Obama's Jobs Bill Could Destabilize State and Local Governments

One of its provisions to increase tax revenue would do significant harm to the municipal bond market

386 obama jobs plan REUTERS Larry Downing.jpg

President Obama says that the jobs bill he proposed last week would help state and local governments retain jobs. In fact, it would spend $35 billion to prevent teacher and first-responder layoffs. That will help, but one of the ways he intends to pay for this and other provisions within his plan would create a headwind for state and local government budgets. By cutting tax exemptions for wealthy investors, municipal bond issuance would be more expensive.

As my colleague Megan McArdle pointed out yesterday, the President seeks to pay for his jobs bill by raising taxes on more affluent Americans. Anytime taxes rise, an economy's output will fall. So this would likely neutralize at least some of the economic benefit that the spending and tax break in the bill provide. One specific way to get more tax revenue he suggests would be to put a 28% floor on the tax rates of individuals making at least $200,000 or families making at least $250,000. To do this, he would limit tax exemptions. And one common tax exemption -- particularly for wealthier Americans -- is income generated from municipal bonds.

Lynn Hume and Patrick Temple-West from Bond Buyer report:

"It would be dramatic for municipal bond demand," said Matt Fabian, a managing director of Municipal Market Advisors. "It would mean higher income investors would pay less for municipal bonds and demand higher interest rates. Issuers' borrowing costs would rise dramatically."

Internal Revenue Service data from 2009 shows that 58% of all of the tax-exempt interest reported to the IRS was from individuals with incomes of $200,000 or higher, Fabian said.

That's a key statistic. If the tax benefits of municipal bonds were significantly limited by the president's proposal, then up to 58% of the market's demand could disappear.

So what happens if those investors who exit the market? In the best-case scenario, municipal bond prices would skyrocket. Then, state and local governments would have an even heavier debt burden. This would put additional stress on their budgets and likely lead to more layoffs.

In a worst-case scenario, the market's demand would not be strong enough to sell the number of bonds some state and local governments need. In this cases, budget cuts would have to be even deeper to avoid default. Again, jobs would be lost.

Would the short-term benefit of this stimulus boost provided by the jobs bill's spending outweigh the short-term harm that the decline in municipal bond demand would cause? It's hard to say. In 2010, tax-exempt municipal bond issuance was around $275 billion. So states and local governments certainly rely a lot these bonds. If demand plummets, they'll certainly notice.

Image Credit: REUTERS/Larry Downing