Action at the state and local levels could help drive demand for municipal bonds.

We are at a critical juncture right now regarding individual and corporate tax rates. To help pay for its long-term economic and infrastructure plans, the Biden administration is considering the first major U.S. tax increase since the 1993 Tax Reform Act. As a reminder, the Clinton administration increased the top federal individual income tax rate to 39.6% and raised the corporate tax rate to 35%. President Biden’s proposed tax increase would raise the corporate rate to 28%. We are also closely following his campaign promise to raise taxes on households making more than $400,000 annually.

The 2017 Trump tax cuts dramatically impacted the buying behavior of Individual and corporate taxpayers (banks and insurance companies) in very distinct ways. The “SALT” cap, which limits deductions for state and local taxes to $10,000 annually, pushed effective tax rates higher for some investors and, as a result, greatly increased in-state municipal demand in so-called “high-tax” states. In contrast, some corporate taxpayers reduced their exposure to tax-free bonds given the reduction in the corporate tax rate to 21%. Case in point, right after the passage of the corporate tax cut, we witnessed several banks selling tax-exempt munis, which weighed on the market sentiment.

In our view, passage of President Biden’s tax increases would likely boost the value of tax-exempt municipals through increased demand from individual and corporate taxpayers. Additionally, state income taxes could rise in some states: New Jersey recently increased its income tax to 10.75% for those earning more than $1 million in taxable income. New York lawmakers have agreed to a graduated “millionaire tax” with the top bracket increasing to 14.8% (including 3.90% NYC tax). Finally, Hawaii has passed legislation increasing its income tax on individuals making more than $200,000 a year to 16%. The big takeaway is the broader trend is toward higher taxes, and more state and local governments could follow suit.

In conclusion, we continue to believe the municipal bond market may be entering a sweet spot for three main reasons: First, the economy has improved considerably, and the growth outlook appears positive. Secondly, state and local governments as well as other major sectors of the muni market will receive direct and indirect aid totaling roughly $570 billion from the recently passed $1.9 trillion stimulus package. In our view, the passage of this law clearly strengthens the overall outlook for the municipal market. Finally, tax rates appear to be moving higher at the federal and local levels. In our view, higher tax rates and improving fundamentals should increase demand for municipals going forward.