My son is in grade 7 and this month his social studies topic is the economy. So being the diligent student that he is, he borrowed a copy of a macro principles text and did a little reading. Have pity on the student teacher, she didn’t stand a chance. When she asked “What is an economist?”, my son’s response was “My Dad”. Things apparently went downhill from there.
There is another economist’s son that did not do his economics reading, or if he did, he didn’t understand it. That would be the son of Barack Hussein Obama Sr., an economist for the Kenyan government. You may be more familiar with the son, the President of the United States. As reported in a Reuters article, the President’s budget recommends ending the tax-free status of municipal bonds. With only a few moments thought on the subject, this economist can come up with several reasons why this is a bad idea, and will not increase the tax burden on “the wealthy”.
Bonds trade in financial markets and bonds of equal risk and equal duration will sell for prices that create the same after-tax expected yield. A bond that gets downgraded, for example, will require a higher after-tax yield and that bond’s price must fall to raise its yield. The interest on municipal bonds in the U.S. is currently exempt from federal income tax. The President believes that most municipal bonds are held by individuals with high incomes and thus, should be taxed. A tax on the interest on these bonds will decrease the after-tax expected yield, and bond markets will react to this by reducing the price of these bonds. Municipal bond prices will fall and their yields will rise. The high income investor, who paid no tax on the interest, will sell his or her bonds and realize a capital loss. That capital loss can be used to offset capital gains on other investments reducing the overall tax liability. The change in tax status will have little effect on high income earners.
Once the interest on municipal bonds becomes taxable, the pre-tax yield must increase to that the after-tax yield remains the same. Financial markets require that. Suppose that a municipal bond yielded 5% when it was tax-free. With a proposed maximum tax rate of 28%, the price of municipal bonds will have to fall until the pre-tax yield is 6.94% so that it continues to yield 5% after tax. All newly issued municipal bonds would also have to yield 6.94% on a pre-tax basis and the interest would have to be paid by the property owners that are ultimately responsible for those debts. I’m sure the middle class homeowners will be thrilled to learn that their property taxes have risen because the President wanted to tax high income earners.
As property taxes rise, the cost of owning a home increases and the demand for housing decreases. When this happens, housing prices must fall. This is going to happen just as the housing market begins to recover from the collapse of 2007. Depending on how much taxes increase, and how sensitive housing prices are to local taxes, mortgage defaults may start to increase again. That would be more good news for cities like Phoenix, Las Vegas and Miami.
Municipal bonds have an interesting use in infrastructure financing. A local government that wants to undertake a revenue generating infrastructure project such as a toll-bridge or county stadium, can initially finance the construction with zero-coupon municipal bonds. These bonds are sold at a discount (less than $100) and then mature at a price of $100 when the project is completed. The interest on the bond is determined by the difference between the issue price and the maturity value. No payments are made while the project is under construction. This type of financing only works for municipal bonds since interest is taxed on an accrual basis, not a cash basis. A corporate bond structured this way would be cash-flow negative to the investor – not an overly attractive selling feature. Once the infrastructure project is completed, the zero-coupon bond is redeemed using the proceeds of a revenue bond; a bond whose interest and principle is guaranteed by the revenue stream from the project. If municipal bonds lose their tax-exempt status, this type of financing will be unavailable and reduce the availability of funding for government infrastructure projects. More good news for the economy.
Changing the tax exempt status of municipal bonds has more far reaching consequences that changing the tax liability of the high income earners that are believed to hold these bonds. An economist would predict a shifting of the tax burden from investors to property owners and a reduction in infrastructure spending. An economist’s son should know better.
© 2012 Pearson Canada Inc., All rights reserved, Used by permission
