Five Considerations About Municipal Bonds if Tax Cuts Sunset

When the Tax Cuts and Jobs Act (TCJA) became law in January 2018, it represented the largest redo of the U.S. tax code in decades — with far-reaching implications for individuals and businesses alike.

Many of its provisions were only temporary and are slated to sunset after 2025. If that occurs as scheduled, the effects will again be extensive, headlined by a considerable boost in the portfolio advantages and appeal of municipal bonds for many investors. Here are five things to keep in mind:

1. A potential reversion to higher marginal tax rates would be positive for muni bond demand.

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In a higher-tax environment — and with higher tax-equivalent yields — demand for munis is likely to spike, making now an opportune time to invest before a potential run-up in demand.

The TCJA reduced the top marginal tax rate on individuals to 37% from 39.6%. If the TCJA sunsets after 2025, the highest marginal tax rate is expected to return to 39.6%.

The tax-equivalent yield on a muni increases as tax rates rise — making the tax exemption on munis more valuable for individuals who pay higher taxes. For example, the tax-equivalent yield on a tax-exempt muni yielding 5% is 7.93% at a 37% tax rate — but increases to 8.27% at a 39.6% tax rate.

2. The number of taxpayers subject to the alternative minimum tax (AMT) would increase dramatically.

The TCJA enacted a higher AMT exemption and an increase in the income at which the exemption begins to phase out. If the TCJA expires after 2025, it is estimated that the number of taxpayers paying the AMT would increase to 7.6 million in 2026 from current levels of about 200,000.

Certain Private Activity Bonds (PABs) issued in the muni market are subject to the AMT, muting the tax benefits for investors who are subject to this tax. With the potential for a major expansion of the AMT on the horizon, investors must remain vigilant about security selection, as we anticipate spreads on PABs, such as some airport bonds, would widen relative to other munis that are not subject to the AMT.

3. A potential lifting of the state and local tax (SALT) cap could benefit demographics — and issuer credit quality — in high-tax states.

Prior to the TCJA’s enactment, there was no limit on the amount of state and local taxes that taxpayers could deduct from their federal taxes. However, under the TCJA, a SALT cap was imposed, limiting the federal deduction to $10,000 for all tax filers.

The SALT cap disproportionately affects taxpayers in high-tax states. The cap’s end would lower the tax burden of residents in those states and could reduce any tax-driven incentive for residents to move elsewhere. The positive impact on the states’ demographics would support the longer-term credit quality of the muni issuers within their borders.

4. If discussions around changes in tax law signal a threat to the muni tax exemption, we could see accelerated issuance ...

Past tax law deliberations often have hinted at the potential for a rollback of the federal tax exemption for muni interest.

Under the TCJA, muni issuers lost the ability to advance-refund — refinance at a lower rate — tax-exempt bonds with proceeds from another tax-exempt bond issuance prior to the original bonds’ call date. As the TCJA legislation came together, some speculated that the impact on muni issuers would be even greater, with not-for-profit borrowers, such as private colleges, hospitals and charter schools, losing the ability to issue tax-exempt bonds.

5. ... But elimination of the tax exemption is highly unlikely.

Heading into this year’s election, we could hear fresh talk of a potential change to the muni tax exemption to help subsidize other elements of tax law change.

But the exemption is critically important to state and local governments, schools, hospitals, electric utilities, water and sewer systems, airports and toll roads that fund the nation’s vital infrastructure. Additionally, the exemption’s cost to the U.S. Treasury is quite modest — about $40 billion annually or $400 billion over 10 years — compared with the $4.6 trillion estimated cost of extending the TCJA for 10 years.

Because the exemption is essential to financing U.S. infrastructure, we do not believe its elimination is likely. However, in that extreme scenario, current tax-exempt munis, if grandfathered into the exemption, would become significantly more valuable — with considerable benefit for current investors.

As the prospects for TCJA’s wind-down become clearer, we will likely see asset prices start to respond to changing views regarding munis’ appeal. Every good planning discussion anticipates the future in enough time to get ready for it. That means that now is the time to revisit a muni strategy — and plan the portfolio adjustments needed to take full advantage if tax law takes a turn.

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