The tax-exempt status of municipal bonds is being offered up in sacrifice to the nation's shameful budget deficit, again. A proposal to abolish exemption is being legitimized by the Federal Reserve bank of Boston, no matter that it would make local governments the thralls of Washington, D.C.

In the first serious assault since South Carolina v. Baker -- the heart-stopping Supreme Court ruling that placed exemption in the hands of Congress -- the Boston Fed's New England Economic Review published an article outlining a plan to do away with the municipal bond market.

Written by Peter Fortune, professor of economics at Tufts University, the article revives some musty arguments about why tax-exempts are bad for the average Joe and, in effect, are unproductive in every way. Mr. Fortune says the federal government lost about $23 billion in 1990 because of municipal exemption, while local governments saved only $17.7 billion.

The "missing" $5.3 billion, he writes, is lining the pockets of the rich and providing compensation for illiquidity and other market variables. This could be recaptured, the Treasury could get more from taxpayers, and municipalities could still save money if municipalities simply sold taxable bonds.

Sound familiar?

It should. Taxable municipals have been floated as a solution to various ills since World War I, when it was proposed that municipal interest be subject to a war tax. Yet Mr. Fortune's assertions deserve close scrutiny, for the main reason behind his proposal -- the $3.93 trillion deficit -- is unlikely to go away soon, if ever.

First, Mr. Fortune stamps himself and his intent by resurrecting that Washington D.C. word for tax-exempts -- subsidy. By not taxing the debt of its independent political sub-entities, the implication goes, Congress makes states, hospitals, and the like indebted to it. What was a local governmental prerogative is, in the post-South Carolina era, federal largesse.

Second, Mr. Fortune distorts the arguments for tax exemption by saying proponents claim "an inadequate amount of public services" would result from taxing municipals.

Not so. Washington, D.C., for example, could just as easily repair the city's dire low-income housing stock with taxable bonds. Adequate services can be provided, but the city would pay through the nose to do so.

Then the scholarly paper, innocuously named The Municipal Bond Market, Part II: Problems and Policies, takes the reader into the confusing world of economics, where a special language -- even worse than the hieroglyphics used in official statements -- prevails.

Macroscopically, the paper says the tax-exempt market creates several problems:

Only the rich enjoy the income benefits, and the very rich enjoy a disproportionately large share of the benefits.

Taxpayers, somehow, are being bilked by the very municipalities in which they live.

And the exemption itself makes municipal yields volatile, leading to a "cyclical variation" in issuance costs.

On a practical level, none of these points holds water.

Mr. Fortune's "Very Rich" argument is a very old assertion that seems to rear its head about every 20 years. In this latest incarnation, he says the wealthiest capture a "windfall" because they get tax-exempt income "that is in excess of the income required to break even on an after-tax basis."

So they're getting a good deal. But there's something odd here: Mr. Fortune is suggesting that all investors should be paying a break-even price, or that when exemption is at hand wealthier investors should pay more. It amounts to a double taxation.

And it hardly jibes with the Treasury market's exemption from local taxes. Treasury buyers, too, would be subject income-adjusted prices if the principle behind his theory were to be equitably applied.

Further more, the whole matter is diluted when municipal distribution trends are examined. Bonds have been flooding into retail hands thanks to the natural evolution of mutual funds. It only takes $1,000 to buy into a diversified, no-load tax-exempt bond fund in the state of one's choice.

Analyses of income-tax returns, in addition, show a trend of ever-larger segments of the market being held by people making less than $100,000 a year.

The gap between "lost" income from not taxing municipals and the benefit to municipalities, the paper says, "imposes greater costs on federal taxpayers." Yet in the real world those same benefits are going to these taxpayers' communities.

It is impossible, therefore, to distinguish local benefits from what in the long run are local costs. In simple terms, there are very few federal taxpayers who don't live in a municipality that benefits from tax exemption.

More to the point, if Mr. Fortune bothered to sample the national mood -- one of embedded animosity towards federal lawmakers of every ilk -- he would find that taxpayers are asking, "what has the federal government done for me lately?" The municipalities haven't handcuffed the country with a $4 billion deficit.

The paper then leaves reality behind altogether. "Tax exemption encourages overproduction of public services," it says. Where is the community that overproduces services?

The last of his three main points, the "cyclical variation" argument, is refuted within the paper itself. Oddly enough, Mr. Fortune raises the issue only to dismiss it later, saying changes in income taxes and the Tax Reform Act of 1986 have nearly wiped out the effect. "Much of this volatility has disappeared," he writes.

It should be noted that Mr. Fortune enumerates several municipal bond characteristics which result in a "risk premium" unique to this market. Call features and liquidity are obvious and important concerns for anyone trying to shelter their investment returns.

His solution is to allow municipalities to sell taxable debt, and then entice this behavior by dangling the carrot of an actual, direct subsidy, which would be pro-rated to the size of the local borrowing and make up for the increased cost of capital.

The package, known as the "taxable bond option," is hardly a new idea. Its first incarnation was in 1968, and it has been revived off and on over the years.

Mr. Fortune says the cost to both federal and municipal governments would be reduced. Municipalities wouldn't be forced to sell taxables, but the subsidy would be raised high enough to make it appealing.

Such dependency resonates of the highway funding debacle, when states were humbled into the 55 mile-per-hour speed limit. The issuance subsidy could be withheld in a similar way to force other, more controversial policies on states.

In a perfect world, at the same time, the resulting eradication of the municipal bond market would stabilize net municipal interest rates; spread out demand for municipals equally over the populace; and drench the market's persistent illiquidity with uniformity.

Never mind that there would be a few casualties along the way. "It also would ... eliminate the human capital invested in the underwriting of tax-exempt bonds," Mr. Fortune notes.

But what is this really creating? The federal "direct subsidy" would be a political tool like any other. Medicare, for example, has been a victim of "policy." Lawmakers of the 21st century are bound to have an astronomical budget deficit -- why not reduce the subsidy?

Further, the proposal begs the question of how committed the federal government would be to municipal governments. A federal guarantee is not explicitly suggested in this paper, but wouldn't these subsidies constitute a relevant revenue stream?

If there's an impending default, why couldn't a state ask for the payment in advance? The possibilities for blurred local and federal liabilities are daunting.

The theory behind this desire to boost the federal coffers appears to be fundamentally socialist. Equalizing all municipals would make municipals equally attractive, or unattractive. States and communities earning their precious triple-A ratings through fiscal conservatism and responsibility would have little incentive to maintain their ways.

Socialist ideals in themselves are not abhorrent, but the implementation of them usually is. In this instance, a desire to equalize a functioning market could spell disaster for credit quality -- and default rates.

Memory Lane

Mr. Fortune's proposal is merely the latest in a long line of attacks on municipal exemption. After the Great War's bond tax proposal, assaults were launched in 1933, 1934, 1941, 1942, 1950, 1951, 1959, 1968, and various caps and restrictions were proposed or enacted throughout the 1970s and 1980s.

In 1968, Congress mulled the same proposal Mr. Fortune presents us with today. Rep. Wright Patman, then chairman of the House Banking Committee, introduced the measure, the only difference being that his version included a federal guarantee for all municipal debt.

The market managed to quell the idea with the assistance of some heavy hitters, and one of the main sticking points was a concern that the Treasury would be the loser. The Bond Buyer's Centennial Anniversary Edition, in an article written by Washington correspondent Joan Pryde, sums it up.

The Comptroller of the Currency, a fed governor, and the chairman of the Federal Deposit Insurance Corp. "were concerned that the increased federal tax revenues - ... would not make up for the money the government would spend paying out subsidies."

Mr. Fortune's 1990 gross estimate of $23 billion lost is based on data from the Office of Budget and Management and charted under the curious heading of "Tax Expenditures in Federal Income Tax." Although the 1968 argument may be perfectly valid today, the mindset of exemption-as-subsidy is being driven home. Capitol Hill clearly sees exemption as "revenue losses."

A survey of the historical attacks on exemption shows us how painfully vulnerable the municipal market is to Congressional appropriation. In the past, a major tenet of exemption advocacy was the profound Constitutional and structural changes that taxation would carry.

Austin J. Tobin, executive director of the New York Port Authority, responded in the May 2, 1950 Daily Bond Buyer to yet another assault by enumerating a host of strong arguments. He concluded with a quote from Sen. Warren Austin that upheld what was then the strongest, most patriotic and unassailable point:

"The argument encompasses an abandonment of the concept of this Government as a Federation of independent States; it would subordinate the States to an all-powerful central Government," Sen. Austin said on the Senate floor in 1940.

South Carolina v. Baker has changed all that. The municipal market no longer has the luxury of appealing to the Constitution.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.