Bonds Ruling Won’t Mean Retroactive Tax
The Supreme Court on Wednesday dropped what initially appeared to be a bomb on the municipal bond market, ruling that Congress is free to tax interest on state and local tax-exempt issues.
The ruling could bolster Congress’ growing tendency to limit the tax exemption of yet-to-be-issued bonds. But investors holding bonds that already have been issued--through individual bonds, mutual funds or unit trusts--needn’t worry that their holdings will become retroactively taxable, experts say. The ruling is extremely unlikely to result in taxation of already issued tax-free bonds and even could benefit holders by driving up prices of those bonds, some say.
“Stick your bonds back under your pillow and go back to sleep,” advises George D. Friedlander, managing director of municipal bond research at Smith Barney, Harris Upham & Co. He and other experts say the court’s ruling doesn’t change any existing laws but just provides a legal basis for what Congress was already doing anyway: deciding for itself which municipal bonds can and can’t be tax-exempt.
Experts also say it will be politically untenable for Congress to retroactively impose taxes on some or all of the $715 billion in tax-exempt bonds outstanding. The backlash from individual investors, who hold more than $400 billion of those bonds, would be furious.
And while Congress has imposed retroactive rules on policies that it wanted to abolish, such as certain tax shelters, it generally shies away from enacting retroactive measures on things it wants to preserve, such as tax-free bonds for highways, sewer plants and other important public projects, Friedlander says.
Consequently, investors have been relatively calm in reacting to the ruling, with little noticeable buying or selling following an initial spurt of panic unloading on Thursday by those who may have misinterpreted the ruling.
However, investors and experts do fear that the ruling could encourage Congress to limit the tax exemption of future bond issues, particularly as lawmakers struggle to raise tax revenue to cut the bulging federal budget deficit.
“It should reinforce in Congress the idea that they can determine and define what municipal issues should be subject to taxation” said Peter J. D. Gordon, head of the municipal bond division at T. Rowe Price, a Baltimore mutual fund company.
“This just gives them further momentum for chipping away,” said Richard A. Ciccarone, vice president for research at Van Kampen Merritt, a Chicago issuer of municipal bond funds.
Such chipping away was prevalent in the Tax Reform Act of 1986, when Congress imposed limits on the amount of tax-exempt bonds that could be issued by municipalities--a move that has sharply curtailed the volume of new issues hitting the market this year and last. Congress also subjected new issues of so-called “private purpose” bonds, such as those financing industrial development or sports stadiums, to taxation for investors falling under the alternative minimum tax.
Many market watchers expect Congress to go further by enacting a revenue-raising tax bill in 1989 that could further limit the tax exemption of municipal bonds. Some analysts worry, for example, that Congress could require that more--or possibly all--municipal bonds be subject to taxation under the alternative minimum tax.
When Sen. Bob Packwood (R-Ore.), then chairman of the Senate Finance Committee, suggested such a policy two years ago, it caused widespread panic in the municipal bond market, virtually shutting down trading for a day until the proposal was modified.
Consternation about possible new limits on tax-exempts could boost demand for existing bonds, driving up their value, some experts say. That’s because the bonds are one of the few tax shelters generally preserved under tax reform.
Also, if Congress decides next year to raise individual tax rates--as many tax experts predict--it could further boost demand and prices for existing bonds, suggests Neal H. Attermann, manager of municipal bond research at Kidder, Peabody & Co. (Higher tax rates make the tax-exempt feature of the bonds more valuable to those in higher brackets.)
On the supply side, however, fear of tighter limits next year may spark state and local governments to increase the amount of bonds they issue this year. Kidder’s Attermann, for example, says he now expects about a 10% to 20% increase in municipal bond issuance this year over what he was predicting earlier, to as much as $95 billion from $80 billion.
Even with all these changes, the bottom line for investors still remains the same: Municipal bonds are a good investment for those in high tax brackets. That is particularly true now, as munis are offering about 90% of the yields of taxable Treasury issues, which makes their after-tax returns superior to Treasuries.
