President Obama’s “American Jobs Act” would cap the amount of interest from municipal bonds that top earners can exclude from their taxable income. The move would decrease the tax break for municipal-bond interest to 28% for couples earning more than $250,000 a year. For top earners, such tax-exempt interest is currently worth 35% in the top tax bracket, as that’s the amount they would otherwise have to pay on their income.
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However, any move to limit the tax advantage for investors in municipal securities will face opposition from local governments, as the tax breaks bolster demand for their debt, which drives down the interest rates they pay when borrowing for public works. Investors willingly accept lower returns than they would with other investments because the income isn’t taxed.
“You’re going to end up punishing state and local governments,” said Mike Nicholas, chief executive of the Bond Dealers of America, a lobbying group for banks that underwrite municipal bonds. State, city, and county governments have yet to recover from the recession that “officially” ended in June 2009. This year, states faced budget deficits of roughly $89 billion, which could increase still further if investors were discouraged from municipal bonds. Already, state and local governments have cut 680,000 jobs since 2008, and that number could grow if Obama’s job-creation plan successfully limits the amount of tax-exempt interest on municipal bonds.
The tax break has been challenged by Congress in the past, though no proposals to cap or eliminate it have advanced. While some have sought to revoke the municipal tax benefits altogether, the president’s proposal only seeks to limit them for those in the top tax brackets. And while the plan could take some money away from municipal securities, and thus state and local governments, Obama’s job-creation package would provide states with monetary aid that would allow them to keep teachers and first responders on the job.
The current exemption provides a 35% tax break for top earners because that’s what they pay on their income. Obama’s plan decrease the value of their tax break to 28%, which is the value of the tax break to earners falling in the 28% tax bracket. Couples earning less than $250,000, or individuals earning less than $200,000 will not be affected by the change.