CHICAGO (Reuters) - A provision in President Barack Obama's jobs act that would reduce the attractiveness of tax-exempt bonds for higher-income investors is unlikely to be passed by Congress, analysts and municipal market participants said on Tuesday.
The American Jobs Act of 2011, which Obama unveiled before Congress on Thursday, targets annual incomes over $200,000 for individuals and over $250,000 for families by limiting tax deductions to 28 percent of their income starting January 1, 2013 from the current 35 percent.
The limitation would cause yields on tax-exempt bonds to rise, boosting borrowing costs for states, cities, schools and others in the $3.7 trillion municipal bond market, where wealthy investors have traditionally turned to reduce their taxable income, according to market watchers.
"Such a change, we believe, would not be agreed to by the Senate Finance Committee and House Ways and Means Committee unless it was part of a sweeping, broad-based reform of the tax code and this kind of comprehensive reform will take a significant amount of time to put together," said Chris Mauro, director of municipal bond research at RBC Capital Markets, in a report on Tuesday.
Mauro added that with muni issuers still under fiscal stress, "members of Congress will be hard-pressed to justify taking any action that would make it more expensive for states and local governments to finance new projects or refinance higher-coupon debt."
Chris Shayne, senior market strategist at BondDesk Group, agreed.
"This is a fundamental flaw in the bill, given that the whole point is to stimulate economic development and government-sponsored hiring," he said.
Shayne added that while a deduction cap would raise yields and reduce retail demand in the short-term, high-quality general obligation and essential service revenue bonds will likely continue to be viewed as safe investments for a possibly wider audience of investors.
There are currently about two times as many muni bond trades each month as there are corporate trades, according to BondDesk. "Most of that discrepancy is because of the tax advantage," Shayne said. "So it seems likely that some of that excess demand for munis will transfer back to corporate or other asset classes."
The deduction limit is part of Obama's plan to pay for his $447 billion program to spur hiring and revive a stalled economy. But top congressional Republicans on Tuesday came out swinging against eliminating tax breaks.
"From a public policy perspective I feel very, very confident. From the politics of the situation, I don't know what will happen," said Michael Bird, federal affairs counsel for the National Conference of State Legislatures.
A so-called super-committee, made up of members of both parties and both congressional houses, will soon suggest where to slash spending to reduce the U.S. deficit. States worry the cuts will hit as they struggle to recover from the 2007-2009 economic recession, but they are also resigned to receiving fewer dollars from the federal government in the next decade.
"States are going to have fewer tools in their toolbox," Bird said, adding that wiping out the demand for their debt along with the federal cuts would "mean we will be economically negative long-term."
Most general obligation debt is issued for infrastructure projects. Obama's plan relies on heavy spending on school construction and road repair to fulfill his promise of creating jobs. In effect, the law would exchange locally driven financing arrangements for direct funding, Bird said.
"You could be essentially starving Peter while paying Paul," Bird said.
Politically, fights over the federal deficit have put the exemption on interest under fire. Members of the Obama administration and Congress are discussing alternatives such direct-rebate debt, in which the U.S. government would rebate to issuers part of their interest payments on taxable bonds, and tax-credit bonds, which give buyers credits on their taxes.
In December, Obama's deficit commission suggested ending the exemptions for all municipal bonds sold in the future. The Congressional Budget Office, a nonpartisan government research agency, has said the federal government forgoes more than $25 billion annually from the tax breaks.
The fact that Obama's curb on deductions would include eligible mortgage expenses, state income and local property taxes and charitable donations, along with interest on municipal bonds, should produce a groundswell of opposition to the move by affected groups, according to John Miller, co-head of global fixed income at Nuveen Asset Management.
Miller said it was unlikely the provision will become law, adding that its passage would trigger lawsuits challenging the retroactive application of the new deduction cap on existing municipal bonds. Also, the measure could launch another legal fight over states' rights similar to the one being fought by some states over the federal health care reform act, he added.
(Reporting by Karen Pierog, additional reporting by Chip Barnett in New York and Lisa Lambert in Washington; Editing by Dan Grebler)