Tax-exempt bonds, a key provision of federal tax law since 1913, enable the 50 states and their political subdivisions to issue bonds (collectively, “muni bonds”) at low, tax-exempt interest rates. This exemption is at risk of being eliminated in 2013. And for the wrong reason!

During the recent presidential race, both President Obama and Gov. Romney called for eliminating the federal tax deduction for interest received on muni bonds, thus ending a traditional power of the states that dates back to the 19th century. Their common message is that all deductions are bad because they help the wealthy at the expense of the middle class. However, in reality, all citizens benefit in the case of the tax exemption for muni bonds because it lowers borrowing costs for roads, schools, sewers, hospitals, water supply systems and a myriad of other capital improvements undertaken by state and local governmental units throughout the United States.

Historically, interest paid to investors by the states and their political subdivisions have been exempt from taxation by the federal government. This exemption was recognized by the United States Supreme Court in 1895 when the court held that the federal government could not tax interest income paid to creditors of the several states. Pollock v. Farmers’ Loan & Trust Co., 158 U.S. 601 (1895).

The first comprehensive federal income tax law was enacted in 1913. Interest payments on obligations of the states and their political subdivisions specifically were exempted from the income tax at that time. This exemption was thought to be protected by the Constitution. Also, it was intended to protect the states from federal interference in the affairs of the states.

During the intervening years from 1913 to 1968, several federal efforts to extend the income tax to interest paid by the states and their subdivisions were unsuccessful. Then, in 1968 and 1969, the Internal Revenue Code was amended to limit tax exemption for muni bonds, based on the use and investment of proceeds of the muni bonds. Unfortunately, none of the states challenged the constitutionality of these laws in court. Since then, the constitutional basis for the tax-exempt status of muni bonds has been in doubt.

In 1984, the federal government passed a law that requires muni bonds to be issued in registered form or lose their tax-exempt status. The state of South Carolina finally woke up to this blatant attack on the exercise of the long-standing power of the states and their subdivisions to issue tax-exempt muni bonds. It challenged the federal law in the Supreme Court. It was too little and too late. In 1988, the Supreme Court decided that the states’ tax exemption is not protected by the Constitution. In doing so, the Supreme Court overruled the 1895 Pollock case that had recognized the states’ constitutional right to issue tax-exempt debt. The federal government now is free to eliminate tax-exempt muni bonds completely or attach whatever limitations it chooses on the further use of tax-exempt debt.

An uneasy truce about tax-exempt muni bonds has existed since 1988. 2013 may be the year when New Jersey and other states lose their ability to finance necessary public improvements with tax-exempt muni bonds. Without tax exemption, New Jersey Transit fares will increase dramatically. School taxes will rise. Hospital costs will jump. State taxes will rise due to higher interest costs on all state bonds, including the $750-million issue approved by the voters in the recent November election.

The attack on tax exemption is a serious threat to the states.

In 2010, the National Commission on Fiscal Responsibility and Reform (the “Simpson-Bowles Commission”) recommended that interest on newly issued state and municipal bonds be subject to federal income taxation.

The American Jobs Act of 2011, proposed by President Obama, denies tax exemption for interest on state and municipal bonds to taxpayers in the “upper tax brackets.”

The Debt Reduction Act of 2011 automatically “sequesters” tax preferences, including tax-exempt interest, if certain ratios of debt as a percentage of gross domestic product are not met.

The Joint Committee on Deficit Reduction (the so-called “Super Committee”) meets in secret to reduce federal government spending. In Washington-speak, continuing tax exemption on state and local bonds constitutes “federal spending.”

A growing movement to save tax exemption is starting to take shape. Supporters recognize that tax exemption for muni bonds is different from tax deductions that benefit only wealthy taxpayers. It assists state and local governments in providing essential government services to all citizens in our nation. In September 2012, the National Association of Bond Lawyers published a list of important reasons to keep tax-exempt bonds. They include:

The exemption of state and local government bond interest helps lower the cost of capital funding for state and local governments.

State and local government bonds provide funding for critical infrastructure.

Changes to the exemption of state and local government bonds will increase state and local borrowing costs, which will be passed on to the public.

Principles of federalism support maintaining the current exclusion of state and local government bond interest.

State and local government bonds encourage local control over the development of infrastructure.

Infrastructure is important to our economy.

Limiting or eliminating the exemption will mean less infrastructure investment.

In October 2012, a new task force, Municipal Bonds for America (MBA), was established to protect tax exemption for muni bonds during the expected discussions of comprehensive federal tax reform in 2013. MBA will bring together issuers, underwriters and other municipal market participants to stand up for tax exemption against those who would like to see its demise.

The New Jersey State League of Municipalities was planning to adopt a resolution calling for the preservation of tax exemption of munis at its annual conference in November 2012. The sponsor of the resolution is Edison Mayor Antonia Ricigliano. Unfortunately, the league found it necessary to cancel the 2012 conference because of severe damages by Hurricane Sandy.

The issue is clear. Only a well-planned and executed effort by the states and local governmental units will save tax exemption and the benefits it has created for all citizens throughout our nation. •