Muni Bonds: How Killing a Tax Break for the Rich Could Hit Everytown, U.S.A.

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Republicans in Congress and President Obama remain locked in their seemingly interminable debate over how to avoid the fiscal cliff of tax increases and spending cuts set to befall us at the end of the year. As they've tried to break the stalemate, lawmakers have looked at a variety of proposals to raise revenue, among them, ending certain tax breaks and exemptions.

One particular tax break that has gotten more attention recently is the exemption for municipal bond interest. However, while it's easy to pitch muni bonds as a tax dodge for the rich, eliminating the tax break could cost local governments a fortune in higher borrowing costs.

The Scoop on Muni Bonds

Municipal bonds are bonds that state and local governments issue to raise money for public projects.

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Ranging from general obligation bonds, the money from which states can use on whatever they choose, to more specialized bonds sold specifically to finance such things as sewers, hospitals, and school construction, muni bonds help governments bridge the gap between their immediate needs and the future revenue with which they'll be able to pay for them.

To encourage investing in munis, the U.S. tax code makes the interest they pay exempt from federal income tax. If you buy munis issued within your state, you won't have to pay state income tax on that interest either.

A Matter of Fairness

But the tax exemption on muni-bond interest is worth the most to high-income taxpayers. That's because the amount you save on exempt muni-bond interest is directly tied to your tax bracket: The higher the bracket, the bigger your tax break.

Recent proposals would put a cap on the tax benefit you can gain from muni-bond interest, preventing high-income taxpayers from getting a full exclusion. That may seem fair, but it could also make life a lot harder for the governments that rely on muni bonds.

Paying More

Because of the tax exemption, muni issuers can offer lower rates than those paid by comparable taxable bonds. In a muni bond market estimated at $3.7 trillion, those lower rates save governments billions of dollars every year.

Tamper with the tax break, though, and you risk pushing muni rates higher. That will take away a big part of those savings and force states, cities and towns to bear an even heavier burden -- and to raise taxes to pay those higher interest rates. Given the financial stresses already hitting towns, that's the last thing many governments need.

Munis may help rich taxpayers, but they also help everyone by making public projects possible. Take the muni tax break away, and you risk plunging local governments into even more difficulty.

Motley Fool contributor Dan Caplinger owns some muni-bond funds. You can follow him on Twitter @DanCaplinger.
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