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Imagine a time when the president, the secretary of the Treasury, businessmen, investment bankers, and congressmen on both sides of the aisle all clamored for an end to the tax exemption on interest from municipal bonds, now a $2.9 trillion market1 that attracts some 6.2 million investors.2 Sound far-fetched? Well, that’s just the kind of drama that unfolded after the Sixteenth Amendment to the U.S. Constitution was ratified in 1913. The Sixteenth Amendment gave Congress the power to impose and collect taxes on incomes “from whatever source derived, without apportionment among the states.”
At first blush, the amendment seemed to repudiate an 1895 decision by the U.S. Supreme Court that held that the federal government had no power to tax interest on municipal bonds.
Even before the amendment’s ratification, New York State governor Charles Evan Hughes, in a message to the state legislature, had warned that the comprehensive words “from whatever source derived” might some day include incomes from state and municipal securities.
“We cannot suppose that Congress will not seek to tax incomes derived from [such] securities,” said Hughes, who would later become secretary of state and chief justice of the United States. “It has repeatedly endeavored to lay such taxes, and its efforts have been defeated only by implied constitutional restrictions, which this amendment threatens to destroy.”
Governor Hughes and others cited the Tenth Amendment, which states that powers not granted to the federal government were reserved to the states or to the “people,” and which gave rise to the doctrine of intergovernmental tax immunity. Tax immunity had helped states and municipalities finance a wide variety of public services, including roads, water, housing, sewers, electricity, and hospitals. It also fueled the growth of quasigovernmental agencies and regional authorities that issued their own muni bonds to build bridges, airports, shipping terminals, and convention centers.
Tax-Exempt Status Denounced
But the mood of the nation was shifting, and the fact that some high-net-worth individuals were paying little or no taxes triggered a fierce bipartisan backlash against the tax-exempt status of municipal bonds. The pressure of financing World War I had pushed up federal tax rates as high as 77%, and wealthy investors found tax-free municipal bonds especially attractive. For an investor in the highest tax bracket, a municipal bond yielding 5% offered a tax-equivalent yield of 21.7%—far more than corporate bonds were yielding at the time.
The tenor of the times was reflected in an article in The New York Times in April 1919.
“In some places, the cry is being raised: ‘Go on with public works so as to give work to soldiers,’” the newspaper reported. “If that cry is put into practice, bankers believe it will mean a flood of state and municipal bonds at very attractive rates, and it may mean seriously interfering with the [federal] government’s tax program.”
During President Woodrow Wilson’s administration (1913–21), Treasury Secretary William G. McAdoo—who at the turn of the century had spearheaded construction of the first railway tunnel under the Hudson River to connect New York and New Jersey—led a campaign to rescind the federal tax exemption on municipal bonds. “Tax exemption is wrong in principle,” McAdoo argued, suggesting the wealthy were avoiding their fair share of taxes.
A bill to curtail the tax exemption was defeated in Congress in 1918, but the controversy would linger for years.
In the early 1920s, both the U.S. Chamber of Commerce and the Investment Bankers Association attacked municipal bonds’ “unfair competitive advantage,” and Republican presidents Warren Harding (1921–23) and Calvin Coolidge (1923–29) also opposed municipals’ tax exemption.
Representative Louis T. McFadden (R-PA), a former bank president who became chairman of the House Banking and Currency Committee, likened exempted securities to a wasting disease. “Tax tuberculosis,” he called it.
Picking up on that analogy, a 1921 New York Times article posed the following rhetorical question: “What is the use of an amendment of the Constitution if it alters nothing, and if lawyers and judges put another meaning on language which is plain to the man in the street, who has difficulty following the lawyers’ explanations?”
In one of the lengthiest attacks on municipals’ tax exemption, Edwin R.A. Seligman, a professor of political economy at Columbia University, published on December 31, 1922, a 5,200-word article on the front page of The New York Times, with stacked headlines that read more like the newspaper’s tabloid competitors:
In calling for yet another constitutional amendment that would provide reciprocal taxation of income from state and federal bonds, Seligman argued the tax-exemption privilege that states enjoyed was much slighter than they thought, especially as they became more reliant on income taxes of their own.
“With every year the situation in the states will become more and more analogous to the situation in the federal government,” Seligman wrote. “Not only will they lose absolutely in dollars and cents but also the growing inequality between social classes, as between the rich and the moderately wealthy in town and country, will be continually accentuated.”
Public Works versus Free Enterprise
Supporters of tax-exempt bonds countered that changing the tax laws would rob states of their sovereignty, raise their cost of funds, and impede economic development, which in turn provides employment. States should retain their right to issue securities and regulate taxation, the supporters said.
States’-rights advocates found themselves pitted against powerful business interests. As Princeton professor Jameson Doig wrote in Empire on the Hudson, a history of the Port Authority of New York and New Jersey: “Private utilities were especially anxious to stop the issuance of exempt securities, which were being used by government bodies to construct electric power systems and other utilities. Because these bonds were tax free, government agencies were able to offer them with lower interest rates, saving large sums in interest costs. Were it not for these lower costs, those large capital projects might be undertaken by private enterprise, which, the utilities argued, was the preferred American way.”3
In 1923, Coolidge (who assumed the presidency after Harding died of a heart attack) and Secretary of the Treasury Andrew Mellon pushed to abolish the right to issue new tax-exempt securities. The proposal garnered widespread congressional support. But in February 1924, the House fell seven votes short of the necessary two-thirds majority needed to pass a constitutional amendment that would allow reciprocal taxation of government securities.
The Rise of Tax-Exempt Agency Bonds
When the Port Authority of New York and New Jersey (PA) completed the George Washington Bridge ahead of schedule in 1931, President Franklin D. Roosevelt hailed the agency as a model for government entities throughout the United States.
Founded at the behest of business and political leaders seeking to improve vital shipping and transportation infrastructure in New York and New Jersey, the PA was empowered to issue its own tax-exempt bonds and charge fees for its services. Over the years, the PA evolved into a formidable quasigovernment agency.
Over the course of the twentieth century, the PA built bridges, tunnels, airports, seaports, bus terminals, industrial parks, and office buildings—the most famous being the ill-fated World Trade Center.
“[The PA’s] strategy for financial independence—issuing revenue bonds rather than relying on legislative funding or voter-approved bonds—was adopted by major public-works agencies in the West, turning them into independent authorities in fact, if not in name,” said Doig. “The continued successes of the [PA] also made it an important prototype for the several thousand public authorities created in the United States and other nations since the end of World War II.”4
As the PA dominated development of the Port of New York, Robert Moses (a powerful but unelected urban planner between the 1930s and 1960s) wielded unprecedented power over public works, housing, and highway construction in New York State, carving up entire neighborhoods and occasionally sparring with Roosevelt. All of which set the stage for another battle over intergovernmental tax immunity.
In 1938, Henry C. Simons, an economist at the University of Chicago, said, “The exemption of the interest payments on an enormous amount of government bonds…is a flaw of major importance. It opens the way to deliberate avoidance on a grand scale…the exemption not only undermines the program of progressive personal taxation but also introduces a large measure of differentiation in favor of those whose role in our economy is merely that of rentiers [people who live off income from property or investments].”5
That same year, President Roosevelt called on Congress to pass legislation that would effectively end reciprocal immunity on the taxation of state and municipal bonds, as well as federal bonds.
“Whatever advantages this reciprocal immunity may have had in the early days of this nation have long ago disappeared,” Roosevelt said. “Today it has created a vast reservoir of tax-exempt securities in the hands of the very persons who equitably should not be relieved of taxes on their income. This reservoir now constitutes a serious menace to the fiscal systems of both the states and the nation because for years both the federal government and the states have come to rely increasingly upon graduated income taxes for their revenues.”
After years of wrangling over constitutional prerogatives and economic imperatives, state attorneys general and PA officials managed to persuade Congress that ending the tax exemption of municipal bonds would be a false economy and too disruptive.
Port Authority officials played an important role in this battle. While most public finance experts objected to tax-exempt bonds, PA attorney Austin Tobin enlisted Harley Lutz, professor of public finance at Princeton, to come up with a scholarly counterargument. The result was a 200-page report that provided strong ammunition in House and Senate hearings.6
In a 1939 address to the Municipal Bond Club of New York, Lutz denied that municipal bonds were a mere haven for the rich. He warned that abolition of the tax-exempt security would pose undue hardship on local taxpayers. He estimated that taxation of municipal securities could boost municipal interest rates by 60 basis points, and he argued that states would lose more in interest than they would get from taxation of federal securities.
“I am convinced that this kind of taxation will mean serious interference by each government with essential functions of the other,” Lutz said. “Such interference will be at least in proportion to the respective tax rates.”7
Chipping Away at Tax Exemptions
While recurring attempts to curb tax exemptions on municipal bonds have failed, there have been some limitations.
Perhaps the most notable was the Tax Reform Act of 1969, which established a “minimum tax” on individuals with large amounts of tax-exempt income. Through subsequent congressional action, that minimum tax has morphed into a levy that now affects millions of middle-class taxpayers.
Following disclosures that certain municipal bonds were financing private ventures with limited benefit to the public, the Tax Reform Act of 1986 imposed a range of restrictions on industrial development bonds. Among the prohibited uses are golf courses, massage parlors, and health clubs.
In 1988, the Supreme Court ruled that Congress had the right to tax interest paid on municipal bonds, if it was so inclined. According to Dennis Zimmerman of the Congressional Research Service, the Supreme Court denied the claim of constitutional protection and found tax exemption to be dependent upon statute and regulation. “In short, Congress has the right to tax this interest income if it chooses—which it has not done,” Zimmerman said.8
—Reported by Steve Govoni
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.