Coping With the Prospect of Higher Taxes : Tax-Free Bonds Alluring, but Wholesale Investment Switches Seen as Unlikely
The ink on America’s new budget proposal is not yet dry, but well-heeled investors are already pouring money into tax-free municipal bonds to avoid the higher tax rates that the budget plan portends.
Net sales of tax-free municipal bond funds have jumped by about $220 million during the first eight months of 1990, according to the Investment Company Institute. And the change has been even more dramatic in the past month since budget talks began, investment experts said.
Fidelity Investments, one of the nation’s biggest mutual fund companies, has seen a 60% increase in investments into its California tax-free bond funds between September and October, said spokeswoman Patricia Harden. Investments in other tax-free mutual funds sponsored by Fidelity have also soared, she said.
“There has been a market shift toward municipal bonds,” added Michael P. Buckley, vice president and municipal credit analyst at T. Rowe Price in Baltimore.
The shift to tax-free investments started months ago because it became clear to investors that the rich would get hit with higher rates, investment experts said. The budget deal proposes about a 3% tax hike on the wealthy, from 28% to 31%. However, it sets a separate maximum tax on capital gains of 28%.
The new capital gains rate would provide a break to wealthy individuals who are active in the stock market and could spur additional market activity next year when it goes into effect, investment experts said.
“This is clearly going to direct more people into equities than before,” Greif said.
However, the same provision is likely to cause a decrease in market activity this year, particularly among upper-middle-income taxpayers who are in the so-called bubble bracket. These individuals currently pay 33% in federal tax. They are likely to put off triggering any capital gains to avoid paying tax at their 33% ordinary income rate this year. The current tax proposal also expects to burst the bubble bracket, presumably next year, by making the top federal rate about 32%.
Nevertheless, the tax increases and breaks proposed in the current budget plan are not significant enough to spur wholesale changes in investment patterns, said Gregg Ritchie, partner at the accounting firm of KPMG Peat Marwick.
In 1986, when tax laws changed to eliminate the 20% capital gains rate, investors rushed to sell anything that would trigger such a gain, causing a flurry of activity at year-end. However, since most taxpayers would see only an increase of about 3% in their federal tax rate, and less than a 5% break on capital gains, they are not likely to act with as much vigor, Ritchie noted.
“It is not going to be some wholesale flight” of capital, he added. “The difference is not that significant.”
Indeed, although there has been a big increase in the tax-free market, investors continue to be cautious about what they are buying, Buckley said. Although the changes could effectively hike the after-tax yield for many investments, the difference is not big enough to overlook investment risk.
“I think investors will be looking at municipals, but they will make sure they are buying high-quality bonds,” he said. “I think you will see investors being much more conservative in jumping into deals where the (bond issuers) have known financial problems.”
