I have my savings in municipal bonds through a mutual fund (they buy many bonds and spread the risk). Stocks are too volatile for my liking and local governments will always be issuing bonds for various projects. The earnings from these investments are exempt from Federal Income Tax. Now, Obama is seeking to change this.
From Forbes:
Ending Tax Breaks On Municipal Bonds Shifts Burden To The Rest Of Us
Better check that portfolio: the Obama administration is continuing to push for limits on the tax exemption of municipal bonds. The plan was tucked away in the President’s budget introduced in April but hasn’t attracted much public attention – until now, when it appears that the cap may actually happen.
Traditionally, municipal bonds have attracted investors because the interest income is tax exempt for federal income tax purposes. Depending on the investment, the interest income may also be exempt for state and local income tax purposes. There’s a reason for the exemption: municipal bonds are generally private investments in state and local government projects like schools, hospitals, water projects and roads and the federal government has an interest in encouraging those kinds of investments.
Here’s how it works. Suppose a local government needs money. Typically, it can: (1) cut spending; (2) raise taxes; or (3) borrow money. Since the first two options are often impossible or not palatable, borrowing money is generally the most appealing. But even in the pre-”too big to fail” bank era, banks don’t generally hand over giant checks to cities and towns that might already be struggling to pay bills. Instead, the city or town borrows money from the public with the promise to pay the loan back over time with interest. That loan is called a municipal bond.
Tax exempt:
The interest has traditionally been exempt from taxation – a tax break that dates more than 100 years. In Pollock v Farmers’ Loan & Trust Company, 157 US 429 (1895), the Supreme Court held that the federal government had no power under the Constitution to tax interest on municipal bonds.
They are talking about capping the rate at 28% - that is a lot of money! Here is the problem:
And I know what you’re thinking: who cares if the rich have to pay a little more? You should care. And here’s why.
Think back to what I said before about why we have municipal bonds in the first place: it’s to encourage private investment in public projects. Those funds are used to build our roads, improve our schools and fund our emergency responders; schools alone accounted for nearly one-third of state and local infrastructure expenditures financed by private investment over the last ten years. We should want to encourage that investment. If we don’t, go back to beginning of the piece: what are the options now? Cut spending (meaning, realistically, those projects don’t happen) or raise taxes (yes, on the rest of us).
A higher tax bill on municipal bonds means that affected investors – those than can afford to shop around – will necessarily seek out other options. They’ll look to find investments that pay out at a higher rate to make up for the higher bite. The result? Instead of money going to public projects – repairing bridges, fixing dams, funding schools – it will go to Apple. Or Netflix. Or Coca-Cola. Or Citi. Is that what we want? There are already plenty of incentives to invest in the private sector; we shouldn’t erase incentives to encourage private investment in the public sector.
The author closes with:
I know that the tax cap on municipal bond interest feels like an easy bump in revenue. But it’s far from painless. Scaling back an exemption available to taxpayers for more than 100 years won’t just result in collecting more dollars. It will alter incentives for private investors to have a stake in public projects and it will make borrowing for those projects more expensive for state and local government. That isn’t bumping revenue: it’s merely shifting it around. And it affects all of us.
My investment is just a couple hundred thousand but it is the money I live on and plan to live on for the next forty years. Taxing this - potentially at 28% - would cripple my finances. I would be forced to move to the stock market and spend a lot more time managing these funds as the market shifted.
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