By Brian Reilly, CFA – Senior Municipal Advisor | Managing Director

The Impacts of Eliminating the Tax-Exempt Status of Municipal Bonds

In mid-January of last year, a roughly 50-page document leaked into the public sphere that originated from Republican staff members of the U.S. House Ways and Means Committee. This document set forth a list of “pay fors” that would offset the “cost” of making permanent the temporary provisions of the 2017 Tax Cuts and Jobs Act (TCJA) set to expire the end of this year. The budget rules Congress follows essentially score debits and credits for the federal purse over a 10-year window.

On page nine of the document, there are two conspicuous sources of “found” money that alarmed those in state and local government, as well as other entities that participate in the domain of tax-advantaged borrowing. House Ways and Means estimated the savings of eliminating the exclusion of interest (and other tax preferences) on state, local, and so-called qualified “private activity bonds” (PABs) at $364 billion over its 10-year budget window. $250 billion of that total was directly attributable to state and local governments, with the remaining $114 billion being associated with PABs.

The uncertainty around these estimates is heightened based on the notion that Congress may try to eliminate the tax preferences associated with both future municipal bond issues and existing ones. It has been speculated that elimination of the tax preference could be applied to existing municipal bond issues, although highly unlikely it can be done so retroactively for legal reasons.

What if the Tax-exempt Status of Existing Bonds is Eliminated?

This is a low probability outcome, but it’s worth exploring the high level of disruption it would cause for both tax-exempt issuers and investors.

Clearly, the biggest losers under this scenario would be holders of existing tax-exempt bonds. For almost all state and local government issuers of fixed-rate municipal securities, this risk has been entirely transferred to the holders of the obligations. The rates of interest on those bonds are fixed, and any change to the tax status has no bearing on issuers’ cost of capital. The holders are now left with interest income that could likely become taxable at the federal and state (even local) levels.

There are occasions where tax-exempt bonds carry provisions associated with a change in tax status that can lead to issuers retaining the risk and cost of interest taxability. The bond documents typically call this out in great detail, but probably not enough specifics to avoid costly disputes between bond holders and issuers. There would likely be differing interpretations as to whether any action by Congress constitutes an “event of taxability” that would require the issuer to make bondholders “whole” by increasing the interest rate(s) on those obligations (this is sometimes formulaic). Events of taxability can also invoke extraordinary optional or mandatory redemption provisions, sometimes with the redemption price stated at a premium to face value.

The situation for those state and local governments with tax-exempt direct purchase bank (or other) debt is probably far more acute. While not standard for debt purchased directly by local or community banks, it is customary for larger, regional and national banks to include “continuing covenant agreements” (CCA) that protect the value of the interest income they receive if an event such as this were to occur, effectively shifting all risks associated with an unfavorable change to the tax status directly to the issuer.  Many bond documents for direct purchase debt include provisions that require the rate of interest to be “grossed up” under certain conditions. This can include a change to the tax rate of the bond holder, an event of taxability, or a change in the tax-preferred status of the bonds. The lender is protecting its after-tax rate of return on its investment with this type of provision, which, ironically, became far more prevalent with the implementation of the TCJA. We point this out to remind issuers to review their bond documents, but to also remind them that CCAs can and should be negotiated. On some occasions, they can be avoided altogether.

None of the above is good for anyone. However, there is an even more ominous consequence to this potential action.  Eliminating the tax-exempt status of existing fixed-rate bonds would cause those bonds to plummet in market value.  The value of tax-exempt bonds is predicated on their income streams being exempt from taxation.  If that income becomes taxable, those bonds are worth materially less than the day before. While these bonds represent liabilities of the issuer, they are conversely assets to some other party.  Banks that directly own municipal loans would be similarly affected as the after-tax return on those assets would decline precipitously, creating a hole in their balance sheets.  Abdicating the tax-exemption on existing municipal obligations could be calamitous to the U.S. economy, as a large swath of financial asset value would literally evaporate overnight.  It’s not hyperbole to equate this sort of event to something akin to what happened during the 2007 – 2008 real estate collapse, impairing investors and bank balance sheets for years to follow.  This seems too obvious to be lost on those within the federal apparatus, which is why we believe the probability of this outcome is near zero

What if the Tax-exempt Status of Future Bonds is Eliminated?

There is a much higher probability for this outcome. A robust effort has been underway to muster lobbying resources across the entire array of constituencies that would be greatly affected by the loss of tax preferences associated with state, local, and private activity bonds. The Government Finance Officers (GFOA) has largely coordinated this effort, which estimates that more than 90% of all infrastructure investment in the U.S. is funded at the state and local levels.

Eliminating the tax-exemption for state and local bonds would clearly increase the costs of debt-financed capital improvements and estimates of that impact are uncertain, at best. A recent report published by Moody’s reasonably assumed a 50% – 70% increase in interest cost if all municipal debt was issued as taxable. That assumption is borne out by some recent examples where the same issuer concurrently priced both tax-exempt and taxable debt on the same date. The spread between the yields of comparable tax-exempt and taxable bonds has ranged from about 150 – 200 basis points (1 bp = 0.01%), historically. When the absolute level of yields was at generational lows, the spread compressed a bit beyond the low end of that range. Based on recent sales, the spread for issuers in Ehlers’ core markets is roughly 160 – 175 bps, depending on maturity and credit. When that spread is added to tax-exempt yields, the increased interest cost is closer to 40% – 50%. For lesser credits, the impact is larger and is within the range estimated by Moody’s.

It’s important to note that interest cost is only one aspect of the negative ramifications associated with this potential legislative change. There are other, more nuanced, albeit important consequences that to the structural attributes of the capital markets and its participants, both institutions and investors.

Other Impacts

• Municipal issuers have become accustomed to a “par call” in the seven- to 10-year range. Being able to pre-pay or refinance debt at face value within that period is very favorable as a means of reducing total interest cost on any capital financing. The issuer reserves the right to refinance at lower rates or pay the debt off early to eliminate some or all of the interest expense.

While municipal issuers have been able to replicate that structure in the taxable market, it is not a standard convention. The taxable market sees a much wider prevalence of the “make-whole” call provision. Under this dynamic, the issuer compensates bondholders when optionally redeeming debt early by paying them the present value of all future cash flows at the time of pre-payment. Those future interest and principal payments are discounted at a pre-determined factor used to arrive at the present value amount. This “penalty” greatly diminishes the opportunity to refinance for savings. A make-whole call is common for taxable municipal issues as a way to make the offering more attractive to taxable investors.

When direct-pay tax credit structures were prevalent under programs like Build America Bonds (issue taxable debt and receive a direct interest subsidy from the U.S. Treasury), municipal issuers were able to influence market conventions through expanding acceptance of the par call feature, but broader adoption across the market could take some time.

• Access to capital would undoubtedly be disrupted for many municipal borrowers. There is a well-established market for tax-exempt municipal securities. In fact, the current amount of municipal securities outstanding is approximately $4 trillion and roughly $500 billion of municipal securities were issued in 2024. Billions of dollars of municipal securities trade in the secondary market on a daily basis through a network of well-capitalized dealers. There are many obligations and diligence requirements associated with issuing securities, but it can be said that most state and local governments currently enjoy reasonable access to capital at favorable cost and terms.

This market is largely domestic, comprised of retail and institutional investors whose motivations are primarily receiving interest income that is exempt from federal, and many times state and local, income taxation, as well as strong credit quality (many private activity bonds are more properly characterized as part of the tax-exempt, “high yield” market).  The long-standing structure of this seasoned market generally results in even small and infrequent issuers finding willing buyers for their bonds and many issuers achieving fixed-rate financing for terms as long as 40 years (or even longer). Even with its idiosyncrasies, one could argue the municipal securities market is a well-oiled machine.

Take away the tax-exemption, and investors lose one of the most attractive features for participating in this market. Credit quality would largely remain, even if debt burdens would increase due to higher interest costs. At least when compared to the corporate market. Think of Lake Superior as the municipal securities market and the world’s oceans as the global, taxable securities market. Lake Superior is named as such for a good reason – it’s huge. But it’s lost in the proverbial “sea” of taxable securities offerings. The larger issuers comprising maybe $300 – $400 billion of the $500 billion in municipal securities issued in 2025 would probably still enjoy access to the much broader taxable securities market. The nuts and bolts of the institutional marketplace would adjust to their emergence as frequent issuers. Their issue sizes are larger and provide for better secondary market liquidity. In addition, they have professional management and staff suited to meet the more stringent reporting and other disclosure standards corporate entities (and investors) are accustomed to.

It’s more likely that smaller and less frequent issuers would lose access to what they currently enjoy:  A deep, (relatively) liquid, and robust municipal securities market that allows them to issue $2 million with a 20-year repayment schedule and post continuing disclosure once a year…all at a reasonable total cost and lower risk profile when compared to other financing alternatives.

There isn’t an immediate alternative source of capital to absorb the roughly $100 – $200 billion of debt financing required for these municipal issuers. Banks are prevalent as direct lenders to state and local governments of all sizes. Over time, they may be willing and able to direct more of their portfolio lending to governmental borrowers, but that isn’t going to happen overnight – not even over months. The infrastructure required isn’t there and balance sheet allocation decisions could take years to unfold as bank’s reposition themselves. Also, they only have so much lending capacity, which doesn’t increase just because more borrowers require loans, even if those borrowers represent good credit opportunities.

Beyond willingness, bank lending doesn’t always look like issuing debt as securities. Banks aren’t generally in the business of offering fixed rates over extended periods outside of 10 years. Borrowers may get payments based on amortization periods of 20 years, but the loan will be subject to periodic rate reset and re-amortization. Rather than dictate what are considered standard terms through a municipal bond offering in the securities market, many terms and conditions of a bank loan must be negotiated. Depending on who the borrower is, the bank may dictate the terms.

Finally, banking has become much more of a fee-based relationship business. Many banks are less interested solely in a credit connection with their customers. They want deposits and transactional ties, like the entire treasury management package.

State and local borrowers, as well as those providing capital, would all adapt, but this would take time and involve some brain damage. Pooled financings and other alternatives might also emerge as a more viable and efficient means for local jurisdictions to finance projects in such an environment.

Big Picture

If one were to look to “the market” for its objective outlook on the probability of a repeal of the tax-exempt status of state and local debt, current tax-exempt yields in relation to U.S. Treasuries would likely be the best indicator. If the market felt there was a high likelihood the tax-exemption on future municipal bonds would be eliminated, a scarcity premium attached to existing tax-exempt bonds would probably emerge. That is, their prices would at least nominally rise and the ratio of tax-exempt bond yields to U.S. Treasuries would decline materially. That ratio really hasn’t moved much in recent months as these discussions have come to the surface and it’s unlikely anyone could presently state whether that means there’s a less than 50% chance, 25%, etc.

State and local governments will always need debt financing to fund the critical infrastructure of our society. Without the preferential treatment of tax-exemption, it will undoubtedly come at higher cost and likely with more effort for many borrowers. Ultimately, taxpayers, users, and ratepayers would bear the brunt of the burden.

One could argue the change in tax status would diffuse the cost of municipal borrowing across a larger base versus federal, state, and local income taxpayers. Yet one could also argue, if ain’t broke, don’t fix it. For decades, the federal government has recognized the important role state and local governments have played in the lives of our citizens by providing an implicit subsidy that comes at reasonable cost to the U.S Treasury. The negative impacts of repeal would almost assuredly be felt unevenly across our vast country.

Many clients are already asking us if they should advance their 2025 (or even later) borrowing plans to ensure tax-exempt financing rates. While we can only know the wisdom of moving the calendar forward with the benefit of hindsight, we can say this:  The municipal bond market is open for business. Rates have declined meaningfully since their 2025 highs and there is strong dealer / investor interest for new debt issues. Highly rated borrowers are achieving all-in costs of a little over 3.00% for 10 years and around 4.00% for 20. There is nothing wrong with certainty and there will be a rush to the market if an “as of date” is established with respect to future debt issues being ineligible for tax-exempt status.

Your Ehlers Municipal Advisor can help you evaluate your options. In the meantime, if you’d like to get involved in advocating for the continuation of tax-exempt municipal debt, contact your federal legislators and visit the GFOA’s Built By Bonds page to share your story.

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