WASHINGTON (Reuters) - Congressional lawmakers working on comprehensive tax reform could harm U.S. cities, states and other governments that sell municipal debt and damage their credit quality, Standard & Poor's Ratings Service said on Monday.
Eliminating the tax exemption for interest paid by municipal bonds, or simply changing the exemption, could reduce market access and raise borrowing costs for issuers, which in turn would have negative credit implications, the rating agency said.
Also, cutbacks to deductions for mortgage interest or state and local property taxes could hurt smaller issuers, it added.
The chairmen of the major tax-writing committees - Senator Max Baucus, a Democrat who heads the Finance Committee, and Representative Dave Camp, a Republican who leads the Ways and Means Committee - are expected to unveil a revamp of the tax code when Congress returns from its August recess.
The chief concern in the $3.7 trillion municipal bond market is that they will cut the value of tax breaks for those earning more than $200,000 a year to 28 percent from the current 35 percent. If approved, the cap would essentially drive down the appeal of municipal bonds, which are often sold to wealthy investors willing to accept lower interest rates because of the exemption.
The market fears Congress could go one step further and eliminate the exemption altogether.
"Without the tax exemption, municipal borrowers would face higher interest rates with the inevitable result that many state and local governments would need to impose higher taxes, do less capital investment, or some combination of both," S&P said. "If ending the federal tax exemption leads to higher state and local taxes, low-income taxpayers could see their tax bills go up."
Larger issuers may be able to weather changes to the municipal bond exemption because they have the resources to appeal to investors, such as big pension funds, which would buy debt with higher interest rates, S&P said. Smaller issuers, though, would likely struggle to attract those buyers.
For many issuers, the higher interest rates accompanying a cap on the exemption would force them to choose "between capital investment, reserve maintenance, taxation and user fee levels, and key services," ultimately resulting in lower infrastructure spending.
Changes to the mortgage interest and local tax deductions "would undercut demand for housing and weaken the prospects for new housing development," it said, as well as risk lowering local tax revenue.
"Any drag on residential purchases — or on the housing market in general — would dampen the rate of economic expansion to some degree. The only debate is by how much," S&P said. "We believe that in aggregate, the contractionary consequences would hit the labor market and retail sales hard."
Property taxes are the primary revenue source for most local governments. If home buyers scale back their purchases because of a smaller mortgage tax break, they would end up paying less in property taxes, S&P said. At the same time, they could pare back purchases of durable goods, which would drag down sales taxes.
(Reporting by Lisa Lambert; editing by Michael Connor and Matthew Lewis)