The Bond Market and the Jobs Agenda

President Barack Obama on Sept. 8 addressed a joint session of Congress to roll out the American Jobs Act. In the wake of a still stagnant recovery, the bill includes a combination of tax breaks and new spending designed to give the economy a booster shot and hopefully put more people back to work.

If passed by Congress, the bill would provide more than $35 billion to state and local governments to retain or rehire teachers and public safety officials. The tax measures used to pay for the bill, however, may ultimately come back to bite the very state and local governments it is designed to support.

The American Jobs Act is paid for largely by eliminating and reducing a wide range of tax deductions and exclusions, as well as closing some tax loopholes.  But the danger in this type of blanket tax reform is that some of these incentives have a direct link to state and local economies, namely, the municipal bond market. 

If passed into law, the president’s proposal would eliminate the tax exemption on municipal bond interest for individuals making more than $200,000 annually. Taxing municipal bond interest creates a new and entirely avoidable disincentive to invest in this historically stable market and it will have a direct effect on the credit of state and local governments.

The tax exemption on municipal bonds is a cornerstone of the federal tax code. The exemption has been in place since 1913, when the first federal income tax was implemented. This helped to establish private investment in public infrastructure as a stable and responsible option for investors and a safety net to state and local governments, a fact that holds true today. Today, more than $2.9 trillion in tax-exempt bonds, issued by 30,000 separate government entities, are outstanding .

Despite the ongoing budget woes, many states are taking advantage of historically low interest rates to fund major new investments in infrastructure. In May, Virginia Gov. Bob McDonnell announced the successful sale of $600 million in bonds “with a true interest cost of 4.025 percent.” This was the first of a series of three bond sales designed to jumpstart 900 transportation projects across the state. However, the interest cost on a bond sale of this type is likely to increase substantially if the proposed exemption limitation goes into effect.

Eliminating the exemption on municipal bond interest would have a domino effect on state and local budgets. Investment in the municipal bond market will look less appealing to investors looking for stability in an economy still plagued with uncertainty. Any contraction in municipal investment would increase state borrowing costs, thereby hindering the ability of states and local governments to fund infrastructure investments vital to economic development. In a time when states are already scaling down budgets and fighting to promote economic growth, this would compound the jobs and revenue crisis that has hounded states since the beginning of the Great Recession.