With the fiscal cliff looming ever closer, recent talk in Washington, D.C., suggests both parties are seriously considering limiting the benefits of the federal exclusion from gross income for interest income earned on municipal bonds.  The tone of the bipartisan discussion on Capitol Hill gives more credibility to a possible change than other instances over the years when legislators suggested a different tax treatment of munis.  While the estimated $30 billion annual price tag to the federal government may make cutting the municipal bond tax exemption an appealing option to shore up the deficit, the resulting implications of any limitation on the muni exclusion may have a greater, far-reaching effect on state and local governmental borrowers of municipal bonds (as well as for profit and nonprofit entities benefiting from the issuance of municipal bonds) and consumers of their services because of the resulting higher borrowing costs.

Whether and to what extent the tax exemption may change is still up for discussion, but in the event of a limitation or elimination of the current tax treatment, it will likely affect more than just high-income holders of bonds.  For example, if the tax exemption is removed retroactively, bonds that include gross-up provisions or other taxability covenants would increase the interest rate applicable to the bonds and impose greater financial burdens on the governmental and non-governmental borrowers who will, in turn, need to increase income or cut expenses to cover the additional debt service requirements.  Issuers, borrowers, investors, consumers of bond-funded infrastructure and services, and all other stakeholders should consider the implications of any changes to the tax-exempt status of municipal bonds.  If you have questions about how proposed or implemented tax changes would affect your bond issuance, please speak with a member of the McCarter & English, LLP public finance group.