Politicians working to avert the "Fiscal Cliff" may take away some of the advantage of tax-free municipal bonds, dealing a blow to investors as well as local governments.
While Congress isn't yet expected to try to change muni bonds' tax-free status, industry experts think lawmakers could take a first step by limiting how much income investors could deduct under the popular tax break, which has been around since 1913.
Limiting the tax deduction could make muni bonds less popular, resulting in higher borrowing costs for state and local governments, particularly those in the weakest financial positions.
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"If munis are taxable, their cost of finance goes up pretty significantly," said Mike Nicholas, CEO of the Bond Dealers of America. "It's simply that the product is less attractive to investors."
The cost of borrowing for the other authorities and entities that use municipal finance would also go up, so charges for things like water and sewers could rise.
"There is a very real possibility that near term efforts to address the fiscal cliff could include a cap on the municipal bond tax-exemption, leading to higher borrowing costs for state and local governments nationwide," Nicholas said.
"This is not just a tax on wealthy investors, it's a tax on everyone," he said. (Read More: Trading the 'Cliff'—CNBC's Model ETF Portfolios)
Worries about the tax status of munis comes as investors—already anticipating higher tax rates on dividends and capital gains—are rushing into municipal bond funds, pushing yields to record lows.
Industry experts say their tax-exempt status has never been so threatened.
"The conventional wisdom states that we won't have to worry about the tax-exempt status of muni bonds until full-blown tax-reform efforts," Nicholas said. "However, there is a very real possibility that near-term efforts to address the fiscal cliff could include a cap on the amount of deductions that would threaten the tax-exempt status of munis."
Muni-bond proposals have shown up in several bills, including President Barack Obama's Jobs Act last fall. If approved, that would have imposed a limit on the tax value of tax-exempt interest.
For that reason, Nicholas and other members of his Municipal Bonds for America coalition head to Washington on Nov. 27 to meet with congressional leaders on the threat to muni financing.
"This is our first fly in," said Nicholas of the coaltion which includes bond dealers and state and local government officials.
And they're not the only interest group descending on Washington next week, when Congress returns from the Thanksgiving recess. Many groups want to make sure their cause is spared from budget cuts or revenue generating efforts as part of the fiscal cliff talks.
Alexandra Lebenthal, CEO of Lebenthal and Co, said the municipal bond industry may have been helped by the severe damage Super Storm Sandy inflicted on New York and New Jersey, which will now need to fund rebuilding.
"Before Sandy, there was a much greater likelihood of the tax-exemption of municipals being on the block," she said on CNBC's "Fast Money" Monday.
She too said a possible outcome is that individuals will be restricted on how much muni income they can deduct.
"Basically, you would be limited in terms of the deductions you can take and in terms of your tax exempt income to at least that earlier 28 percent bracket. In the past you could have obviously had so much tax exempt income that you were in no tax bracket or in a lower tax bracket than 28. That's what people should be thinking about now is that 28," said Lebenthal.
The 28 percent level was also in the Jobs Act proposed last year.
After this week, Congress is expected to work non-stop to prevent the fiscal cliff, the expiration of dozens of tax breaks and automatic spending cuts that would deal a $500 billion blow to the economy starting Jan. 1, if no action is taken.
"The bottom line is there's plenty of talk because everything about the fiscal cliff is about finding revenue sources, and the thinking is it's a benign source," said John Donovan, head of municipal bond trading at Cantor Fitzgerald. "There's been all sorts of talk and rumors."
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