IS TRUMP’S TAX REFORM A THREAT TO MUNICIPAL BORROWING COSTS?

The recent release of the Trump Administration’s tax proposal has led to speculation about what these changes could mean for municipal borrowing costs. The proposal still needs to be reconciled in and approved by both houses of Congress before the new tax reform is officially enacted. The advertised plan of cutting taxes to spur economic growth sounds great to many and could be the essential cure for our economy’s current lackluster growth rate of around 1.80%.

However, what’s not being advertised, but is very much at the forefront of the municipal finance world is the almost immediate increase in municipal borrowing costs that will occur if the decreased tax rates become reality. To illustrate, a municipal lender or bondholder in the 35% effective tax bracket that purchases a tax-exempt municipal bond or other form of tax-exempt indebtedness yielding 2.50% receives a tax equivalent yield of 3.85 (2.50%/(100%-35%)). To say it another way, the lender would have to invest its funds in a taxable instrument at 3.85% to achieve the same 2.50% after-tax yield. So, let’s take a look at what happens if President Trump’s tax reduction plans come to fruition and the municipal lender is now subject to a lower tax rate of 25%. The lender would now need a 2.89% to maintain the same tax equivalent yield of 3.85% (3.85% * (100%-25%)). In a $3.8 Trillion municipal bond market, this potential 15.6% increase in tax-exempt borrowing costs should not be overlooked.

Setting aside President Trump’s tax agenda, let’s review what’s been on the Federal Reserve Bank’s agenda over this past quarter. As planned, the Federal Reserve did not increase the Federal Funds Rate in their most recent Open Market Committee meeting. However, Chairwoman Yellen, along with 75% of the Committee members are still forecasting an increase of 0.25% for their upcoming December meeting. They believe the U.S. economy is still on good solid footing, even though growth and inflation continue to lag their expectations. Accordingly, the general consensus among the Committee is that they will raise the Fed Funds Rate three times in 2018.

In summary, the U.S. economy remains headed in a positive direction. Despite the horrifying and disruptive impacts of the recent hurricanes and tropical storms, economic growth prospects are good and the proposed tax cuts could provide a nice tail wind. Municipalities will continue to participate in and contribute to the growth of our economy, but will likely see their borrowing costs go up heading into 2018.

Written by: Zac Saldi of Government Capital Corporation