First the basics: interest on municipal bonds you own is not taxed at the Federal level. If you own bonds of issuers in your state, say through a Nuveen closed end fund or similar, you are shielded from state taxes as well. So why talk about municipals if it’s tax free income anyway?
Because the largest changes in the tax code since 1986 are potentially on the table with the GOP’s new tax plan.To be clear, the proposal hasn’t mentioned stripping the tax exempt status of municipal bonds away. The current proposal wouldn’t change the highest tax bracket from 39.6 percent today, so the effect on demand for tax exempt bonds could be minimal. There also isn’t much of a relationship between marginal tax rates and the ratio between tax exempt and taxable bond yields.
Eliminating all itemized deductions and doubling the standard deduction won’t affect municipals as income from municipals isn’t deducted from taxable income – it’s excluded.
However, the proposal to eliminate deductions for state and local taxes could bolster demand for municipals. Eliminating the deduction would increase the taxable-equivalent yield of a California-exempt bond from 3.47% to 3.72% for a taxpayer subject to California’s 11.3% tax rate (assuming a 35% federal rate).
Reducing the corporate tax rate from 35 to 20 percent would effect demand for municipals, as banks and insurance companies do own nearly 30% of municipals.