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Rumors have been floating around for months that taxing municipal bond interest was on the fiscal cliff table. Bloomberg, Wall Street Journal and New York Times are all reporting that limiting muni bond interest deduction to 28% is likely in the cards. From the Times: [1]

President Obama’s proposal would not “grandfather” existing bonds, but would apply to all of the $3.7 trillion worth of municipal bonds now outstanding, most of them held by individual investors, directly or through mutual funds.

High-bracket investors who hold them would have to start paying an effective tax of 7 percent of the interest — or even more if the highest tax bracket increases from the current 35 percent.

“This would be the first time that a tax law has affected existing debt,” said Chris Mauro, head of municipal bond strategy at RBC Capital Markets.

Investors are anxious because they bought the bonds, often issued for 20 to 30 years, in the expectation that they would be tax-exempt until maturity.

The significance IMO is NOT grandfathering existing muni bonds. If Uncle wants to make a mess of floating new muni issues, let them have at it. Every penny of incremental tax revenue will be offset by more than a penny of incremental cost to municipalities. The law of unintended consequences will rear its ugly head. No big deal.

The BIG DEAL IMO is the precedence of changing the rules in the middle of the game, in a dramatic fashion. Assuming this becomes law, it makes it easier to foresee taxation of ROTH IRA earnings for example. Maybe 401k/IRA income is taxed each year, instead of being tax deferred until payout? Neither of these in on the table currently but how confident are you then will survive say the next 50 years?

My guess is that the “keep muni interest tax free” lobby is not as powerful as the “keep mortgage interest deductible” lobby. If they did an abrupt change that mortgage interest deduction was somehow limited, a similar argument could be made about breaking promises.

Muni bonds have seen a dramatic fall this month and are down about 1.5% which is a lot for bonds. Apparently some large muni bond holders think the taxability issue has been decided and they lost.

“Breaking” tax law promises seems like a Macro Economic RISK to me. . .



[1] New York Times article on taxing muni bond interest
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