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Obama's Muni-Market Tinkering Could Ding Everyone

Tedra DeSue

NEW YORK ( TheStreet) -- The municipal bond market was dealt a harsh blow. On Wednesday, President Obama released his fiscal 2014 budget proposal. It had about $800 billion in new taxes over the next 10 years, says TheStreet's Joe Deaux. The plan also includes measures to place a 28% cap on the amount of interest bond investors can deduct from their taxable incomes.

Everyone knows, the rich prefer municipal bonds. Typically at 5k a pop, munis protect equity, offer income and have had attractive tax benefits. However, the proposed cap would apply to all itemized deductions, including interest on tax-exempt bonds.

To be clear, Obama's proposed budget would decrease the deductible amount of income wealthy taxpayers receive from interest payments when they buy tax-exempt debt. This not only damages the market for tax-exempt bonds, it will ultimately result in higher taxes for everyone, once the wealthy dump muni bonds in search of other shelters.

This attack on the tax-exempt market is to raise revenue to offset spending increases. His budget for fiscal 2014 is roughly $3.77 trillion. Fiscal 2014 begins Oct. 1. Obama's goal is to reduce the deficit over three years by taxing at higher rates those who earn more than $1 million a year. It's a 28% cap on deductions for households in the top 2% of income scale, more than $250,000. And a 30% minimum effective tax rate on incomes of more than $1 million. Spending cuts are also included.

The Administration faces a projected deficit of $973 billion coupled with an unwillingness to raise taxes dramatically on the middle class. What's more, the proposal would reduce to 28% the taxable income for individuals in the highest brackets of 33%, 35% and 39.6%.

Unfortunately for the $4 trillion industry, the borrowing costs to state and local governments will likely increase because governments will have to offer higher interest rates to make their bond offerings attractive.

The Bond Dealers of America has surmised that the proposal could drive up borrowing costs by 70% or more. The group's CEO, Mike Nicholas, acknowledged that the Administration has shown it is focused on infrastructure needs through proposals that aim to help with state and local government finance.

"But limiting the value of the interest on tax-exempt bonds, as proposed by the Administration and some in Congress, doesn't simply target the wealthy -- it permanently damages the market for tax-exempt bonds and forces everyone to pay more for state and local government services," Nicholas says.

Obama has explored many budget options to raise additional revenues, including tinkering with the tax-exempt status of municipal bonds -- for the third time. The first time was in 2011 when Obama submitted his Jobs Act to Congress. It failed. He submitted a similar plan as part of his 2013 budget proposal.

The idea was also bandied about as the Administration and Congress struggled to come up with meaningful ways to avoid the fiscal cliff. At that time, the market reacted negatively. There was a large move to the downside in muni bond ETFs, including iShares S&P National AMT-Free Municipal Bond Fund and the Market Vectors High Yield Municipal Index .

The effort to reduce the tax value of muni bonds is aimed at the wealthy, or the top 2% of earners. Obama steadfastly proclaims that the rich must pay their fair share. However, when taxing munis, those being targeted for their muni bond investments would likely flee and seek investments elsewhere. Under this proposal, the main incentive to buy munis would be diminished. So would the demand for municipal bonds.

The domino effect would land on the doorsteps of the state and local governments that rely on issuing bonds to build a wide array of public projects, such as roads, bridges, schools and prisons.

Also note that many state and local governments are still recovering from the Great Recession. Limiting their ability to issue debt at this point in their recovery could be detrimental to their budgets. Ultimately, they will be faced with scaling back projects or raising taxes.

Observers doubt that this budget, let alone this proposal, will pass. Still, the fact that the threat continues to rear its head has given many people pause.

Nicholas adds that he is concerned about how sequestration has tarnished the view of investors and issuers of direct-pay bonds, such as the America Fast Forward Bonds, or AFF, which could replace tax-exempt bonds and fund infrastructure projects.

"While direct-pay bonds as proposed by the Administration in the AFF program have been useful in certain niches, previous programs have been hit by the Congressionally enacted sequestration," he says. "Investors and issuers are not going to forget the lesson that the federal government may pull back on its subsidy midstream."

If Congress does approve the budget and the measure, the cap would take effect for the next three taxable years beginning after Dec. 31, 2013, according to the proposed budget.

--Written by Tedra DeSue in Atlanta

At the time of publication, the author held no positions in stocks mentioned, although positions may change at any time.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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