Bill linking tax-exempt munis to school choice shows threats to market from 'unrelated agendas'

Legislation pending in Congress that would limit the issuance of tax-exempt municipal bonds from states without so-called school choice laws illustrates the risk facing the municipal market's prized exemption from agendas that are unrelated to state and local financing.

With Congress set to take up major tax reform next year, many market participants fear that the tax exemption will be vulnerable as a "pay for" to cover the costs of extending the Trump tax cuts or rising federal deficit.

But a threat also looms from measures, like the school vouchers or potential higher-education bills, that are crafted as a way to penalize or reward issuers for unrelated agendas.

House Bill 6795 and its companion measure, Senate Bill 3520 are titled the Achieving Choice in Education Act or ACE Act. The bills would amend IRS Section 103, which excludes interest from income on state and local bonds, to only apply to states and their local governments that have enacted school choice laws, including tax credit scholarship programs, voucher programs, education savings account program or refunding tax credit for private education expenses.

The bill would also trim the interest exemption by 50% for states with minimum choice laws.

Both measures were introduced in December and have seen little action. The House bill, from Rep. Eric Burlison, R-Mo., has nine co-sponsors, all Republicans. Sen. Mike Lee, R-Utah, introduced the Senate companion, which has five Republican co-sponsors.

That kind of targeting could also pop up for nonprofit issuers, said Charles Samuels, attorney at Mintz who is counsel to the National Association of Health & Educational Facilities Finance Authorities

"Neal Martin and I, representing the state issuers of nonprofit bonds, including health care and education institutions, are acutely sensitive that separate, unrelated agendas for these sectors could impact next year's tax debate," Samuels said.

"When the rhetoric starts flying next year, we would not be surprised if various allegations are made about practices in the hospital and college sectors, for example. These issues have nothing to do with the interest in federalism and support for the charitable private sector to be able to access reasonably priced capital," he said. "We need to prepare for all manner of legislation and attacks. Some of it may be based on whatever is in the news at the moment on healthcare and education."

Controversies earlier this year around campus protests over the war in Israel sparked warnings from Republicans that they were scrutinizing the ability of universities and colleges to float tax-exempt bonds.

In January, House Ways and Means Committee Chair Rep. Jason Smith, R-Mo., sent a letter to the presidents of Harvard, Massachusetts Institute of Technology, University of Pennsylvania and Cornell. The schools benefit from "lucrative financial benefits from your tax-exempt status," Smith said in the letter.

"Ultimately, as the U.S. House committee with primary jurisdiction over tax-exempt institutions and the treatment of their endowments, we are left to wonder whether reexamining the current benefits and tax treatments afforded to your institutions is necessary," Smith wrote in the letter.

Tax reform will be front and center next year as most provisions in the 2017 Tax Cuts and Jobs Act, former President Donald Trump's signature legislation, are set to expire.

For Republicans who support the TCJA, the tax exemption is a tempting "pay for" to cover the costs of extending the tax cuts, said Adam Michel, director of tax policy studies at the libertarian Cato Institute.

"It depends on how big Congress wants to go," said Michel. One option is that lawmakers simply opt to extend the TCJA provisions, he said.

"Path two is they do that, plus they open up the code again," he said. "There are lots of iterations of that, but if you want to continue lowering rates and improving the tax base, everything has to be on the table, including all the special deductions and carve outs and exemptions."

A July 18 blog in Reason names tax-exempt municipal bonds as one of the first things that should be "terminated once and for all" to help pay for the TCJA.

"These also disproportionately benefit high-income individuals and can lead to overinvestment and debt in municipal projects," wrote Veronique de Rugy, a Reason contributing editor and senior research fellow at the Mercatus Center at George Mason University.

Despite potential threats, Cooper Howard, director and fixed-income strategist at Schwab, said he's not recommending any portfolio moves based on the possibility.

"We aren't suggesting that anybody do anything at this point," Howard said, adding he believes it's a "low probability" the exemption would be repealed.

Treasury has noted that the tax exemption costs $300 billion over 10 years, a "drop in the bucket" compared to the estimated $4.6 trillion cost of extending the TCJA provisions over 10 years, Howard noted.

The most likely option, Howard said, which is still a low probability, is that Congress takes a scalpel to the tax exemption in certain sectors and for certain types of bonds. But even if that happens, it will likely be 2026 before such measures are enacted. "That's a year and a half down the road," he said.

In the meantime, the market will be more affected by traditional issues like interest rate moves and Fed policy, he said. "Those crosscurrents are weighing on the market more than the tax law."