Recent legislative discussions concerning tax reform have included the potential elimination of several federal provisions long considered sacred to state and local governments and untouchable by federal policymakers. Those provisions include the itemized deduction for state, local and Indian tribal taxes, and various tax benefits accorded to state, local and tribal government bonds used to finance governmental and certain private projects. Potential reform of these and other so-called "tax expenditures" is part of a broader, growing push to overhaul federal tax law, support for which has been building on both sides of the aisle.
The summary below should be of interest to state, local and Indian tribal governments, as well as to financial institutions involved in relevant bond transactions.
In his State of the Union speech last month, President Obama called for "bipartisan, comprehensive tax reform," while the chairmen of the House Ways and Means Committee and Senate Finance Committee — Representative Dave Camp (R-Mich.) and Senator Max Baucus (D-Mont.) — have each pledged to pursue an overhaul of the tax code in 2013. Further, the Government Accountability Office and the Internal Revenue Service's National Taxpayer Advocate continue to urge Congress to prioritize tax reform. Both offices have recommended that Congress reexamine the deduction for state and local taxes and the exclusion of interest on municipal bonds as part of comprehensive tax reform.
Lawmakers recognize that, unlike the last major rewrite of the tax code in 1986 — when they were able to finance rate reductions largely by eliminating widespread tax shelter abuses — major tax reform today will likely require repeal or limitation of popular and longstanding tax benefits that are deeply embedded in our society and financial markets. As Senator Baucus noted last year, "We know tax reform won't be easy. We will need to slay some sacred cows."
Few cows are more sacred than the deduction for state and local taxes and the exclusion of interest on municipal bonds. The Joint Committee on Taxation estimates that, for 2013, tax expenditures resulting from the deduction of state and local taxes and the exclusion of interest on municipal bonds will be $68.6 billion and $25.7 billion, respectively.
Obama Administration Proposals
Although the Obama Administration has yet to release its budget (including the tax legislative changes it supports) for this year, the administration's fiscal year 2013 budget contained several revenue proposals related to tax-exempt bonds. One proposal would have capped the exclusion from income on tax-exempt bonds at an amount equal to the tax benefit accorded to someone taxed at a 28 percent marginal rate. Another would have repealed the "essential government function" restriction on Indian tribal government bonds, thus placing such bonds more on par with state and local bonds. The administration also released a study and report to Congress in December 2011 on tribal bonds. (See: Report and Recommendations to Congress Regarding Tribal Economic Development Bond Provision Under Section 7871 of the Internal Revenue Code, Department of the Treasury, December 2011, at 2, recommending that Congress repeal the essential government function standard for Indian tribal government tax-exempt bond financing.)
Ways and Means Committee Hearing
On March 19, 2013, the House Ways & Means Committee held a hearing on federal tax provisions that affect state and local government operations and financing, including the itemized deduction for state and local income, property and sales taxes, and various benefits for state and municipal bonds. (While the hearing did not include a focus on Indian tribal governments, both of these federal tax expenditures apply to tribal governments — although tribal governments still have not achieved parity in their ability to use tax-exempt financing.) In his opening statement, Chairman Camp said that because a wide range of policymakers, including President Obama, the majority members of the Simpson-Bowles Commission and former President George W. Bush each concluded that tax provisions affecting state and local governments should be part of the tax reform discussion, it is critical to understand why they have reached that conclusion.
During the hearing, the Committee heard testimony from witnesses with diverging views on how Congress should address state and local tax provisions. Scott Hodge, President of the Tax Foundation, favored eliminating deductions for state and local taxes and municipal bond exemptions while reducing tax rates by five percent. David Parkhurst, Director of the National Governors Association's Economic Development and Commerce Committee, argued that Congress should preserve the itemized deduction for state and local taxes and tax benefits for municipal bonds. Mr. Parkhurst noted that tax-exempt bonds are the primary method for state and local governments to finance infrastructure projects, including schools, hospitals, roads and bridges.
Although neither Chairman Camp nor any of the other Committee members took a firm position on the issues, several members defended aspects of the state and local provisions, while recognizing that reform may be necessary to curb abuses, particularly with respect to private activity bonds. Those bonds were the focus of a March 4, 2013 article in The New York Times, which was referenced by several Committee members during the hearing. The articled referred to private activity bonds as a "stealth subsidy" for private enterprise that had been used to finance such projects as a winery in North Carolina, a golf resort in Puerto Rico, foreign-owned fertilizer plants in Indiana and Iowa, and a Corvette museum in Kentucky.
A day after the Committee hearing, House Republican Leader Eric Cantor urged members of the National Association of State Treasurers to continue lobbying Congress to preserve the municipal bond tax exemption, telling the members that they "need to keep focused on this and relay the benefit that [municipal] bonds can provide to the people that [they] represent."
Takeaway for State, Local and Indian Tribal Governments
State, local, and Indian tribal governments should be involved in the tax reform discussion to ensure that access to bonds permitted under existing law is not substantially curtailed and that long overdue technical fixes are included in tax reform. Congress is eager to hear from stakeholders who are willing and able to articulate and justify which tax code provisions are (or are not) in need of reform and how best to undertake any changes. The Ways and Means Committee will accept written comments for the hearing record on State and Local Government Tax Issues until the close of business on April 2, 2013. Stakeholders may also submit comments on any federal tax reform issue until April 15, 2013 through the comment process for the Committee's comprehensive tax reform initiative.