Will the Buffet Rule impact Tax Free Municipal Bonds?

Short answer is “How Can It Not?”  When the effective rate of taxation is raised on an investment, then less capital will flow to that investment.  All else equal.

The dirty economic secret no one wants to talk about in DC is that the Buffet Rule would NOT be a tax on labor but instead a new tax on capital.

Follow me here:

Wealthy people use tax-free bonds as a significant percentage of their asset allocation and hence much of the income of the ‘wealthy’ is derived from dividend income and capital gains — and NOT from labor.

Tax free bonds fund our beloved infrastructure projects on state and local levels and much of the capital invested in these bonds flows from people and institutions (groups of people) who want low-risk and tax-free income.

To be effective, the so-called Buffet Rule would have to raise new tax revenue by taking a new bite from income derived from investments in (formerly) tax-free bonds.

We should really call the Buffet Rule a new Alternative Minimum Tax on Capital.

Why? Because if it quacks like a duck…

Were the Buffet Rule to pass, then rational investors would adjust to the new tax regime.  This will reduce incentives to buy these low-return bonds on the margin.  Which in turn would result in an increase in cost of capital to fund these infrastructure projects — projects that build our schools, roads, airports, etc.  The outcome would be less infrastructure work per dollar of capital.  Less efficient capital means less capital production on the margin.

So the Buffet Rule could actually mean less bridges, roads and schools as we ride the Slippery Slope of Progressive Inanity to Achieve Economic Growth.

Q:  Why would tax-free bonds be disadvantaged against other opportunities?

A:  Because the Buffet Bite would be bigger on a relative basis.

If you have to pay the New Capital AMT you may as well invest in riskier investments with the opportunity for a greater rate of return.  The bigger the size of the Buffet Bite to ‘equalize’ tax rates to the Middle Class Tax Rate, then the more that (formerly) tax-free munis and their brethren are impacted.  This makes it tougher to attract investment dollars as they compete in the capital markets.

The famous Chicago School of Economics theory of “Rational Expectations” makes the conclusion obvious.  Obvious to all, of course, except to those of the Krugman Kamp of Economics.

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