As investors gear up for the November 6 midterm elections, we outline four topics on the election battleground that could have the greatest impact on municipal bonds. Most forecasters expect the Democrats to take control of the House of Representatives and the Republicans to retain the Senate, but the outcome is uncertain and could initiate various technical and credit trends.
1. Infrastructure Bill
An infrastructure bill might be in the offing if Democrats win the House. House Democrats and President Donald Trump are relatively aligned on infrastructure, so if the Democrats take control of that chamber an infrastructure bill becomes slightly more likely. By contrast, the Senate is lukewarm on increasing infrastructure spending, so if the House and Senate remain in Republican control a meaningful increase in infrastructure spending becomes less likely.
The shortfall in infrastructure spending across the U.S. is a long-running problem for municipal credit. State and local government spending on infrastructure ticked higher in the first half of 2018 but the backlog is still large, and we estimate that spending is now $115 billion behind schedule (Figure 1).
In 2017, the president proposed a plan for a 10-year, $1 trillion boost in infrastructure spending funded by the federal government, state and local governments, and the private sector (see Is It Morning Again in America for Infrastructure?). However, that plan lacked specifics on funding sources, and fell behind other priorities.
Passage of an infrastructure bill may provide an additional fillip to new-money issuance, depending on the size and shape of any infrastructure package. A meaningful uptick in federal aid could contribute to increased supply, reversing recent market tailwinds from lower issuance.
From a credit perspective, increased infrastructure spending is a mixed blessing. More spending could help put toll roads, bridges, transit authorities, water-sewer credits and other issuers on a track to fixing aging infrastructure. Also, infrastructure repair has become more crucial due to extreme weather risks related to climate change (see New Lanes of Analysis for Municipal Transportation Bonds). However, many issuers are likely to leverage any increase in federal aid. That means debt levels might rise in some places.
2. Federal Deficit Trajectory
The deficit is unlikely to shrink regardless of which party controls the House or the Senate. Democratic control of the House would provide more voices in favor of federal funding that could inflate the deficit. However, Democrats are also likely to favor some increase in taxes to pay for more federal spending. If Republicans sweep both the House and the Senate, the federal budget deficit likely stays the same or rises with additional or extended tax cuts. Republicans have proposed making permanent the individual tax cuts passed in last year’s Tax Cuts and Jobs Act (TCJA), which are currently set to expire in 2025.
A larger deficit creates long-term credit and tax risks. It threatens future spending on items such as infrastructure and Medicaid.1 Over the long term, a higher deficit may make it harder to enact fiscal stimulus in the next recession, and it also might nudge lawmakers to reconsider the municipal tax exemption to raise federal revenue.
3. Tax Reform
The likelihood that the next Congress enacts tax changes that impact the muni market is higher than the market perceives. If Democrats flip the House, there could be more proposals to raise personal income tax rates and restore the state and local tax (SALT) deduction. There may also be proposals to liberalize the private activity bond rules to promote public-private partnerships.
If Republicans take both the House and the Senate, then Tax Reform 2.02 becomes more likely and SALT provisions may be made permanent.
A full blue sweep of both houses could mean a rollback of the 2017 tax cuts and higher marginal rates.
Tax Reform 2.0 would also expand tax-advantaged savings accounts. While Tax Reform 2.0 could improve GDP growth, it could also add to the deficit. Passage of Tax Reform 2.0 could be overall negative for municipals, as lower taxes reduce the value of the municipal tax exemption for investors. In addition, a permanent cap on the SALT deduction could make in-state municipal bonds more attractive for residents in some high-tax states.
4. Ballot Initiatives
Ballot initiatives impacting municipals have modest credit implications but they highlight trends in Medicaid, energy and education funding.
- Medicaid Expansion (ID, MT, NE, UT, OR):
- Expansion could benefit hospital credits in Idaho, Montana, Nebraska, Utah and Oregon.
- Energy (AZ, CA, NV, WA):
- Several states have ballot initiatives aiming to reduce carbon emissions. For example, legislation in Washington would allow a carbon emissions “fee” to be assessed on large carbon emitters.
- In Nevada, Questions 3 and 6 are on the ballot. Question 3 would establish an “open, competitive retail electric energy market” and allow residents to choose their electricity provider. This may increase renewable generation. Question 6 would require electric utilities to acquire 50 percent of their power from renewable sources by 2030.
- In Arizona, Proposition 127 would increase the renewable portfolio standards (RPS) for electric utilities to 50 percent by 2030, versus the state’s current RPS of 15 percent by 2025. RPS is the minimum amount of electricity required from renewable energy sources.
- Stricter carbon emissions standards could be negative for municipal utilities in these states due to the expenses of complying with the new restrictions. However, the utilities that adjust to the new standards could be stronger from an environmental, social and governance (ESG) perspective, and could be more stable in the future as regulation and the conversation around clean energy grow stronger.
- Education (CO, GA, HI, MD):
- Ballot initiatives could spawn changes to education funding in Colorado, Georgia, Hawaii and Maryland.
- In Colorado, Amendment 73 calls for a tax hike for education.
- In Hawaii and Maryland, there are moves to funnel new sources of revenue into education. In Hawaii, voters will be asked whether the state legislature can establish a surcharge on investment real estate property to support higher education. In Maryland, voters will decide whether casino revenue should be earmarked for K-12 education.
- In Georgia, the School Sales Tax Referendums Amendment will make it easier for counties to call for a referendum to levy a sales tax for education.
- Given that these initiatives potentially augment revenues for public schools, they could be positive for education bonds in those states.
We will be closely monitoring the election results and the potential ramifications of a new Congress.
 While a Republican sweep could lead to a smaller deficit, it could also be credit negative for the hospital sector, as future reform of the Affordable Care Act or Medicaid, or experimentation with waivers, would be more likely.
 Tax Reform 2.0 refers to three bills that constitute a potential Republican update to the TCJA of 2017 (see Tax Reform: From Risks to Reality). Tax Reform 2.0 seeks to make the following TCJA policies permanent (among others): The individual tax cuts, the $10,000 cap to the state and local tax (SALT) deduction, and the 20 percent pass-through deduction of business income for owners of businesses such as sole proprietorships that pay their taxes through their owners’ tax returns.
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