No one knows what impact a new minimum corporate tax will have on demand for tax-exempt municipal bonds, with speculation ranging from gloomy to simply pointless, although most agree the policy implications are not. not encouraging.
President Joe Biden on Tuesday signed into law the Cut Inflation Act, a $740 million climate, health care and tax bill that marks a major victory for Biden and Democrats heading into tough midterm elections.
The main revenue driver of the law is a 15% minimum tax applied to the adjusted financial statement income – as opposed to the adjusted taxable income – of corporations with a three-year average revenue of more than $1 billion. It is expected to generate $222 billion over 10 years.
Municipal bonds generally exempt from taxable income are not exempt from accounting income. Large corporations that have relied on tax-exempt municipal bonds to help reduce revenue may find paper less valuable under the new regime.
Since the Sens. Chuck Schumer and Joe Manchin unveiled the IRA on July 27 as muni market participants try to gauge how the tax provision will affect demand.
The joint tax committee estimates that 150 companies will be affected by the new tax, almost half of them in the manufacturing sector. On the municipal side, the entities concerned are banks, insurance companies and P&C insurers.
Corporate buyers make up just under 27% of municipal holdings, according to Federal Reserve data, a number that has increased in recent years, though many hold taxable and tax-exempt munis.
Vikram Rai, the head of Citi’s municipal strategy group, warned that the new rate would restrict business demand, which would mean more volatility and ultimately higher funding costs for states and local governments.
“The market is not paying enough attention to the problem,” Rai said. “I’ve been inundated with business buyers telling me it doesn’t make sense to buy tax exemptions. Business demand is going to be hampered.”
Citi estimates the minimum rate will apply to seven life insurance companies, 16 banks and 11 P&C companies that are muni holders, although Rai declined to name the companies.
That’s going to hurt the most during exit cycles, when the muni market’s reliance on mutual funds already poses a challenge, Rai said.
Corporate buyers who used to step in during exit cycles to help establish a floor may now want to see even cheaper bonds. “The safety net is moving further away,” Rai said.
Most market participants agreed that the new minimum corporate tax rate would be detrimental during exit cycles.
“This exacerbates the market’s dependence on mutual funds and there will be fewer alternative sources of demand,” said Matt Fabian, partner at Municipal Market Analytics.
But Fabian said he expects the overall impact to be only a “gradual negative” and that the market has weathered a much bigger hit with the Tax Cuts and Jobs Act. in 2017.
Big banks and insurers probably don’t rely heavily on tax-exempt municipal bonds as a tax avoidance strategy, Fabian said.
Banks have other reasons for holding municipal bonds, including maintaining customer relationships that are important to underwriting or lending businesses, he said. “They don’t own them just to get that sweet 8% tax rate relief,” Fabian said.
Comparing current tax rates to future AMT rates as well as calculating the role of tax-exempt paper in triggering the minimum rate is key to determining the impact on municipal demand, said Yingchen Li, strategist from BofA Global Research Municipal Research.
“The question is, do they hold enough municipal bonds to trigger the minimum tax?” Li said. “It’s not a simple question, because you have to look at the other things of preference” that are included in book earnings, he said.
“It’s quite complicated because there are eight different items of preference,” Li said, adding that tax-exempt municipal interest seems to be the top item for many companies.
Banks hold about 14.7% of municipal holdings in the first quarter of 2022, according to Fed data.
Large monetary central banks typically have tax rates between 17% and 20%, while regional bank rates tend to be between 18% and 21% and S&L banks have the highest effective tax rates. high among banks, Yi said. Given that bank tax rates are already above 15%, the new minimum tax is unlikely to affect them too much, he predicted.
Insurance companies – which own about 5.3% of municipal assets in the first quarter – appear to have lower effective tax rates and therefore could be closer to the triggering of the new tax, Yi said.
But even the insurance companies that trigger the new rate likely won’t have to sell huge amounts of municipal bonds, Yi said.
“It is clear that it is negative, but what is the impact?” Li said. This could prompt companies to dump some of their ammunition holdings, “but not enough to impact normal market selling and trading operations.”
In an August 12 report On the impact of the IRA on public finances, HilltopSecurities’ head of municipal research and analysis, Tom Kozlik, called concerns that the new minimum tax would reduce municipal demand and liquidity “no founded”.
“I’m not necessarily thinking about this lower percentage of up and down cycles, but what it’s going to look like in the continued operation of the market,” Kozlik said in an interview. “State and local governments would prefer to market their titles to more potential buyers because in theory it will help reduce overall costs, but I don’t think removing a few potential entities, even large size, will revalue what is happening in the market on a day-to-day basis.”
Although market analyzes may differ, most participants agree that the inclusion of tax exemption as a penalty in the new law could portend future political battles.
“We let lawmakers cut corners on the fundamental tax exemption without properly educating them,” Rai said. “We took our eyes off the ball.”
Fabian said the municipal market had recently made big gains from stimulus money flowing to issuers, but the latest measure marks a “reduction” in the value of the tax exemption.
“Any time the value of the tax exemption is diluted…it’s a long-term drag on performance,” he said.
This is a reminder that the market must remain focused on preserving the tax exemption itself, which has been repeatedly threatened in Washington, Kozlik said.
“What this reinforces is that issuer organizations and groups need to educate lawmakers,” Kozlik said. “They need to beat and deliver the message that tax-exempt municipal bonds are an effective and efficient infrastructure financing tool.”