Internal Revenue Service data from 2009 shows that 58% of all of the tax-exempt interest reported to the IRS was from individuals with incomes of $200,000 or higher.

(Bondbuyer.com)

In recent weeks, The Federal Reserve and the so-called Obama Administration have teamed up to restrict the ability of American Municipalities to finance long-term, necessary infrastructure projects. Of course, this was neither the stated, nor the implicit intent of either organization in promulgating new policy initiatives. However, the unintended consequences of what both The White House and The Federal Reserve are doing to counteract economic sluggishness would probably have this effect.

The Federal Reserve recently announced a plan to roll-over short-term, government debt by selling bonds with longer maturities. This would force down interest rates on long term debt securities. This reminds many observers of an old John F. Kennedy-era anti-recessionary policy dubbed “Operation Twist.” This policy endeavored to reduce the cost of long-term capital investment without simultaneously draining American cash assets abroad.

An academic study of Operation Twist concluded that The Federal Reserve is able knock down interest rates on government securities (make these bonds a cheaper way to borrow money) by statistically significant amounts.

We find that Operation Twist lowered long-term Treasury yields by about 0.15 percentage point (15 basis points), an amount that was highly statistically significant, but moderate…. For example, 0.15 percentage point (15 basis points) is the typical response of the 10-year Treasury yield to an unanticipated 1 percentage point (100 basis point) cut in the federal funds rate target (Gurkaynak et al., 2005).

President Obama, meanwhile, intends to pay for his new American Jobs Act of 2011 by eliminating the tax exemption for interest on municipal bonds for taxpayers earning more than $200,000 in income. Many people of differing ideologies will voice some support for the idea. It flattens the tax code and takes away a tax break for the dreaded Leisure Class. However, it does so at an unintended cost.

The tax-exempt status on municipal bonds represents a truce of sorts between high income workers and class warrior types who claim to speak for the poor. The wealthy get a productive place to park their money, while cities that would otherwise never have access to credit get their hands on money to maintain and build municipal infrastructure. The primary economic justifications for the concentration of assets in a municipality are convenience and shared facilities. One of these two sources of municipal advantage could become imperiled if the city has trouble getting enough money to provide such shared infrastructure.

What is more troubling than either the lower yields on long-term bonds or the loss of the municipal bond tax break individually is the potential synergetic effect of both of these policies being executed in synonymy. Corporate and Municipal bond yields are set in a manner analogous to how mortgage rates are calculated. The issuers take the UST rate for a security of similar duration and then tack on an appropriate credit risk premium. When the UST rate drops, the bond yield drops in reaction. Long term bonds, like pass-book savings accounts, have now fallen victim to misguided government policy.

One of the prime reasons investors are willing to lend Cleveland, Ohio money to build schools and Hospitals is the concept of tax-equivalent yield. This tax-break has the implicit effect of allowing cities with poor credit ratings to offer bonds at a lower premium. The tax break in comparison to corporate bond issues of similar safety and duration acts as a subsidy against the risk premium that cities would otherwise have to pay in order to make investors willing to lend them money for infrastructure.

The knock-on effects of these combined policies also impact the ability of corporations with dubious credit to raise money in debt markets. Investors take risks on these firms in return for high-yield corporate debt. They are more willing to do so when they can effectively hedge these risks via Municipal Bond Arbitrage. The risk of the corporate bonds is hedged via an interest rate swap. The transaction cost of the interest rate swap is subsidized via the tax-free income from some market basket of municipal bonds.

The key to municipal bond arbitrage is the tax-free nature of the municipal bond acting as a subsidy to lower the cost of the interest rate swap. Kicking the subsidy-prop out from under the transaction makes the interest rate swap a more expensive hedge and thereby reduces the ability of an investor to afford risky corporate bonds. This impacts corporations by further drying up their pool of available credit. Eventually, fewer workers will get hired, and fewer high-risk, high-potential-return technologies will be researched in the private sector.

So we once more see the large and overly-complicated machinery of our government work against its own intended effect. Barack Obama wants to put people back to work in time for his reelection campaign and Ben Bernanke wants to make more credit available to business and consumers. Building lots of roads, schools and hospitals with Federal expenditures paid for by repealing the municipal bond tax exemption for interest income seems counterproductive.

Our government’s current portfolio of policies robs Peter to pay off Paul. Doing so at a time that the Federal Reserve is decapitating long term bond yields makes municipal bonds a risky investment that has minimized yield. Again, our government will miserably fail to stimulate our economy because it is institutionally incapable of getting out of its own way.