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Opinion

Obama's proposal to tax municipal bonds will hurt states, cities, and Americans

A proposal to impose a federal tax on revenues from municipal bonds would be a destructive and unconstitutional way for profligate Washington to raise funds. The tax would deter investors and squeeze cash-strapped states and cities like Detroit. Americans would pay the price.

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Today’s Supreme Court takes federalism and state sovereignty much more seriously than did the Court on which Justice O’Connor sat in 1988. It is safe to say that if Baker were reheard today, the current federalism-minded majority would side with O’Connor on the far more injurious tax now at issue.

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The experience of the last quarter century has made it unlikely that a municipal bond tax would survive Supreme Court scrutiny. The Baker decision in 1988 was written in an era of enormous prosperity. The Court’s majority suggested that states did not need constitutional protection from federal tax laws, as no Congress would try to raid state coffers. And the federal government had plenty of money.

Since then an increasingly cash-strapped Washington has heaped more and more obligations on the states, most recently Obamacare, without providing dollars to pay for its mandates.

A federal tax on muni-bond revenues would make them less attractive to investors who would then expect the bonds to give higher yields to compensate for the tax. But many struggling states and municipalities would not be able to pay the higher interest rates on their debt and would be priced out of the lending market. In many cases, tax exemption is the only reason for investing. (When the idea of taxing muni bonds was first floated in December, muni interest rates went up a half point.)

Some have discussed the possibility of federal bailouts for those states and municipalities that could no longer afford to pay the higher interest rates the market would demand, but such prospects are hardly reassuring. Those assurances depend on a national government that now grasps at every penny from every source to pay for the rising trillions of its own debt.

Indeed, bailouts would make things worse all the way around. As the Securities Industry and Financial Markets Association has told Congress, “the tax exemption is better than direct subsidies for infrastructure investment because bonds must be repaid, forcing a market test on the project’s viability.”

Threatening irreparable injury to state and municipal finances would not close a tax loophole, but it would transfer resources from struggling states to spendthrift Washington. Meanwhile, investors would feel duped and resolve not to be duped again: They invested in muni bonds based on the understanding that the revenues would not be taxed. A retroactive change would likely lead investors to sue. A test in the Supreme Court would almost certainly follow. That is not a test that the administration and its allies would likely win.

It would be better for state and local economies, investors, and the American people if Washington dropped the foolish proposal to tax muni bonds before it gets any further off the ground.

Stephen Shapiro served as deputy solicitor general under President Ronald Reagan. Timothy Bishop is a former law clerk for Supreme Court Justice William Brennan. They are both partners in the Supreme Court practice group at the law firm of Mayer Brown.

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