Time to cry UNCLE!!

After almost 35 years of effort by the federal government, it may be time for the municipal bond market to cry uncle and give up the “benefit” of tax-exempt status on municipal bonds. Since 1974, the federal government has been placing a stronger and more vicious stranglehold on the muni market. It appears that the government’s long quest for the holy grail of no tax-exempt bond issues may be close at hand.

Recently, the United States Supreme Court held that the state of Kentucky could tax the interest paid by another state to a Kentucky resident. According to the Court, such taxation does not run afoul of the “Commerce Clause” of the U.S. Constitution. While this decision may be seen as a victory for Kentucky, it realistically should be viewed as a substantial setback for the proponents of maintaining the tax-exempt interest on municipal bonds.The Opinion is here.

Between the chipping away at the municipal market by the government through the operation of the arbitrage regulations and the self-destruct mode the muni market has been in for the last few years, it really is just a matter of time before all municipalities lose the right to sell tax-exempt bonds.

While this may be greeted with glee from some parties, Joe Mysak, Bloomberg, the halls of Congress and the SEC, we taxpayers will wind up shouldering most of the cost.

At this time, the spread between municipal and corporate rates is about 1%. In percentage terms, municipal rates are about 81% of AAA corporate rates. With approximately $200 billion in municipal debt being issued this year, the increase in borrowing costs will be about $2 billion annually.

But rather than trying to defend and keep the tax-exempt status, the municipal market would be well served to attempt to fashion a plan whereby they give up exempt status in return for other items.

For example, the elimination of the arbitrage regulations could be first on the list to be eliminated. It has been estimated that the costs of compliance with these regulations costs the tax-exempt market approximately $600 million a year.

Next, the federal government should be willing to eliminate its own tax-exempt status on the bonds it sells. Currently, municipalities cannot tax the interest on US government bonds; imposing an effective 5% rate on the interest paid on those bonds could generate almost a billion dollars per year. And that amount is only going up as the growth in federal borrowing exceeds the growth in municipal borrowing.

Lastly, eliminating the tax-exempt status of municipal bonds would open a huge new market of investors. Pension funds, IRA’s, Keogh’s, and other tax-exempt investors would all now be attracted to municipal bonds. The increase of efficiency and tradability in the market would assist municipalities in the issuance of their bonds.