Podcast recorded April 28, 2017

Muni Bonds and Trump’s Latest Tax Announcement

Podcast Transcript

Hello this is Natalie Baker, vice president of marketing here at Breckinridge, and welcome to the Breckinridge special topic podcast “Munis and Trumps Latest Tax Announcement”. On Wednesday President Trump released a tax plan that presented a wide variety of deductions, many of which are familiar given the tax plans the new president campaigned on or has already laid out. Today I am joined by Adam Stern to give us some comments on the plan and how it might impact municipal investors. Adam is the head of our municipal credit team and a member of our Investment Committee. So Adam, what did we learn on Wednesday?

Well, that is a good question. The president's proposal was really only a page long and I think the best thing you can do is call it a proposal. It is not a fully fleshed out plan but I think to the extent that there was any doubt or wavering that we were actually going to get some movement, or at least a few swings and attempt on a wide-ranging tax reform, I think if there is any doubt there that was put to bed. Most people expect that, but the President coming out and saying here is my proposal and the many pieces of it dovetail with details that the House Republicans have been talking about for a while, so it says you know all hands are on deck and let us see what we can get done.

All right. So for the purposes of this call we are really interested in how the tax plan may impact municipal investors. To that end, can you speak about the state and local tax deduction and what that means for muni investors?

Yeah sure. So I think you bring up the state and local tax deduction because that is one of the items that folks have pulled out and asked the President and the Treasury Secretary, who made the announcement, and they said, “Yes we’d like to eliminate the state and local tax deduction.” You know, the plan writ large is designed to eliminate pretty much every deduction, with the exception of mortgage interest and charitable deductions. It is silent about exclusions, importantly. The tax exemption from municipal bonds is an exclusion not a deduction so that is an important distinction. But to your question about the state and local tax deduction in particular, there are two things to think about there for investors. The first is if you are in a high tax state... so if you are in New York or California where your top state personal income tax rate is over 9% when you have a state and local tax deduction your effective rate is actually lower than that, since you are deducting the 9% from your federal tax liability. So if you eliminate the deduction there is actually then a larger advantage to owning municipal securities in-state. So if something along the lines of what President Trump is proposing were ever to pass, we would expect to see maybe more bias in certain New York or Cal or other high personal income tax state portfolios towards in-state bonds. The second piece is more subtle, something I think about a lot, is the credit impact of the state and local tax deduction. Because the state and local tax deduction allows for state taxpayers to reduce their federal tax liability using the state and local tax paid. It effectively subsidizes the cost of government in states with higher tax rates. And so what it means is the marginal cost of providing government would go up if you eliminate the deduction. So you may see a downtick in public willingness to fund services because to fund an extra dollar of services will actually feel like an extra dollar out of your pocket as opposed to something less than an extra dollar out of your pocket. So it is definitely something to keep an eye on especially because the House Republicans’ plan also considered eliminating this deduction.

Okay, so you have touched on several things here that are important, the distinction between exclusions and deductions and also it sounds like it is important to think about which state you are actually talking about and the tax in that state.


Let us switch gears a little bit. I know one part of the plan is the reduction in corporate taxes from 35 to 15%. Can this actually have an impact on municipals as well?

Yeah, and I think we have spoken to this before either on podcasts or in monthly commentaries or in the 2017 Credit Outlook. There is a demand for municipal bonds from insurance companies, property-casualty and increasingly in the past few years, banks. So those two parts of the buyer base, if the corporate income tax rate were to fall, the demand from those two sectors might decline a bit. You know, our position has been these entities would not be sellers of municipal bonds, but they probably would not be buying quite as much going forward. The other piece that Trump has talked about with the corporate tax has been repatriation. That does not have to do with lowering rates necessarily, but if they did lower rates and then offer maybe a one-time rate on repatriation of overseas income, that could relate to infrastructure spending but that is not quite exactly what was discussed here.

I got you, and one thing that also been on investors’ minds is the AMT, the alternative minimum tax. As he said earlier, the President plans to eliminate this. What could that mean for municipal investors?

The AMT, some municipal bonds, some private activity bonds are subject to the AMT cap. The AMT exists to make sure that high-income taxpayers pay some tax and so if you invest in certain kinds of private activity bonds you may have to pay them. Certainly, if you owned a private activity bond today and the AMT tax is eliminated tomorrow, that is a good deal because, you know, the yields on these bonds tend to be a little higher to reflect the fact that taxpayers have to pay tax on them if their subject to AMT at time of purchase and so there would be more value in these bonds, all things being equal.

I see, and what about individual tax rates, plain and simple, did the President say anything new about planned cuts there?

Well the overall plan is to try and broaden the base and then reduce rates for everybody and so we would go from seven brackets, income tax brackets to three, there would be a 10% bracket, a 25% bracket, and a 35% top marginal rate. That would be down from the current 39.6%. So there is some tax relief there, you know, relative to where we are now if you are 39 to 35 is not a whole lot of movement for that marginal payer if this were to take effect, though you know, and this has been talked about elsewhere in the papers and other analyses, the President also proposed a 15% business tax rate which would apply to both corporations and pass-through entities, and there has been a lot of commentary, which I would agree with, that suggests that anyone who could would try to you know, reinstitute their labor or services in the form of some sort of LLC or a format where they could take advantage of the 15% rate, as opposed to a 35% top marginal rate. And my guess is the lawyers would be clever enough to figure that out. So again we are commenting on a plan that is pretty speculative and is really just a proposal at this point.

Well to that end, let us talk a little bit about some of the challenges here. I have heard estimates that the plan can cost upwards of $7 trillion. One thing we have heard in the news related to the cost of the plan is this concept of dynamic scoring. Can you explain what that means and maybe give a little bit of detail on the challenge there?

Well I am not sure I can give detail on the challenge. It is very challenging to do dynamic scoring. In fact, there is a quote Alan Greenspan once said, he is a huge fan of dynamic scoring, you should definitely try and do it. But when asked if you could actually do it in practice, he sort of skewed that and said, “I’m not sure can be done in practice”. So, but what is dynamic scoring? It is just this idea that when you pencil in a dollar of tax cuts does that result in a dollar of revenue loss and dynamic scoring would say, “no”, because by cutting taxes you pump some more money into the economy and cause the economy to grow and the growth rate should grow fast enough to actually produce more revenue than just a dollar for dollar calculation would suggest. Precisely how much in the way of new growth this plan could reasonably generate, I think is up for debate and pretty questionable at this point. But it certainly would enlarge the deficit under basically any of the estimates that we have seen. You know, this proposal is very similar to the President’s proposal during the campaign and the deficits that were projected there, done by a places like The Tax Policy Center, showed multi-trillions of deficits. So that will make it harder to pass which is important to understand, which is again why we think this is a proposal and unlikely to meaningfully impact the market but as a sort of a shout across the bow an announcement that tax reform will be a priority, which is what the President has said, and we will see where it goes from here.

Okay, so it sounds like there are still many challenges and uncertainties here, but we here at Breckinridge will continue to monitor tax reform as things transpire. For further information, please see our 2017 Municipal Credit Outlook which is under the white paper section on our website. Thanks so much for joining us and we hope you have a great day.



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