By MICHAEL CORKERY And ANDREW ACKERMAN
The tax break> for municipal-bond investors, a cornerstone of the $2.9 trillion market for bonds sold by cities and states, is under fire in Washington.
The latest assault came Tuesday in the Senate when Ron Wyden (D., Ore) and Dan Coats (R., Ind.) proposed a bill preventing municipal borrowers from issuing tax-exempt bonds. Municipal-bond buyers would instead receive a tax credit that analysts say likely would be less attractive to investors.
The bill comes on the heels of a Congressional Budget Office report last month advocating replacing tax breaks for municipal bond investors with a direct federal subsidy to borrowers, similar to the Build America Bond program that expired Dec. 31.
Advocates of changing the current exemption face high hurdles. The tax break on municipal bonds is a bedrock of public borrowing and the engine of the municipal-bond industry.
Still, they say, the prospect appears to have broadening support among Democrats and Republicans seeking ways to save money and plug the federal budget deficit.
"A year ago I would have scoffed at the mere suggestion," of eliminating the municipal-bond tax exemption, John Buckley, former chief tax counsel for the House Ways & Means Committee and now a visiting professor at Georgetown Law, said at a bond industry conference last week. "Things have changed. These are real proposals."
Mr. Buckley says the Build America Bonds program, which he helped craft, is a more-efficient way to support public borrowing than a tax exemption to investors who buy bonds.
Without the tax exemption on earned interest, total returns would likely be lower for many muni-bond investors, many of whom are individuals.
The Wyden-Coats proposal would make all state and local debt taxable after 2011; the bondholder would get a tax credit for 25% of the interest earned on the taxable bond.
The proposal would grandfather the tax exemption for bonds issued before 2011.
States and localities that issue the bonds would face higher borrowing costs unless a comparable subsidy was put in place.
"It would be a huge change," Chris Mauro, an analyst at RBC Capital Markets, said in an interview.
RBC hosted a call for its institutional clients last month with Alice Rivlin, a former CBO director and senior fellow at the Brookings Institution, who warned that the municipal tax exemption could be on the chopping block, Mr. Mauro said.
Ms. Rivlin sat on the president's bipartisan National Commission on Fiscal Responsibility and Reform, which supported eliminating the tax exemption.
Proposals to eliminate the tax exemption have been raised a handful of times throughout the past century, but it has endured.
"This has come up any time the federal government needs cash," says Thomas Doe, chief executive of research firm Municipal Market Advisors.
Some critics of the exemption argue that trying to draw individuals to municipal bonds isn't the most-efficient way to lower costs for public borrowers. They say it is more efficient to give borrowers a direct subsidy on interest payments they make to their bond buyers.
The Build America Bonds program subsidized 35% of the borrower's interest costs, leading to a boom in municipal borrowing last year.
Yields on the bonds were comparable to some taxable corporate debt, which increased their appeal to investors such as pension funds and foreign buyers.
Critics of that program said it encouraged municipalities to load up on too much new debt. The nonpartisan CBO study proposed a 15% subsidy.
The Wyden-Coats bill seeks to end several large tax expenditures.
A report by the Congressional Research Service last week said the tax exemption for state and local borrowings will cost the federal government $161.6 billion from 2010 through 2014.
Jeannette Neumann contributed to this article.