The Who, When and How’s of Ending DC’s Tax Break for Out-of-State Bonds

August 11th, 2011 | by Ed Lazere

Confused about the controversy surrounding out-of-state bonds? You aren’t alone. In May, the DC Council eliminated the city’s tax break for income earned from non-DC municipal bonds. This was done as part of next year’s budget, but it received little public discussion. Since then, two proposals to partially restore this tax exemption have been raised, including one that drew a veto from Mayor Gray. Amidst this back and forth confusion, it is clear that many policymakers are frustrated with the situation. 

So what’s really going on? 

To be clear: Right now, DC is the only jurisdiction* in the country that gives a universal tax exemption on out-of-state municipal bonds. The Mayor and a majority of the Council seem to agree that the city should get on the bandwagon and stop offering a blanket incentive for residents to invest in bonds from other jurisdictions. 

What is up for debate, however, is how the tax change should occur: who should be impacted, when it should happen, and how should the city pay for it. 

Who Should Be Impacted by the Out-of State Bond Tax Change?  Some people believe the tax exemption should be eliminated for new investors, but should remain in place for DC residents who currently hold non-DC bonds, because they might have made the investment choice due to the tax exemption. This would “grandfather” current bondholders under the old tax exemption policy.  The provision adopted by the Council did not include a grandfather clause. 

When Should the Tax Break Be Eliminated?  The Council voted to eliminate the tax break starting January of this year.  Some argue that it is unfair to make a “retroactive” tax change, and want to move the elimination date to January, 2012. 

How Will Any Modifications Be Paid For?  Grandfathering existing bondholders or moving the implementation date would reduce city tax collections. In July, the Council voted to use $13 million in savings to cover the revenue loss from moving the implementation date to January 2012.  But Mayor Gray vetoed it, arguing that it would be fiscally irresponsible to renege on commitments to build up reserves. DCFPI agrees with Mayor Gray’s position. This means another revenue source is needed to partially maintain the out-of-state bond tax exemption. 

Today, we’ll write about the “who.” We’ll address the “when” and “how” in future posts. 

Should all current bondholders keep their tax break? 

The DC Council eliminated the out-of-state bond tax entirely, meaning that current bondholders would lose their tax break, and anyone buying new bonds would not get a tax break from DC. (For both groups, a federal tax exemption still would apply.) 

Most tax increases are made this way — the change applies to everyone, even though that may upset someone’s financial plans. An increase in property taxes, for example, may throw the budget out of balance for someone who scraped to buy a house. Yet jurisdictions that raise property taxes apply the new rate to all homes, not just new homeowners. 

That is why it is important to understand who will be impacted by any tax change, and how they will be affected.  Data provided by the CFO show that two-thirds of the revenue raised by eliminating the out-of-state bond tax exemption would come from households earning $200,000 or more, and 87 percent would come from households with incomes above $100,000.  Closing this tax break largely would affect higher-income residents.

Given that most tax increases do not have a grandfather clause and that the out-of-state bond tax break largely benefits higher-income residents, it was reasonable for the DC Council to eliminate the tax break for everyone.

That said, there may be some households that currently invest in out of state bonds who would be substantially affected by eliminating the tax exemption. This includes lower-income households and households that get a large share of their income from out-of-state bonds.  The District could act to protect these households by maintaining their tax exemption, while eliminating the tax exemption for other current bondholders and future bondholders. 

Efforts to grandfather the out-of-state bond tax exemption for families who would be most affected would address the most serious concerns that have been raised, while also limiting the revenue that would be lost.

Stay tuned to the District Dime tomorrow for more!

*Utah taxes out-of-state bonds, but has an exception for Utah residents who invest in bonds from  states that do not tax interest earned on Utah bonds. These states include the seven states without an income tax, as well North Dakota and the District.  Once the DC provision to eliminate this exemption goes into effect, Utah will start taxing income earned by its residents on DC bonds.

One Response to “The Who, When and How’s of Ending DC’s Tax Break for Out-of-State Bonds”

  1. Luke says:

    One of the questions you have to ask, and that the DCFPI has not mentioned, is the readily available supply of District bonds, or lack thereof, to District residents. Before the policy is changed, it would be helpful if the Council, the CFO’s office or, perhaps the DCFPI showed an analysis of what bonds were available to residents on a daily basis who wanted to purchase them as an investment/retirement instrument.

    Retiring residents in every state have local bonds they can invest in which provide tax-free income and an as assured income stream as possible. Will changing the exemption, as the DCFPI has advocated, take this function away from residents who wish to age-in-place in the District? Or, will changing the policy make the District hostile to reitrees?