Obama's proposal to tax municipal bonds will hurt states, cities, and Americans

It is hard to imagine a more destructive and less constitutional way for the US government to raise revenues than with a new tax proposal now afloat in Washington.

In February, the US Senate passed a budget resolution calling for taxation of previously tax-exempt municipal bonds. In April, President Obama’s budget repeated the call. For the first time since 1913, when the 16th amendment – which established the income tax – was ratified, the federal government is considering taxing investors’ municipal bond income.

Presented as closing high-end “tax loopholes,” taxing municipal bonds, known as “munis,” would impose crushing new expenses on US states and municipalities – the consequences of which would be felt by citizens at every income level.

If taxes are imposed on muni bond income, will investors lend US states and municipalities money at all? Investors already have more reasons than they need to say “no” to state and local government paper: rising interest rates that have sent the bond market into decline, mounting dangers of default (Detroit has declared bankruptcy), and poor financial disclosure. Detroit is not alone. With one city after another on the edge of bankruptcy and some states not far behind, the proposal could not come at a worse time. 

By some estimates, the hike in state and municipal borrowing costs could exceed 70 percent. Some states simply could not afford to borrow for new projects.

Consider what that means. Three quarters of US infrastructure projects are the work of state and local governments. Tax-exempt bonds finance them. But the bonds’ uses don’t stop there. Yes, bonds fund roads, bridges, schools, libraries, hospitals, prisons, and sewer systems. But bonds also provide disaster relief. And when old debt matures (comes due), municipalities must issue new bonds to pay off the old – a process known as “rolling.”

A report by the National League of Cities finds that had the Obama administration’s proposal to tax muni bonds been in place over the past decade, it would have cost states and localities a staggering $173 billion in additional interest.

Indeed such profound destructiveness to state and local government raises questions about whether the courts would see taxing munis as a direct assault on the federal system of government and, therefore, unconstitutional. It is true that in South Carolina v. Baker (1988) the Supreme Court upheld a federal tax on municipal “bearer” bonds. But this was a very special case in a very different time.

The bonds in question at that time were constructed not just to exempt income but to hide ownership. Congress feared that these untraceable instruments would encourage evasion of estate and gift taxes. On appeal, the Supreme Court found that taxing them would have little impact on state finances as few had been issued. Even so, Justice Sandra Day O’Connor’s dissent questioned whether the federal government could constitutionally step across the line to impose such a burden on states at all. Her concern echoed Chief Justice John Marshall, who famously wrote that “the power to tax is the power to destroy.”

Today’s Supreme Court takes federalism and state sovereignty much more seriously than did the Court on which Justice O’Connor sat in 1988. It is safe to say that if Baker were reheard today, the current federalism-minded majority would side with O’Connor on the far more injurious tax now at issue.

The experience of the last quarter century has made it unlikely that a municipal bond tax would survive Supreme Court scrutiny. The Baker decision in 1988 was written in an era of enormous prosperity. The Court’s majority suggested that states did not need constitutional protection from federal tax laws, as no Congress would try to raid state coffers. And the federal government had plenty of money.

Since then an increasingly cash-strapped Washington has heaped more and more obligations on the states, most recently Obamacare, without providing dollars to pay for its mandates.

A federal tax on muni-bond revenues would make them less attractive to investors who would then expect the bonds to give higher yields to compensate for the tax. But many struggling states and municipalities would not be able to pay the higher interest rates on their debt and would be priced out of the lending market. In many cases, tax exemption is the only reason for investing. (When the idea of taxing muni bonds was first floated in December, muni interest rates went up a half point.)

Some have discussed the possibility of federal bailouts for those states and municipalities that could no longer afford to pay the higher interest rates the market would demand, but such prospects are hardly reassuring. Those assurances depend on a national government that now grasps at every penny from every source to pay for the rising trillions of its own debt.

Indeed, bailouts would make things worse all the way around. As the Securities Industry and Financial Markets Association has told Congress, “the tax exemption is better than direct subsidies for infrastructure investment because bonds must be repaid, forcing a market test on the project’s viability.”

Threatening irreparable injury to state and municipal finances would not close a tax loophole, but it would transfer resources from struggling states to spendthrift Washington. Meanwhile, investors would feel duped and resolve not to be duped again: They invested in muni bonds based on the understanding that the revenues would not be taxed. A retroactive change would likely lead investors to sue. A test in the Supreme Court would almost certainly follow. That is not a test that the administration and its allies would likely win.

It would be better for state and local economies, investors, and the American people if Washington dropped the foolish proposal to tax muni bonds before it gets any further off the ground.

Stephen Shapiro served as deputy solicitor general under President Ronald Reagan. Timothy Bishop is a former law clerk for Supreme Court Justice William Brennan. They are both partners in the Supreme Court practice group at the law firm of Mayer Brown.