Costs could be passed on to residents if Congress decides to curb tax breaks on municipal bond interest in bid to agree deal
It isn’t easy for Juan Venegas to support his wife and three children with the money he earns installing fiberglass at a construction company in Riverside, California. He’s lucky to have a job at all; the industry here is still reeling from the housing crisis.
But supporting his family would become even harder if the local utility company were to raise electric and water rates.
“Electric service is already expensive in Riverside,” Venegas, 30, said after buying ice cream for his three sons at a local market. “We would have to sacrifice other expenses, like some school supplies for the kids.”
Higher utility bills could become a reality for Venegas and his fellow residents if Washington decides to curb tax exemptions on municipal bond interest as part of a bid to avert the fiscal cliff, a move that House speaker John Boehner has said he’s willing to consider. Eliminating, or even just curbing, the tax break could chase investors away from the bonds, raising borrowing costs for municipalities across the nation. To pay for that, cities would have to pass off the cost to residents in the form of higher rates, or by putting off needed improvements to infrastructure.
“You would have higher borrowing costs for issuers, which would ultimately be passed on to taxpayers,” said Peter Hayes, who heads BlackRock’s municipal bonds group. “In some cases, the increased costs would be very detrimental to municipalities’ budgets.”
Riverside would be one of those cases. Unlike the majority of California municipalities, the city, located about 60 miles east of Los Angeles, runs its own electric and water companies. It is an expensive undertaking that swallows about half its $1bn budget. The city regularly issues debt to help pay for that, and plans to go to the market several times next year.
Should borrowing costs rise, the city, which is known for its famous Mission Inn hotel and as the birthplace of California’s citrus industry, would raise utility rates on residents and might also postpone plans to improve electric and water infrastructure.
Local officials say they don’t think Washington understands how much its possible approach to solving the country’s fiscal woes will end up hurting its own local governments.
“This is going to make life more difficult for us on Main Street,” Riverside mayor Rusty Bailey said in an interview. “They think it’s another revenue source but I don’t think they realize it’ll increase the interest cost for every city.”
It’s not a good time to make it harder for California’s cities to get funds. Many of them are still reeling from heavy unemployment and the rash of foreclosures caused by the financial crisis. Some have been firing city workers and a handful – such as Riverside’s neighbor San Bernardino – even filed for bankruptcy. As a result, many cities have already been putting off projects to improve their infrastructure.
What’s notable about the federal proposal is that it wouldn’t only affect the municipalities already in trouble. Those most impacted would be the ones that plan to issue bonds in coming months and years, said William Holder, dean of the USC Leventhal School of Accounting. Many of those cities are fiscally healthy.
“They’ll pay more for debt service,” Holder said. “They may forgo an attractive capital project: building a new fire station or a civil center.”
Riverside, for example, has maintained solid finances throughout the economic crisis, even with an unemployment rate currently at 12%. The city earned an AA- rating on its general obligation bonds from Standard & Poor’s, which said it showed “strong financial management practices.”
Right now, the city can get financing through a 30-year bond at around 4.5% interest. That rate could rise to 6.5 or 7% under current market conditions if the tax exemption were removed, said Brent Mason, the city’s finance director.
“We’re a regular issuer in the bond market, so the cost of capital is of endless importance to us and to our citizens, who are the rate payers,” Mason said. “You can see why they’d be interested in removing the tax exempt rate, but it’s a huge cost to us.”
The changes wouldn’t only affect utilities. “I look at the calendar of stuff to do six months from now, and there are always things to do,” Mason said. “The economy is starting to recover and people will start flooding in again to the region. They’ll be a demand for this or that.”
One such project that city officials are considering is a $20m upgrade to Riverside’s downtown public library. That plan would likely be put on hold amid higher borrowing costs, as would the jobs the remodel could create.
The library was built in 1965 and hasn’t been upgraded to cater to modern technology or to provide more space for community programs. The second-floor area that gets the best wireless internet reception doesn’t have any access to outlets for laptop computers, and users aren’t allowed to access certain websites because the server could overload. Indeed, on a recent afternoon, no visitors were using the area to work on their own computer.
“The building needs updating to meet the needs of our customers,” library director Tonya Kennon said.
To be sure, some analysts and investors consider it more likely that federal officials would cap the tax break rather than eliminate it.
Laura Milner, senior investment manager on the fixed income strategies team at Wells Fargo Private Bank, said a cap wouldn’t stop her group from continuing to buy municipal bonds for their high net-worth clients because they would remain safe investments compared with other fixed-income products and because their yields would still be more attractive than other taxable debt such as corporate bonds.
“There might not be as much as an adjustment as you’d think,” Milner said.
But Riverside believes the cost of borrowing would still rise even if the interest is only capped, Mason said. “It’s the same effect but not as dramatic. In either case, it makes it substantially more expensive to borrow funds. We’re certainly opposed to that.”
If he’s right, local attitudes towards Washington might deteriorate.
“I have no confidence in the federal congress,” said Susan Heath, 69, a retired clinical lab scientist who was shopping at the Home Depot. “At a local level, we’re going to be hard pressed to get things done.”