Obama’s Jobs Bill Will Punish Muni bonds. Municipal bonds have always been synonymous with tax-free income. That would end if President Obama gets his way. The Obama Administration wants to raise taxes on “high earners” defined as couples earning more than $250k to pay for the jobs bill. Yet in many US cities the $250k earnings level represents the upper middle class not the wealthy. And retail middle class bond investors own 70% of all municipal bonds. Changing the tax free investment status rules retroactively on muni bonds will completely disrupt the investment marketplace.

That said, while reviewing the tax exempt status afforded to muni bonds is a legitimate question for a democracy and all its people to consider, it should be addressed forthrightly, not by the back-door mechanisms being proposed by the administrative branch. If Washington wants to change the tax status on newly issued bonds by states and municipalities, thats reasonable as the success with the Build America Bond has already proved, a direct subsidy to issuers is more efficient than tax exemption.

Here is more below on this issue from Barron’s ever prescient columnist Randall Forsyth.

Under the jobs bill the President sent to Congress Monday, high-income individuals and families would no longer receive interest from state and municipal bonds free completely from federal income taxes, beginning in 2013. The legislation would also reduce the value of tax deductions for taxpayers in the highest bracket.

Specifically, individuals earning over $200,000 and families earning over $250,000 would effectively have the value of tax breaks against the top 35% bracket lowered to the 28% bracket.

The proposed change would help pay the $447 billion tab for the American Jobs Act of 2011. There have been previous attempts to enact a back-door tax hike on the upper brackets. Reformers have asserted that it is unfair that high-income taxpayers receive a greater benefit from deductions; a $1,000 deduction saves somebody in a 35% bracket $350, $70 more than the same deduction saves a taxpayer in the 28% bracket.

Never before have high-income investors in municipal bonds been so targeted, however. With the exception of so-called private-purpose bonds subject to the Alternative Minimum Tax, interest on munis generally was exempt from federal income taxes.

As with deductions, the tax-free feature on munis is more valuable to investors in the top income-tax brackets. For that reason, Internal Revenue Service data show that 58% of all tax-exempt income was earned by individuals earning over $200,000, according to The Bond Buyer, the muni-market trade paper.

For instance, a tax-free bond that yields 3.50% (about the going rate on a 30-year, triple-A muni) is equivalent to a taxable bond that yields 5.38% for an investor in the 35% tax bracket. But for an investor in the 28% bracket, that 3.50% muni is equivalent to a taxable yield of 4.86%.

All else being equal, the yield on muni bonds would have to rise to compensate for the lesser tax benefit, if the Obama jobs bill is enacted as proposed. For instance, a rise of 50 basis points (one-half percentage point) would result in a price decline of about 9% for a 30-year bond — equal to $90,000 for a $1 million holding.

As a result, upper-income investors would suffer the dual blow of lower after-tax income and capital losses from their muni-bond portfolios.

That could severe repercussions for the muni market, which only in recent months has recovered from the so-far errant prediction of hundreds of defaults totaling billions of dollars from analyst Meredith Whitney.

“In my opinion, this will have a negative effect on the muni market and could start another wave of heavy withdrawals from muni-bond funds, even though many investors in these funds will be minimally affected,” says Ken Woods, who head Asset Preservation Advisors, an Atlanta manager of bond portfolios specializing in high-net-worth individuals. “The muni investor’s thought process will be, ‘the government’s next step could be the complete elimination of the [tax] exemption.’”

One of the ironies of this proposal in the so-called jobs bill is that the measure contains infrastructure spending, some $38 billion worth. It would also create an infrastructure bank to fund such projects.

But reducing demand for bonds issued by state and regional authorities that build highways, bridges, airports, water and sewer systems and transportation projections would hamper the very sort of projects the legislation seeks to encourage.

Obviously, the proposal to reduce the appeal of muni bonds to high-income investors is aimed at sentiments such as voiced recently by Berkshire Hathaway’s Warren Buffett, who lamented his tax rate was lower than his secretary’s.

If the Obama Administration wants to raise taxes on high earners to reduce income and wealth inequality, that is a legitimate question in a democracy. But it should be addressed forthrightly, not by back-door mechanisms.

And if Washington wants to change the tax status on newly issued bonds by states and municipalities, that also is legitimate. A direct subsidy to issuers is more efficient than tax exemption.

But to change the rules after the fact on an investment that has always been tax-free, as in the case of munis, isn’t just counterproductive; it’s not fair.