Municipal bonds continue to look attractive for a variety of reasons for bond investors, especially when considering the outlook for higher individual taxes at some stage down the road.
Listen to On the Minds of Investors
With the presidential election just under two months away, investors are considering how individual income tax changes proposed by both candidates might affect the municipal bond market and their tax-advantage benefits.
Under a continuation of the current administration’s agenda, current individual income and estate tax changes under the Tax Cuts and Jobs Acts (TCJA) could remain in place through 2025 with the potential for the 3.8% mandatory net investment income tax to be repealed. Given this, under current law, its unlikely individual municipal bond demand would be meaningfully impacted. On the supply side, it’s reasonable to expect taxable municipal bond issuance to continue to remain robust in the years ahead given the elimination of issuers’ ability to issue advance refunding tax-exempt municipal bonds under the TCJA.
A Democratic Sweep in November could lead to more significant changes to the municipal market. Some major policy proposals current Democratic nominee, Joe Biden, has campaigned on are to increase the top marginal individual income tax rate for incomes >400k USD back to 39.6% and restore the alternative minimum tax to pre-TCJA levels. Importantly, there would need to be significant support in Congress to pass these tax increases and this would likely be hard to find if the economic recovery turns out to be weaker than expected.
On net, a reversal back to a top marginal tax rate of 39.6% should translate to greater investor demand for municipal bonds, especially in high tax states like NY, CA, CT and NJ. Importantly, Joe Biden has also pledged that he will not increase taxes for those making under 400k USD. This might imply a revision to the current individual income tax brackets, as the current income threshold for the top tax bracket is north of 510k USD (for single filers). This would expand the pool of taxpayers who would derive the maximum tax benefit from tax-exempt municipal bonds and thereby potentially increase demand. Of course, tax accounting will be different for every individual and in assessing the tax advantages of municipal bonds, investors will need to take a close look at their current holdings and assess the ideal approach to minimize their tax liability.
Most importantly, however, even if no significant changes are made to individual tax policy at the start of the next administration, it will still have to face the mounting challenges of federal debt and 2021, like 2020, will likely see large deficits. While the Federal Reserve may continue to “foot the bill” for Treasury borrowing in the near term, eventually, the budget will have to be funded beyond the monetary side of the house, which suggests that over the long run, higher taxes are likely, regardless of who is in control in Washington. This is important because individual taxes do much of the heavy lifting in the federal budget, representing around half of tax revenue.
As highlighted, an increase in individual tax rates would increase the attractiveness of municipal bonds given their tax advantages. Over the longer-term, we might see top marginal tax rates edge up towards 50%, closer to their levels during the early ‘80’s, although there will likely be little political appetite to increase taxes any further than that. Overall, municipal bonds continue to look attractive for a variety of reasons for bond investors, especially when considering the outlook for higher individual taxes at some stage down the road.
Current municipal tax equivalent yields under various individual tax schemes
Municipal bond tax equivalent yields by rating