Obama Plan To Tax Muni Bonds Would Destroy State, City Finances
Posted 05/29/2013 05:37 PM ET
Copies of President Obama's budget plan for fiscal year 2014 are distributed to Senate staff on Capitol Hill in Washington on April 10, 2013. AP View Enlarged Image
Buried in the Obama administration's budget is a proposal that would destroy state and municipal finances. Overturning a provision that has been central to the Revenue Code since 1913, it would impose for the first time a federal tax on municipal bond income. The result would be irreparable harm to the market for tax-exempt bonds and higher taxes for everyone. The law itself could be unconstitutional.
The math is simple. Instead of paying 3.5% for long-term bonds, states and localities would have to offer 6% at a time when their budgets are already stretched to the breaking point. New York Gov. Andrew Cuomo says his state's borrowing costs would soar by nearly $16 billion over the next five years.
Mike Nicholas, CEO of the Bond Dealers of America, estimates state and local borrowing costs could rise by 70% or more. He adds that this measure would not simply target wealthy investors. It would force middle-class citizens to pay more for state and local services by permanently damaging the market for tax-exempt bonds that make funding those services possible at reasonable costs.
Municipal bonds are issued to finance roads, schools, libraries, hospitals, and water and sewer systems, as well as the vast public indebtedness of states like Illinois, California and New York. And they finance relief efforts for victims of hurricanes and other natural disasters.
A report by the National League of Cities estimated that if the administration's proposal had been in effect during the last decade, it would have cost states and localities a staggering $173 billion in additional interest-related expenses to finance their infrastructure projects.
This idea could not come at a worse time for states and municipalities still reeling from the Great Recession. Investors considering long-term muni bonds must already price in the risk of market decline from rising rates, increasing risks of default, and poor disclosures of risk spotlighted recently by the SEC in states like Illinois.
In such circumstances, the century-long tax exemption is their real inducement to invest. Even a temporary hiatus in the exemption would shake their confidence. They must ask, what if they are hit with the double whammy of dramatically deflated market values and post-tax yields.
Then, too, the president's proposal is of dubious constitutionality. In South Carolina v. Baker, decided three decades ago, the Supreme Court upheld a federal tax on municipal bearer bonds, which unlike ordinary registered bonds left no record of ownership. Congress reasonably concluded that these bonds were used to evade estate and gift taxes. Then, too, taxation of these bonds promised to have little impact on states because few were issued.
States' Rights Rising
Chief Justice Rehnquist explained that this meant that the law would have no adverse economic impact on the states. Still, Justice O'Connor dissented on the ground that principles of federalism enshrined in the 10th Amendment barred the federal government from hampering state finance.
Would today's Supreme Court extend Baker to ordinary registered state and local bonds? Unlikely. The Baker opinion was signed by since-retired Justices Brennan, Marshall, Stevens, White and Blackmun. They took an expansive view of the domain of the federal government in our constitutional scheme, which differs in many respects from the majority view on the Roberts court.
Chief Justice Roberts and Justices Alito, Scalia, Thomas and Kennedy show more deference to federalism and state sovereignty. And they can be expected to resist destructive practical effects for the 50 states, which were intended by the Constitution's framers to be indestructible members of an indestructible union.
In the background is an unfinished debate within the court. In National League of Cities v. Usery in 1976, five justices concluded that Congress could not hike state expenses in even a modest way by imposing minimum wage laws on them.
In a 5-to-4 vote in Garcia v. San Antonio Metropolitan Transit Authority a decade later, the court reversed itself. At that time, Chief Justice Rehnquist predicted that National League of Cities would someday be reinstated. As noted, since then, the membership of the court has shifted in a more conservative direction. A leading treatise on constitutional law maintains, "If a later court with somewhat different membership resurrects National League of Cities, then a constitutional tax exemption for state and municipal bond interest cannot be far behind."
That day may come soon. The Baker decision suggested that states do not need protection from encroaching federal tax laws because they are represented fairly in Congress. But since then the federal government has heaped massive obligations on the states via programs like Medicaid and Obama-Care without providing nearly enough funds to cover the new costs. The facts no longer support the court's earlier confidence.
Obama Vs. The World?
Is this a constitutional squabble that the president and Congress want to inflict on the country close on the heels of divisive litigation over ObamaCare? The federal government would likely face the united opposition of all 50 states, not to mention cities and municipalities. Investors would join in the challenge on due process grounds and because of the provision's harmful retroactive effect upon them. Spiraling costs for local government, and the threat of large tax increases and draconian cuts in municipal services, would loom large.
Threatening irreparable injury to state and municipal finance under the banner of "closing loopholes" may make for good populist theater, but it is not sound — or constitutional — policy.
• Shapiro served as deputy solicitor general in the Reagan administration.
• Bishop is a former law clerk for Justice William Brennan. Both are partners in the Mayer Brown Supreme Court practice, which Shapiro co-heads.