Posted 3:17 PM by Robert

UPDATE: Unintended Consequences

While the Bush tax proposal eliminating federal income taxes on dividends may reduce the tax advantages of municipal bonds, the proposal will clearly not eliminate those tax advantages.

This is because under current law the corporate income stream that ultimately becomes a corporate dividend is subject to double taxation (at the corporate level and at the shareholder level). But the corporate income stream that ultimately becomes an interest payment on a municipal bond is subject to no taxation (not at the corporate level and not at the bondholder level).

The Bush proposal would eliminate double taxation of the income stream that becomes dividends. But the corporation will still pay corporate income tax on that income stream - the "double taxation" will become "single taxation." The tax disadvantage of dividends will be reduced - and municipal bonds will have to compete more fiercely with private corporate stock. That may mean that municipal bond yields will have to go up to attract investors who otherwise might go to the stock market.

But non-municipal corporate bonds are already subject only to "single taxation" - since interest is deductable from income on which the corporate income tax is assessed (ignoring the demonic "Alternative Minimum Tax" for the moment). It's not at all clear how much additional competition single-taxed dividends will create for municipal bonds over the already existing competition from single-taxed corporate bonds. Corporate bonds resemble - and therefore compete with - municipal bonds more easily than corporate stock does. Exactly how much more is another question. [Gabriel Torres has some thoughts on this.] Preferred stock paying a fixed, periodic coupon (dividend) looks an awful lot like a bond to an investor if the corporation is nowhere near insolvency.

Another level of complexity arises from the fact that while under the Bush proposal the corporate income that becomes both dividends and interest payment will be subject to "single taxation" - the taxpayer will be different for debt and equity. The tax needs and brackets of investors and the corporation in which they invest are quite different - and the terms of the corporate income tax code are different in many key places from those of the individual income tax code.

Put another way: it is not at all clear how much municipal bond yields will have to go up if the Bush proposal goes through. Answering that kind of question is why some of the rocket scientists on Wall Street get paid the big bucks and use so many computers these days.

Democrats, especially, have been looking for ways to reduce what they term the "costs" of the Bush tax proposal. One way to do that would be to subject all municipal corporations that engage in commercial projects (such as sports arenas) to ordinary federal corporate income taxes.