After five years of worries over widespread budget cuts, crushing pension obligations and shrinking tax bases in many American cities, a recovering housing market and healthier state balance sheets could send more money trickling into municipal coffers this year.
But uncertainty still hangs over some local governments and the debt they issue to fund everything from roads to schools. Fitch Ratings, one of three major ratings agencies, recently said it expects to downgrade an above-average number of municipal credits again this year. Looming federal budget cuts are making cities and towns nervous, as is a discussion in Washington about taxing municipal bond interest to reduce the deficit.
Will the Muni Tax Exemption Survive?
A proposal included in 2010’s mothballed Simpson-Bowles deficit reduction plan would eliminate tax exemptions for interest earned on municipal bond investments. President Obama has suggested limiting the exemption to filers taxed at a rate of 28 percent or less, effectively imposing an 11.6 percent tax on previously exempt interest income for those in the top bracket.
“The Administration seems to like the idea of a maximum 28 percent deduction in the municipal market,” said Lori Cohane, a Managing Director who oversees U.S. tax-advantaged fixed income portfolios for Credit Suisse’s Asset Management division. “Although there are numerous representatives who would prefer not to tinker with the muni tax exemption, when it comes down to it, this could be something these politicians negotiate away. There are other things they’re more likely to hold firm on; this may not be one of them.”
Higher Borrowing Costs
Cities and other public issuers worry that a loss of tax-exempt status would make municipal bonds less attractive to investors and drive up borrowing costs. Public sector lobby groups, including the National League of Cities and U.S. Conference of Mayors, argued in a recent Politico op-ed that the costs would be passed on to taxpayers.
“Repealing, replacing or limiting the tax-exemption on municipal bond interest would cause governments — and taxpayers — to pay more for their infrastructure needs,” the op-ed said. “This would result in higher taxes and fees, which translates into less infrastructure investment, fewer jobs and higher costs to states and localities that are already under fiscal stress.”
But Cohane said the concern about investor flight may be premature. “We’re not trading based on tax rates,” she said. “If you buy a bond today…and you feel it’s a solid credit that’s going to perform well in a client’s portfolio, you’re going to be less concerned about whether eventually you can only take the deduction up to 28 percent. The safety of the bond, the current income it generates, and the role it plays in properly diversifying the client’s overall investment portfolio – none of that is altered by a shift in the tax deduction.”
Cohane also pointed out that lawmakers have other options for extracting revenue from municipal bonds, such as removing the tax-exempt status of specific credits, such as housing or health care bonds.
Uncertainty in Washington
Cities are also watching Washington because Congress’ resolution of the so-called fiscal cliff merely delayed until March federal spending cuts of about $110 billion a year for the next 10 years. Republicans and Democrats will have to reach another deal in order to avoid the full impact of the cuts.
“Over the last several years, these programs, which support infrastructure, job training, housing, and education investments, have already been subject to significant cuts in the name of deficit reduction,” said Marie Lopez Rogers, the mayor of Avondale, Ariz., and president of the National League of Cities. “If the automatic spending cuts are implemented, they will set back the economic recovery we are only now beginning to see in our communities.”
As of December, local governments still employed 400,000 people fewer than they did five years earlier – a decrease of about 2.9 percent, according to the Nelson A. Rockefeller Institute of Government at the State University of New York – Albany.
“The reality is, from the revenue-raising standpoint, a lot of these areas are at their limit,” Cohane said. “From the cost standpoint, you’ve already cut people. You’ve cut programs. But certain basic services, like public safety, need to be provided.”
Fitch has said that municipalities that failed to rein in the ballooning costs of labor, retiree health benefits and pensions will face particular difficulty this year. But both the ratings agency and Cohane noted that the fiscal health of cities varies widely, and so will their fates in 2013. Some cities, having cut costs during the lean years, may be well placed to take advantage of property tax, sales tax and state aid revenues that are expected to slowly improve this year.
“Our feeling is, it’s going to be very credit-specific,” Cohane continued.
Still, both Fitch and Cohane said more Chapter 9 bankruptcy filings, such as those filed over the last two years in Stockton, Calif., and Central Falls, R.I., could be in the offing. Some parts of California, for example, have been plagued by high foreclosure rates, heavy debt loads and hefty operating costs, with little room to raise revenue through taxes or fees, Cohane said.
“In places like that, I just don’t see where there’s been enough of a turnaround in the economy to make a difference,” she said.