WASHINGTON Corporate tax reform is likely to be a priority for Congress and the Obama administration no matter which party has control of the Senate after the midterm elections, said tax experts and congressional observers who, nevertheless, differ on how this might impact municipal bonds.
The Senate has been controlled by the Democrats since 2007 and the House by the Republicans since 2011. In the Senate, 53 members are Democrats, 45 are Republicans, and two are Independents that caucus with the Democrats. In order to take control of the Senate, the GOP would have to have a net gain of six seats from the midterm elections. In the House, 233 are Republicans, 199 are Democrats, and there are three vacancies. To gain a majority in the House, Democrats would need a net gain of 17 seats.
Republicans are likely to maintain control of the House, but the Senate could go either way, according to congressional observers. The midterm elections are in November, but the fate of the Senate may not be known until later because there could be runoffs in two states with competitive elections: Louisiana and Georgia.
Members of Congress and the Obama administration have been particularly interested in making changes to the corporate tax system because of recent concerns about corporate "inversions." An inversion is when a U.S. company merges with a foreign business and then reincorporates in that business' country, typically to lower their taxes.
The Treasury Department recently released guidance designed to slow inversions. However, Treasury Secretary Jack Lew, the top Democrats and Republicans on tax-writing committees, and other members of Congress have said that the best way to curb inversions is through legislation.
The executive branch's focus on inversions "has probably placed corporate and international tax reform on a higher priority for the administration," said Micah Green, chair of the financial services and tax policy practice group at Squire Patton Boggs.
Key members of Congress such as House Speaker John Boehner and the leaders of the tax-writing committees continue to express a commitment to comprehensive tax reform. However, corporate tax reform may be more politically attractive initially, several sources said.
Democrats and Republicans agree on the need to look at the corporate tax system to improve the United States' ability to compete with other countries, Green said. Corporate tax reform is "less politically volatile" and may be easier for Congress to vote on than individual tax reform because there is a smaller range of issues that Congress and the White House have to address, Green said. The range of deductions and credits that have to be touched in individual tax reform are "more Main Street issues," he said.
Susan Collet, president of H Street Capitol Strategies, said that the focus on tax reform appears to be narrowing to corporations. Because of that, "I think either party could make progress on tax reform," she said.
But congressional observers are divided over what that might mean for munis.
"Certainly a more piecemeal approach to tax reform takes the focus off of proposals to limit the exemption," Collet said.
Some members of Congress and the Obama administration have proposed capping the value of tax exemption, which market participants contend would be equivalent to taxing municipal bonds. The president's recent budget requests have proposed capping the value of the exemption at 28%.
Chuck Samuels, an attorney at Mintz Levin and counsel to the National Association of Health and Educational Facilities Finance Authorities, also contends that Congress probably wouldn't make changes to the exemption if it focuses on corporate tax reform.
The Joint Committee on Taxation estimated that the exemption for governmental bonds will lead to revenue losses to the federal government of $49.2 billion from corporations and losses of $131.2 billion from individuals from fiscal 2014 to 2018.
"Most tax writers would view [the muni exemption] as an individual tax preference as opposed to a corporate tax preference," Green said. And unless business tax reform is subsidized by raising taxes on individuals, which is unlikely, preferences for individuals would probably not be discussed in the context of business-only tax reform, he added.
But Green also said that businesses such as banks and insurance companies sometimes hold munis, and their ability to do so could be discussed as Congress works on corporate tax reform.
Other congressional observers also expressed concerns that the municipal bond market may not be unscathed by corporate tax reform. "Any time there's talk of a tax bill, we're vulnerable," said John Murphy, executive director of the National Association of Local Housing Finance Agencies.
Even under corporate tax reform, munis could face "collateral risk" because bond curbs could be used to pay for changes to the corporate tax code, said Frank Shafroth, director of the Center for State and Local Leadership at George Mason University.
However, Shafroth thinks it's more likely that Congress would limit or eliminate the exemption for private-activity bonds than impose what amounts to a surtax on overall tax-exempt interest.
"A surtax sounds too much like a straight tax increase," Shafroth said. "It's perception."
Also, it is unclear whether Congress could reform the corporate tax system without also making changes to the individual code, experts said. Many companies are "pass through" entities that aren't taxed themselves, but have their income passed on to their shareholders who are taxed on the earnings at the individual level.
Divided vs. Republican-Controlled Congress
During the past few years a divided Congress has gotten little accomplished due to major differences of opinion between Senate Democrats and House Republicans.
If there are Republican majorities in both houses of Congress, the House and the Senate "will work more closely together on tax reform," Green said. There could be an "environment for more cooperation," he added. If Republicans view tax reform as a major issue going into the 2016 election cycle, they may use the power of controlling both houses to bring tax reform front and center as part of the national debate.
But Murphy said that if a Republican-led Congress undertakes tax reform, it will want to lower rates and will have to figure out how to pay for doing so. The tax exemption for munis could be an offset to pay for reform. Curbs to munis could include a cap on the value of the exemption or the elimination of the exemption for private-activity bonds, he said.
When you think of the types of changes that could be made to munis, "the status quo is preferable," so in that sense congressional inaction could be beneficial, he said.
Samuels suggested a Republican-led Congress could have incentive to take action on tax reform. When the party that doesn't control the White House controls Congress, it wants to prove that it can win the presidency, and to do so it actually has to accomplish things in Congress, he said. If a Republican-controlled Congress focuses on infrastructure financing, the muni market could benefit. However, if it instead tries to do whatever is necessary to lower taxes, the muni exemption could be harmed, he said.
In February, House Ways and Means Chairman Dave Camp released a draft comprehensive tax reform legislation that included a 10% surtax on muni interest for high earners and eliminating the ability to issue tax-exempt private-activity bonds or advance refunding bonds after 2014.
Camp's plan would be a starting point for future tax reform plans because "it's the blueprint right now," said a tax lobbyist who did not want to be identified. As a result, anyone that would be hurt by Camp's proposal should explain why their preference shouldn't be cut, he warned.
No matter what type of tax reform Congress tries to undertake, it will be a challenge to get it enacted before the next presidential election, experts said.
Regardless of which party wins control of the Senate, President Obama will still be in office and will have the power to veto legislation. Vetoes can only be overridden by two-thirds of both the House and the Senate, and Republicans are highly unlikely to have large enough majorities in these chambers, observers said.
To enact comprehensive tax reform, there has to be coordination between both houses of Congress and the administration, there needs to be "agreement toward the goal and a willingness to negotiate," Green said.
Additionally, even if Republicans have a majority of Senate seats after the midterm elections, they almost certainly won't have 60 seats. Typically legislation in the Senate needs 60 votes to avoid it from being blocked by a filibuster.
If reconciliation instructions for tax reform were included in an enacted budget resolution, only 51 Senate votes would be needed to approve the tax bill based on the instructions. But Obama would still need to sign the tax bill.
John Buckley, former chief tax counsel for the Democrats on the House Ways and Means Committee, noted that Camp couldn't get the House to consider his plan, let alone vote for it.
"I'm dubious on whether you're going to see any real action on [significant] tax issues until after the presidential election" in 2016, Buckley said.
No matter what happens after the midterm elections, market participants need to be able to explain to Congress why it is important to preserve the muni exemption, market group officials said.
"We expect to fight hard for the provisions that build Main Street," said Jessica Giroux, senior counsel and managing director of federal regulatory policy for the Bond Dealers of America.
The Municipal Bonds for America Coalition, a coalition of state and local government officials and senior leadership at broker-dealers who seek to protect and promote tax-exempt municipal bonds, is gearing up from next year by sharpening its message, expanding membership, and identifying members of Congress that could be lead supporters of the exemption and make munis a priority, said Murphy, whose group is a member of the coalition.
"All the key players in tax reform have changes they'd like to see to tax-exempt municipal bonds and other municipal financing mechanisms, like Build America Bonds," Giroux said. "These changes could have devastating effects on the muni market."
If Republicans take control of the Senate, Sen. Orrin Hatch of Utah would almost certainly become chairman of the Senate Finance Committee, congressional observers said. If Democrats prevail, Sen. Ron Wyden of Oregon would likely continue to lead the committee.
Wyden has spooked the muni market in the past because he has introduced comprehensive tax-reform legislation that replaced the exemption for municipal bonds with traditional tax-credit bonds.
However, Michael Decker, managing director and co-head of municipal securities of the Securities Industry and Financial Markets Association, said "I don't know that he's necessarily wedded to that position."
Hatch was the lead sponsor of legislation in the early 1990s to make permanent the authority to issue mortgage revenue bonds and low income housing tax credits, and Congress approved it in 1993, Murphy said.
Shafroth said he thinks that Hatch may be a better chairman for the muni market than Wyden.
He pointed out that Hatch is from a Western state with a lot of infrastructure needs, but that those needs are harder to finance because the state has a relatively sparse population and has a small tax base. As a result, Hatch recognizes a "critical federal role" in infrastructure, including tax-exempt bonds.
Wyden has expressed more of an interest in taxable but tax-credit or direct-pay bonds, though right now he seems more interested in them as a supplement to munis, rather than a substitute, Collet said. Hatch, on the other hand, is more conservative and interested in preserving the status-quo, Collet said.
Howard Gleckman, a resident fellow at the Urban Institute, echoed that sentiment, saying that Wyden is "willing to take risks" while "Hatch is a much more low-key guy" who is more cautious.
Hatch and many other Republicans have generally opposed Build America Bonds. A spokeswoman for Hatch said that the senator has long viewed the bonds as a disguised bailout for states. Sen. Chuck Grassley, R-Iowa, has complained that BABs provided lucrative fees for underwriting firms and are used by states with lower credits, which get higher subsidies because they have to sell at higher interest rates.
But some tax experts believe the Republican opposition stems primarily from the fact that BABs were part of Obama's economic stimulus legislation, the American Recovery and Reinvestment Act. Most observers believe efforts to revive the program would never be able to pass a Republican-led Congress.
However, Samuels suggested Republicans could take a different view of BABs once they are in power and aren't devoting their time just to opposing everything Obama supports.
The House will have a new chairman of its Ways and Means Committee in January, no matter the outcome of the midterm elections, because Camp is not running for reelection and was term-limited as chairman. The leading two contenders to succeed Camp are Reps. Paul Ryan, R-Wis., and Kevin Brady, R-Texas.
Brady has been a strong "inside the committee player," Samuels said.
Ryan is currently the chairman of the House Budget Committee and has released budgets that include principles for tax reform, such as lowering individual and corporate tax rates.
Gleckman said that Ryan's top priority has been to lower rates, which could hurt bonds. If marginal tax rates are lower, they lose some of their advantage over taxable bonds and become less valuable. Also, Camp's plan showed that it's hard to lower rates without going after tax preferences like the tax exemption for munis.
But there is always a question about how much flexibility committee chairmen have over the direction of tax legislation, and how much control congressional leadership has, Green said.
Buckley said that while Wyden may be more committed to tax reform than Hatch is, the committee chairman doesn't control the debate. The key question is whether there is support in Congress for the difficult decisions that have to be made in tax reform, he said, adding, "I don't see it."
Competitive Senate Races
Some of the more competitive races involve senators who have supported munis and/or backed bond-related legislation in the past two years.
Two of the endangered Senate Democrats, Mark Pryor of Arkansas and Mary Landrieu of Louisiana, have been sponsors of bond -related legislation. Over the summer, Pryor introduced legislation that would revive the BAB program at a lower subsidy rate. And both Pryor and Landrieu have sponsored legislation that would provide disaster tax relief and would allow states to compel out-of-state online retailers to collect sales taxes.
Pryor served in the Arkansas state legislature and as the state's attorney general. Landrieu served in the Louisiana state legislature and as the state's treasurer. Also, her father is a former New Orleans mayor and her brother is currently serving in that job.
Another Senator in a competitive reelection race, Mark Begich, D-Alaska, took the lead on a letter to Obama in April 2013 that said it would be "inappropriate and shortsighted" to cap or eliminate the muni exemption. Begich is a former mayor of Anchorage.
Shafroth said most members of Congress don't know what bonds are unless they have served in government at the state or local level.
Sen. Pat Roberts of Kansas is one of the most likely Republicans to lose their seats. Roberts serves on the finance committee, and he's been "helpful and supportive" of munis in the past, Samuels said.
In 2013, Roberts told the American Public Power Association that he is not a fan of proposals that cap the value of tax preferences, such as municipal bonds.
Several current Senators are retiring. The departure of Carl Levin, D-Mich., will be a loss for the municipal bond community, Shafroth said. Levin heads an investigative subcommittee that played a big role in the Dodd-Frank legislation, and as a former member of the Detroit city council, he has knowledge of how important bonds are to financing cities, he said.
Naomi Jagoda is a tax reporter for The Bond Buyer.
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