The Impact of Tax Policy Changes on Municipals

Well obviously the tax policy in the US is very important to the municipal market because it derives a lot of its value from the taxes, that nature of the income. We've heard increasingly more and more talk about tax reform, the need for it in the US, because tax code is so complicated – 72,000 pages with 173 different types of tax credits and deductions.

One of the problems is they get farther and farther apart. So that's going to be the big issue is how they can come together on a proposal. The first and most immediate is if the Bush tax cuts do expire at the end of the year for this impending fiscal cliff, the top marginal tax rate would go from 35 percent to 39.6. That right there makes Munis more attractive and will go up in value almost immediately and bring in more investors.

The other is the Affordable Care Act. That healthcare surcharge of 3.8 percent is actually very important because it's on a net investment income, and munis are the only asset class where it would not be included in that calculation. So, again, you have another institution of something that would increase the value of munis. So that's the immediate one facing us right there.

Further on we talk about tax policy and what it means for particularly the tax exemption. We've heard the Obama Administration talk about capping the value of the exemption at 28 percent on several occasions, and you have to find the difference between the top tax rate in that 28 percent to figure out what that surcharge actually is.

The other we've heard much talk about is just doing away with the tax exemption altogether. We've heard this for decades now. We think that that's very, very unlikely. In fact, the chance of it being imposed retroactively, almost zero. The cost to municipalities, to states, the cities just when they're getting on firmer footing would actually go up quite a bit. So all taxpayers bear the brunt of that, not just those that benefit from buying municipal bonds.

So we think that the chances of anything really occurring are going to be very difficult because the lobby against these from issuers against some of these proposals is very, very loud because of the impact it has on issuers.

The other is just I think the inherent nature of the government itself. They've grown farther and farther apart on many issues. The lack of willingness to compromise tells us that it's going to be very difficult to implement tax reform in 2013. It might be more of a 2014 mid-term election scenario if the construct of the current Congress stays the same, meaning the balance of power between the House and the Senate in terms of Democrats and Republicans.

So we think that basically there's not going to be a big impact from the negative side to munis, it's probably going to be more positive. There's probably good value in the market if you think tax rates are going up next year, supply's going to dwindle, it's probably a good time to buy.