Now that talk of tax reform has taken center stage in Washington, the biggest concern for municipal investors is whether the upside of lower taxes could spell downside for their municipal bond valuations. The good news is that not every proposed change is likely to have a negative impact.
House and Senate Republicans are rushing to land a tax reform bill on the president’s desk before Christmas. Speaker Ryan hopes to have the House version passed as early as Thanksgiving, and House leaders are preparing to socialize it in early November. Senate leaders have promised to be quick on their heels, now that they’ve passed a major budget agreement. That agreement prevents Democrats from filibustering any tax bill.
While visibility remains limited—after all, what (other than healthcare, perhaps) could be more complex than federal tax codes?—we can provide a few guideposts for municipal investors. Let’s look at the major proposals outlined by President Trump and Republican Congressional leaders that directly affect individual taxpayers:
Cutting the top marginal rate to 35%. There’s a pretty straightforward relationship between individual tax rates and the value of municipal bonds. A tax-rate cut reduces the value of the tax-exemption component of a municipal bond, which in turn results in lower municipal bond prices.
We’ve estimated the potential price decline from such a cut in the Display below. Longer municipal bonds would experience more than twice the price decline of intermediate-maturity bonds.