If State and Local Deduction Is Axed, Munis Could Benefit

If the plan in President Trump‘s new tax proposal to eliminate the deductibility of state and local taxes from Federal income tax actually becomes law (still a big “if”), municipal bonds could benefit.

Interest income from municipal bonds are still tax-free, according to the Trump administrations tax reform plans outlined Wednesday.

The plan to eliminate the state and local deduction would slam residents of high-tax states, most of which didn’t vote for Trump, like New York, New Jersey and California. That would make them more eager for tax-free bonds.

For individuals in the highest tax brackets in those states, the tax plan would effectively negate the benefit of the top tax bracket going from 39% to 35%, since they would effectively be paying 40% more in state and local tax, points out Ron Mass of Almitas Capital.

At least in high tax states, that should lead to better muni prices.

Also, as Nicholos Venditti, a muni portfolio manager with Thornburg Investment Management,told Barron’s last week, preserving the muni interest tax exemption would be a relief for the muni market.

There are countervailing forces that could be a negative, however.

Muni prices could get dampened due to the proposal to drop the top tax rate, which in theory should make munis less attractive to high-net worth investors. But even if the tax-equivalent yield falls a bit, munis are still more attractive than other fixed-income options, analysts from Goldman Sachs wrote earlier this month.

Also, it might hurt state tax revenues in those states if people move due to the higher effective taxes.

“I think there is a tug of war between those who see fewer deductions as pro-muni bonds and those who believe that no state tax deductions is anti-general fund revenue and therefore anti-muni bond,” says T homas Byrne of Wealth Strategies Management. “Essential service revenue bonds should benefit from stronger demand without a meaningful hit to revenues,” he adds.

So far, the broader muni index was unchanged Wednesday afternoon, showing there is no clear direction coming from tax reform proposal. The iShares SP National AMT-Free Municipal Bond Fund  (MUB) was just 7 cents higher at $109.30 as the market close approached.


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