Tax rates and federal government expenditures are being discussed in Washington. The ultimate result could affect the value of municipal bonds. My colleague Michael Brooks explains.
The “Bush tax cuts” are set to expire at the end of this year. At the same time, the annual federal budget deficit is unsustainably high and must be addressed. Of course, strong economic growth would help policymakers fix our budget shortfall, but that doesn’t appear to be in the offing.
The eventual solution may affect the value of municipal bonds, and that impact could be either positive or negative. But most likely, the value of intermediate-duration bonds—that is, bonds maturing over the next three to 10 years—will be more insulated from this issue than the value of long-duration bonds (securities coming due 10 to 30 years from today).
On January 1, 2013, all the Bush tax cuts will expire under present law and the top federal tax rate will rise from 35% to 39.6%. Some economists and politicians have argued that a tax increase in the current environment would be detrimental to the economic recovery and should be delayed until the economy is stronger. Others argue that the increase is needed to help balance the federal budget.
Additionally, in 2013, higher-income taxpayers will be subject to a Medicare Contribution Tax of 3.8% on investment income, but also under present law municipal bond income would be exempt from this tax.
Higher federal taxes would make tax-exempt municipals more attractive to investors, which could drive yields lower and push prices modestly higher—especially for long-maturity bonds—benefiting total return, as shown in the display below.
Conversely, policymakers could decide to reduce the government “expenditure” on municipal bonds by limiting their federal tax exemption, which could reduce the value of municipal bonds. Last fall, President Obama proposed that the municipal bond tax exemption should be curtailed for high-income taxpayers. The president defined high-income taxpayers as those with adjusted gross incomes in excess of $250,000.
Specifically, the president would only allow a tax exemption up to a 28% federal marginal tax rate, regardless of how much higher the taxpayer’s marginal tax rate actually was. Building on our previous example, under the president’s proposal, taxpayers subject to the new top tax bracket of 39.6% would in effect face a tax on municipal bond income of 15.4%, including the Medicare Contribution Tax. The proposal would apply to all municipals regardless of issuance date.
If the proposal were enacted, the attractiveness of previously tax-exempt municipal bonds would decline, causing their value to drop and yields to rise. This would completely reverse the positive effect on municipal returns of ending the Bush tax cuts and imposing the Medicare Contribution Tax, and would result in a net negative return impact, as shown in the display below.
Any discussion about future tax rates and deficit reduction is unlikely to take place before Election Day in November, but it should be a hot topic immediately following the election, as Congress decides what it will do. Changes in the tax code could have an impact on the value of municipal bonds, though more on long-term than intermediate-term municipals.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.
Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income, and Michael Brooks is Senior Portfolio Manager of Municipal Bonds, both at AllianceBernstein.