current proposals do not include the elimination of the municipal bond interest tax exemption — welcome news to the municipal bond community.