Wealth tax populism and the muni market

Bonds

Populist animosity to income inequality is again surging in this campaign season. Have-not and progressive resentment of billionaires, in particular, has spawned centerpiece tax proposals from both Sens. Bernie Sanders and Elizabeth Warren on the left wing of the Democratic party. Between them, their campaigns represent a huge voter bloc that should now be taken seriously by the entire financial community. Notably, the municipal bond market is sitting dead center of an unwelcome tax policy conundrum if this political wildfire spreads more widely into the general election.

Municipal bond principal is a form of wealth — indisputably. If wealth is to be taxed equitably, it must include all forms of wealth: stocks, real estate, gold bars, emeralds, Picassos, private equity, and muni bonds. For the first time in U.S. history, the taxation of muni bonds as principal would be on the tax committees’ drafting tables. Given the Supreme Court’s 1988 decision in South Carolina v Baker as the prevailing judicial precedent, it is hard to imagine how its logic could differ as to bond principal. The Court’s landmark decision held that muni bonds’ tax-exemption is derived politically as Congressional policy under Article 1 rather than as a sovereign right under the 10th Amendment. It’s doubtful that taxation of principal is any different from interest under that ruling.

Girard Miller

Girard Miller

Would political progressives, who align themselves with state and local government employee associations and infrastructure spending, be willing and able to exempt muni bond principal from their wealth tax agenda? If they don’t, it will stir up a hornet’s nest in the muni marketplace and drive a wedge between their various supporters’ camps in the public policy coalitions that state and local leaders have worked for decades to nurture.

Taxation of muni bond principal, at the levels proposed by prominent candidates, would be far more costly to their rich investors than would taxation of the corresponding interest. A 2% or higher annual tax on bond principal would collect far more federal revenue than an income tax on its interest payments, with tax and market rates at current levels. It’s impossible to see how this deterrent to ownership can benefit state and local governments as issuers of wealth-taxable bonds.

Granted, such a tax would affect only the stratospheric segment of the muni bond investor base. Taxpayers with assets below the Fat Cat levels that these politicians are now targeting would remain unaffected, at least initially. Muni interest rates would tick upward, but not devastatingly so. But the state and local government community, and the muni industry, may naturally suspect that this opening salvo could become the camel’s nose under the tent. The federal estate tax is the only one whose base has been sequentially reduced in the modern era, and it too may be broadened in coming years if populism prevails.

Conversely, if muni bond principal deserves exemption from a federal wealth tax, then why shouldn’t Congress also exempt U.S. Treasury bonds that fund national defense and HUD and food stamps and education and the federal deficit? Their public purpose arguably is just as valuable to progressives, especially those favoring expansive social spending without offsetting revenues.

The market math is potent. An asset exempted from the wealth tax will enjoy an increase in its effective rate of return equal to the wealth tax rate. For an insured municipal bond yielding 3%, exempted from a 2% wealth tax, the rich investors’ effective risk-free after-tax rate of return becomes 5% annually. Adjusted for market, business and failure risks, very few equity investments in today’s markets can offer superior after-tax returns, with even fewer if corporate taxes are raised along with capital gains and dividend income. Entrepreneurial and risk capital will have to come from lesser wealth and institutions, and that poses a marginal drag on economic growth. A muni exemption would clearly distort capital allocation.

If muni principal is exempted from a wealth tax, it will become an obvious, popular and highly visible tax haven for the wealth class that will readily draw public attention and outrage. The resulting negative publicity for the entire muni industry could conceivably put taxation of muni interest at risk — which is a line that nobody reading this publication wants to be crossed.

A fiscally superior tax policy to address income inequality is to stiffen and broaden the Alternative Minimum Tax (AMT) to include virtually all forms of taxable income (not exempt public-purpose muni bond interest). Smart AMT reform can focus only on those in the One Percenter bracket, around $500,000 of total annual income from all sources. That income level actually coincides with today’s upper tax bracket for capital gains rates.

A new top AMT bracket could capture all forms of taxable “preference” income including capital gains, dividends, carried interest, real estate profits and depreciation recapture, and commodity trading profits. For approximate equivalency to a Warren-level wealth tax, an upper AMT marginal tax rate of 50% would be necessary. Despite protests from the ideological right wing, that level seems logical, reasonable and defensible to prominent fair-minded billionaires, such as Leon Cooperman who has spoken on this issue in TV interviews.

My book, Enlightened Public Finance, explains the central flaws and limitations of the wealth tax concept, and the more practical, equitable and achievable solution that a comprehensive AMT would provide. For policy wonks in the public finance community, it also includes major sections on innovative intergovernmental infrastructure financing policy options, federal deficit reduction, and feasible healthcare reform funding.
Campaign proposals come and go. Let’s hope that the wealth-tax vigilantes and populist tax reformers’ energy can find a smarter vehicle to reduce the deficit, address inequality and strengthen America’s social fabric, before the next Congress convenes.

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