Tax reform affects municipalities

Early discussion in Congress and the press regarding federal tax reform already has had an effect on the municipal bond market, and — even though a final resolution is at least two years away — it is not too early for local governments to begin thinking about how tax reform might affect them.

Investors in municipal bonds are cautious about the potential effects of federal tax restructuring on their tax-exempt portfolios. Municipal bonds, whose price movements often track those of fixed-income securities, lagged considerably in early 1995. The principal reason is many buyers of municipal bonds are worried that federal tax reform could hurt their tax-exempt investments.

Investors’ concerns may be premature. The national debate over tax restructuring will be a long one and surely will become tangled in the 1996 presidential campaign. Nevertheless, each of the tax reform ideas currently circulating in Washington could have a profound effect on municipal finance and deserves explanation.

Flat Tax: The flat tax has the strong support of House Majority Leader Dick Armey (R–Texas), Senator Richard Shelby (R–Ala.) and others. It is essentially a payroll tax. The proposal would eliminate virtually all deductions and credits, leaving only a relatively large standard deduction. Taxable income would be taxed at a flat rate of 17 percent. All investment income would be exempt from taxation. Municipal bond interest, therefore, would be treated the same as other investment income.

Unlimited Savings Allowance Tax: This proposal, introduced earlier this year, essentially is a form of consumption tax. The “USA” proposal has a graduated rate and permits individuals an unlimited deduction for contributions to savings and investment, as well as limited deductions for home mortgage interest and charitable contributions. No deduction would be permitted for state and local taxes. The proposal contains municipal bond interest exemption of much less value to issuers and investors than that available under current law.

National Sales Tax: This plan would scrap the income tax altogether in favor of a federal tax on retail transactions. No investment income, from either municipal securities or currently taxable instruments, would be taxed.

Value-Added Tax (VAT): Under a VAT, businesses are taxed on the value of goods produced less the value of raw materials. A VAT is a consumption tax because it is assumed that businesses pass on their tax liability as higher prices on finished goods. Both the VAT and the national sales tax have yet to be formally proposed.

There is no clear indication yet which approach to tax reform is most favored by Congress. There is also a lack of consensus among analysts as to how each of these proposals might affect the finances of local governments. A federal tax code that is simpler and more favorable toward savings and investment could have some very positive ramifications.

However, a number of other questions have also been raised, questions that Congress should consider as it pursues tax restructuring. For example, under most of the proposals being discussed, interest on municipal securities would lose its tax preference. Also, residential real estate could lose some value if the home mortgage interest deduction is curtailed or eliminated, reducing local property tax revenues. At this early stage in the debate, there are many more questions than answers.

Still, now is the time for anyone with an interest in the tax reform debate, including local governments, to begin thinking about how to respond to the tax reform tide that is overtaking Washington.