The Joint Select Committee on Deficit Reduction, tasked with finding $1.5 trillion in spending cuts or revenue increases to reduce the ballooning U.S. deficit, is considering a proposal to end the tax exemption for the $2.9 trillion municipal bond market.
Municipal bonds are an opportunity for state and local governments to carry out their capital projects in the most cost-effective manner. Currently, the tax exemption on municipal bond interest allows municipalities to borrow money by offering yields below treasury rates. Investors are willing to accept the lower rates because they don’t face taxes on the bond payments.
Elimination of the tax exemption could result in rapid price adjustments for some municipal bonds resulting in a major challenge for bond fund managers who oversee $480 billion in nearly 600 separate municipal bond funds. If investors start jumping ship in search of better returns, fund managers will be pressured into selling to meet redemptions. The highest quality bonds are typically liquidated first creating a downward spiral for the fund.