The American Interest
Analysis by Walter Russell Mead & Staff
Obama, Boehner to Take on Blue Model Funding Source?

President Obama and congressional Republicans haven’t seen eye to eye lately, especially when it comes to taxes, but the Wall Street Journal reports that they may have found one issue on which they agree: eliminating the tax exemption for municipal bond investments. There looks to be at least a chance that eliminating or significant reducing these breaks will become a significant part of any possible deal to keep from going over the fiscal cliff.

Both sides can find something to like in getting rid of this exemption. Obama and the Democrats like it because it raises taxes on income that goes predominantly to the rich. Boehner and the Republicans like it because it allows government to raise revenue without raising tax rates. And the potential budget savings are significant: foregone revenue from this exemption is estimated at $30 billion per year.

There’s one group that doesn’t like this emerging bipartisan compromise, of course: city mayors. They worry that their cities’ borrowing costs are about to rise:

By exempting municipal bond interest from federal taxes, the government creates an incentive for investors to buy them, which helps hold down the borrowing costs of the states, cities and other entities that issue them. Curbing the exemption would likely reduce demand for the bonds, pushing those borrowing costs higher.

State and local governments, dealers in the $3.7 trillion municipal-bond market, and other interest groups have mounted a lobbying effort to keep the tax out of any agreement forged by the White House and Congress to avoid the fiscal cliff.

Investors are willing to accept lower yields for municipal bonds because their interest income is exempt from federal income taxes and from taxes in the state in which the bonds were issued. In some high-tax areas, such as California, the bonds are also exempt from local income taxes.

What this means is that the exorbitant costs of blue governance in urban districts with crippling regulatory burdens, out of control public unions, and other factors are spread around to taxpayers in general. The municipal bond interest exemption is a federal subsidy for blue—like the federal tax exemption for state and local tax payments, it is a complicated mechanism that reduces the burden of blue governance primarily on the rich.

A direct attack like one President Obama and the Republicans seem to be mulling on a vital funding mechanism for the crony capitalism strangling many blue cities and states is unlikely to succeed. Raising borrowing costs for cash-strapped blue governments makes everything harder for mayors and governors around the country. While Republican-run local governments as well as Democratic-run ones would feel these costs, an end to this subsidy would likely hurt Democrats and Democratic interests most.

But for Republicans and other opponents of excess federal power, there’s a catch. Ending the tax exemption would also make state and local governments that much more dependent on federal money, strengthening Congress and the White House at the expense of local officials.

On the whole, at Via Meadia we like the idea of making taxes as simple and transparent as possible. People should be able to see clearly what they are paying and where it is going. Hidden subsidies in the tax code and back door efforts at social engineering through tax incentives rarely work well, and they remain in force long after their useful life is over. We won’t weep for the muni bond tax exemption if it goes the way of the dodo, though we aren’t holding our breath for anything to change.

Published on December 13, 2012 9:00 am