Municipal bond investing

A low sodium diet for municipal bonds

Shawn P. O’Leary
Senior Research Analyst,  Nuveen Asset Management
Highlights
  • The challenges state and local governments may face due to the cap
  • The dispersion of SALT deductions across the 50 U.S. states
  • The states with the highest average SALT deduction

While the Tax Cuts and Jobs Act largely spared municipal investors from direct impacts, several measures may indirectly influence municipal issuers. Perhaps chief among these is the $10,000 cap on deductions for state and local taxes paid (SALT). The cap, which limits deductions against federal tax liability for state and local taxes paid to $10,000 annually, will have differential outcomes for state and local governments.

Some state and local governments face new challenges

Many clients have asked about the impacts of SALT on state and local governments and whether the limitation will create immediate nancial challenges for municipal issuers. The answer is somewhat nuanced and depends on the nancial condition of various issuers and their specific taxation levels.

As a start, it’s important to understand what the SALT limitation does and doesn’t do. The SALT cap doesn’t roll back or limit any currently authorized taxes levied by state and local governments. Similarly, it doesn’t prevent any state or local government from increasing taxes or creating new taxes.

The obstacle to implementing new taxes is not legal but political.

The obstacle to implementing new taxes is not legal but political. In years past, policy makers could lessen the blow of property and income tax hikes by assuring constituents that the increases were deductible against their federal tax liability. Under the new tax law, that may not entirely be the case.

In states where most residents’ combined income and property taxes paid are well below $10,000, incremental tax increases will remain deductible against federal tax liability. For high-tax jurisdictions where residents pay far more than $10,000 annually in property and income taxes, the incremental increase in such taxes will no longer be deductible and therefore will be more acutely felt by taxpayers.

This sets up, from a credit perspective, a divergence of issuers: those that have revenue-raising flexibility with respect to the $10,000 cap and those that are already above the threshold. In jurisdictions where combined property and income taxes commonly exceed $10,000, there is an additional credit bifurcation to consider: those that can unilaterally raise taxes by a vote of elected officials (city council, legislature, etc.) versus those that require the approval of voters.

We expect issuers with the ability to raise taxes without voter approval to navigate the political challenges posed by SALT. We’ve seen issuers behave strategically with respect to raising taxes in years past. State and local governments frequently implement tax increases in years without elections, leaving time for the tax increase to be implemented, absorbed and – hopefully, from the perspective of the elected body – forgotten.

We also expect ever more targeted use of taxes intentionally aimed at the very highest income earners, particularly at the state level. Such taxes are easier to pass politically, but also carry the risk of creating financial dependence on a very narrow – and potentially mobile – segment of the tax base.

For those that require voter approval of tax changes, we anticipate the development of more sophisticated campaign efforts on the part of municipal issuers to explain why the additional revenue is needed and what programs are at risk in the absence of the tax increases. Such campaign efforts have been commonplace in certain states for many years. One such example is Ohio school districts that routinely need to seek voter approval for both new operating revenues as well as the replacement of expiring tax authorization.

The success or failure of these efforts to persuade voters to agree to higher taxes will – along with the ability of the issuer to trim costs in the event approval isn’t granted – determine the credit trajectory of individual issuers. Any increased transparency about how tax revenues will be spent is positive for taxpayers and bondholders alike, especially if it encourages issuers to be disciplined and identify spending priorities.

The success or failure of these efforts to persuade voters to agree to higher taxes will determine the credit trajectory of individual issuers.

Salt deductions vary widely by state

The SALT cap was a critical component of the overall tax reform bill, as it is projected to raise over $650 billion over 10 years. This money is needed to help offset the cost of lower corporate and individual tax rates. The political appeal of the deduction cap is also quite apparent when one studies where the bulk of SALT deductions have historically been taken.


The most populous states, unsurprisingly, are well represented among the states with the largest aggregate SALT deductions. And, for the most part, these states are predominately considered blue – or Democratic – states. The correlation is even stronger when the per capita SALT deduction is taken into account.

The per capita SALT deductions shown above reflect the average of only the tax filers in a state that itemized their taxes; it is not an average taken across all filers in a state. This is because those that don’t itemize their taxes cannot take deductions for state and local taxes paid. Of the 18 states with per capita SALT deductions already above the $10,000 cap, 12 are solidly blue states. Only two are considered reliably red states (Nebraska and Ohio) with the balance representing swing states.

With the largest impact borne by taxpayers largely in states not represented by Republicans, it is easy to see why the SALT deduction cap became a politically palatable way of creating an offsetting revenue raiser for tax cuts. Of course, the partisan nature of the SALT cap is also likely to be a source of motivation for partisan response on the part of the states.

States seek alternatives to the salt cap

 The changes to the deductibility of state and local taxes paid brought about by the Tax Cuts and Jobs Act of 2017 may well incentivize the higher tax states to seek ways to work around the SALT cap. Both California and New York (third and first, respectively, in per capita SALT deductions) have already begun discussing ways of limiting or escaping the impact of the SALT cap, though in very different ways. Importantly, as of this writing, neither state has formally adopted legislation in response to the SALT cap; both are merely openly considering their options.

California 

The California model is, in our opinion, less workable than the New York model. The California model would essentially allow California residents to make charitable donations to the government in amounts approaching their tax liability. Charitable donations remain deductible against federal tax liability, so this would effectively function as a replacement for an uncapped SALT deduction. We think this proposal is unlikely to withstand scrutiny and, ultimately, could be simply disallowed by the U.S. Treasury and Internal Revenue Service.

New York model

The New York model would probably withstand such scrutiny, but also represents a more difficult policy change. The New York proposal would take advantage of an important loophole in the Tax Cuts and Jobs Act of 2017 by shifting from a state income tax on individuals to a payroll tax levied on corporations.

The tax law retained the full deductibility of state and local payments on the corporate side and limited them only on the individual side, so a shift to a corporate payroll tax would mean New York (and other states) could continue to adjust income taxes as needed without creating commensurate additional federal tax liability. To retain the progressivity of their tax code, New York could offer refundable credits or other such tax rebates to individuals based upon income.

These proposals remain just that: proposals. If and when legislation is formally adopted, we will be able to study the details to better understand the likelihood of limiting the impact of the SALT cap, as well as its ability to withstand federal scrutiny.

It’s easy to see why the states are motivated to respond to the change in federal tax policy – not only are many of them well above the $10,000 cap already, but SALT also applies to more than just the wealthiest earners.



While the SALT deduction is commonly viewed as a benefit available only to the very wealthy, it’s actually more widely distributed. Filers with adjusted gross incomes (AGIs) of $1 million or more accounted for just over 20% of the SALT deductions take in 2015. However, those with AGIs between $100,000 and $500,000 represented nearly half (48.9%) of the total SALT deductions and just over half of the SALT deductions taken for real estate taxes in particular. A substantial portion of the taxpaying public from these high-tax states is likely to be impacted by the deduction cap, and states are wise to look at policy changes to mitigate such effects.

Does the SALT cap have staying power?

The SALT cap is temporary. To comply with budget rules in the U.S. Senate, the changes to the individual side of the tax code were written to expire. Within 10 years, the individual tax rates and the cap on SALT deductions will revert to prior law. The SALT cap expires on 31 Dec 2025, meaning new legislation will be required for it to continue past that date.

Practically speaking, continuing the SALT cap into 2026 and beyond seems unlikely. Failure to enact new or extending legislation that contains a SALT cap means the current SALT cap ends in 2025. It seems unlikely that a Democratic Congress would pass legislation to extend it, given their opposition to the SALT cap. Continuing the cap would require a Republican Congress and president, just as it was when the legislation was signed into law.

This combination seems unlikely. The previous 50 years of two-year congressional terms shows that political division (no party controlling both Congress and the presidency) is much more likely than political unification (one party controlling both Congress and the presidency).


Divided government is the norm in modern federal politics, not the exception. Dating back to 1969, the makeup of 22 out of 25 (or 88%) of the congressional two-year terms would make extending the SALT cap highly unlikely. As such, any financial pressure for state and local governments by increasing political resistance to tax increases may be for a fairly limited period of time.

Is there a SALT silver lining?

The $10,000 cap on SALT deductions could potentially present new political and fiscal challenges for some municipal credits. The extent to which the cap may impact a community will depend on present levels of taxation, the proportion of the residents in those jurisdictions who itemize their taxes and take SALT deductions, and the willingness of voters to support new state and local taxes. Yet these challenges need not be viewed as uniformly bad for municipal credit.

Transparency

SALT has the potential to support greater transparency between state and local governments and their taxpayers as to the need for new and/or higher taxes to support various services. Greater transparency around the financial needs and priorities of governments is also generally good for municipal bondholders.

Political constraint

Further, for governments wrangling with various forms of financial stress such as a declining tax base or growing pension liabilities, a newfound political constraint like the SALT cap may force the issuer to deal with such problems sooner rather than later. Issuers in these situations often seek ways of kicking the can down the road by utilizing one-off sources of revenue, deferring various payments or other such methods of essentially buying time and leaving the problem to a future set of policy makers.

Problem resolution

The SALT cap may work to prevent issuers from buying time as easily and therefore dealing with their problems in a structural way sooner rather than later. In municipal finance, the sooner a problem is dealt with the smaller it is; the most intractable financial problems tend to be those that have festered for years.

Regardless, we expect the bulk of municipal issuers have the capacity to deal with the challenges posed by the SALT cap and, ultimately, the cap is likely to be repealed or allowed to expire by 2026. In the meantime, careful analysis of an issuer’s financial flexibility and ability to persuade voters will be critical to understanding how they will fare under the SALT cap.

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Sources
Tax Cuts and Jobs Act of 2017
Internal Revenue Service
Whitehouse.gov
Congress.gov
“Cuomo Says Budget Will Defend New York against Trump’s ‘Economic Missile’,” The New York Times, January 16, 2018
“California’s plot to avoid the new tax cap wins key vote,” The Mercury News, January 30, 2018
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.

A word on risk
This report provides general information only. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any investments or related securities. The analysis contained herein is based on the data available at the time of publication and the opinions of Nuveen Research. Information is current or relevant as of the date indicated and such information may become outdated or otherwise superseded at any time without notice. This analysis is based on numerous assumptions. Different assumptions could result in materially different outcomes.
The report should not be regarded by the recipients as a substitute for the exercise of their own judgment. An investment in any municipal portfolio should be made with an understanding of the risks involved in investing in municipal bonds. There are risks inherent in any investment including the possible loss of principal. Bonds and other fixed-income investments are subject to various risks including, but not limited to interest rate risk or the risk that interest rates will rise, causing bond prices to fall; and credit risk, which is the risk that an issuer will be unable to make interest and principal payments when due. The value of the portfolio will fluctuate based on the value of the underlying securities. This information should not replace an investor’s consultation with a professional advisor regarding their tax situation. Nuveen Asset Management is not a tax advisor. Investors should contact their tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer.
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