State-Local Tax Break Repeal Could Create Long-Term Credit Stress

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By Allyson Versprille (Bloomberg BNA)

Repealing the state and local tax deduction could harm credit ratings for some states and localities in the long term, analysts say.

“Trimming the SALT deduction means that it will be harder for some state and local governments to raise taxes” because their residents’ federal taxes will be higher, said Matt Fabian, a partner at Municipal Market Analytics Inc. who leads the firm’s market and credit research. In the long term, the inability to raise taxes could be a modest credit negative to fiscally stressed states that want to use tax hikes to raise revenue in order to offset slow economic growth and federal aid cutbacks, he told Bloomberg BNA.

Fabian said states like New Jersey that already have high taxes and are in poor credit situations could bear the brunt of this long-term effect.

Moody’s Investors Service had a similar message. “The proposed elimination of the deduction for state and local taxes would be credit negative for the public finance sector by raising the effective cost of state and local taxes for many taxpayers and reducing disposable income,” the company told Bloomberg BNA in an emailed statement. “The reform’s effect would be to increase political resistance to tax increases and suppress home values and property tax revenue growth, particularly in high-tax regions.”

The loss of the SALT deduction in high-tax states may also lead to out-migration, which would have a negative credit impact on those states, Citigroup Inc. analysts Vikram Rai, Loretta Bu, and Jack Muller said in a recent note to clients.

Immediate Effects

In the short term, repealing the deduction likely won’t have much of an impact on the municipal bond market, Fabian said. One reason is that the market is already “being squeezed from all directions.”

Bonds are typically refinanced 10 years after they are issued, Fabian said. And 10 years ago the U.S. was facing a financial crisis, so that very few bonds were issued, he said.

That means today there are far fewer refunding opportunities, Fabian said, adding that refundings are down by about 40 percent from last year. Refinancings typically comprise half of the issuance in the bond market so there’s a significant supply shortage, he said.

If anything, repeal of the SALT deduction may have a slight positive effect in the near term, Fabian said. “Taken discretely, if you eliminate the state and local tax deduction,” taxpayers will see a federal tax increase, he said. “So you’re paying more federal taxes, which means tax-exempt bonds are more attractive,” he said. However, other changes in tax reform can affect whether a person’s taxes will increase or decrease, he said.

Guy Davidson, director of municipal fixed income for AllianceBernstein LP, said in-state bonds would become especially attractive to investors living in states with high taxes like California and New York. Repealing the SALT deduction would make buying out-of-state bonds more expensive for those investors, but the change would be small because yields are low to begin with, he said Oct. 3 in an interview with Bloomberg.

The Citigroup analysts in their note dismissed the notion that repealing the SALT deduction would have a positive impact on municipal bond investment in high-tax states. “While it is true that higher-income residents in higher-income states like California and New York might see an increase in their effective tax rates, this is certainly not the base case” when combined with repeal of the individual alternative minimum tax, the analysts said. Repeal of the AMT was proposed in the Republican tax framework released Sept. 27.

Potential Reaction

Fabian said he isn’t optimistic that Congress will be able to enact sweeping tax reform by year-end.

“It gets more and more likely that they just cut tax rates and widen out the federal deficit and issue a ton of Treasuries.”

If the SALT deduction is repealed, however, large municipal bond managers “would increase their allocations to ‘specialty’ states like New Jersey and Connecticut because those bonds would become more attractive,” Fabian said. A specialty state bond is a type of bond issued by states with high income tax rates.

Citigroup’s Rai told Bloomberg BNA that he would advise investors and managers to “sit tight” and refrain from making any hasty decisions, because the SALT deduction might not be eliminated in the final tax reform product.

With assistance from Amanda Albright in New York (Bloomberg).

To contact the reporter on this story: Allyson Versprille in Washington at (Bloomberg BNA)

To contact the editor responsible for this story: Meg Shreve at (Bloomberg BNA); Christopher Maloney at (Bloomberg)

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