- - Wednesday, July 17, 2013


For the first time in a century, the Obama administration’s April budget proposal would levy federal taxes on municipal bond income. That proposal is now under review in the House Ways and Means and Senate Finance committees. Presented as a measure to close “tax loopholes,” it would transfer hundreds of billions of dollars from the states to Washington, collapsing the market for municipal bonds. Democrats in Congress concerned about jobs, infrastructure investment and massive debt costs for the blue states have every reason to shun such an idea. However, it should be even more objectionable to Republicans.

Mike Nicholas, head of the Bond Dealers of America, has quantified the hike in debt costs for the states as 70 percent or more. It wouldn’t simply target the wealthy, Mr. Nichols added. It would force everyone to pay more for all state and local services.

How? Three-quarters of all infrastructure projects are built by state and local governments with tax-exempt financing. According to the National Association of State Treasurers, “limiting the tax exemption would reduce investor demand for municipal bonds and raise the interest states and localities would have to offer to attract the investments they need.” The National League of Cities has concluded that if the administration’s proposal had been in effect for the past decade, it would have cost states and localities a staggering $173 billion in additional interest-related expenses for such projects.

Investors considering long-term muni bonds already face significant disincentives: the risk of market decline from rising interest rates, mounting dangers of default and poor disclosure of risk. The century-old tax exemption is the only real inducement to invest.

To ease the pain, the Obama administration now proposes that Congress establish a new infrastructure bank to funnel more federal funding to the states, picking and choosing among infrastructure needs and imposing federal standards in the process. However, the tax-exempt bond market is far superior to such a massive, new federal bureaucracy. Consider the Army Corps of Engineers and Federal Highway Administration. Approval of projects has been slow, money is poorly targeted, and decisions are subject to political pressure and cronyism from every corner of the country.

There is also a question of federal versus state power. If $173 billion in revenues shift from the states to the federal government, the administration will know which states have been politically cooperative and which have not, and it will reward its allies. Meanwhile the federal Davis-Bacon Act will require infrastructure work to be performed by the highest-cost union labor. To get back their lost funds, states would have to bow to Washington. In the process, the public would lose the check of a free market that requires that municipal bonds be repaid on schedule, a spur toward efficiency in spending.

In fact, by taking $173 billion from the states and paying it back in dribs and drabs subject to its own rules through a new Infrastructure Bank, the administration appears intent on recreating the constitutional battle in the Obamacare case. There, seven Supreme Court justices held that Congress could not take away federal dollars for Medicaid, where new financing was combined with an array of federal standards imposed on the states. That kind of coercion was constitutionally forbidden. Taking away the century-old tax immunity of the states, and reducing them to beggars before a new infrastructure bank, is a greater constitutional affront — something most Republicans would oppose.

Is this a constitutional battle that President Obama and Congress want to inflict on the country after years of divisive litigation over Obamacare? In such litigation, the federal government would likely be opposed by all 50 states, and all cities and municipalities. Investors would join in challenging this law on due-process grounds because of its unprecedented retroactive effect. They bought bonds, tying up their money for decades, on the reasonable understanding that their income would be tax-exempt. The negative effects of this new tax proposal would fall heavily on lower-income investors, including many senior citizens, through a reduction in the market value of everyone’s bonds.

Threatening irreparable injury to state and municipal finance does not close a tax loophole but simply transfers resources from struggling states to a spendthrift national government, while duping investors. It is not sound — or constitutional — policy. Republicans should join ranks in opposing this misguided idea.

Stephen M. Shapiro served as deputy solicitor general in the Reagan administration. Timothy S. Bishop is a former law clerk for Justice William J. Brennan Jr. They both are partners in the Supreme Court practice group at Mayer Brown.

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