Opposing Views: How the Candidates’ Tax Plans Could Affect Muni Bonds
- If enacted, the two presidential candidates' tax proposals could affect municipal bond prices and yields.
- Donald Trump’s tax proposals would see taxes fall, especially for high-income earners, which would likely cause municipal bond prices to fall and yields to rise.
- Hillary Clinton’s tax proposals would raise taxes on high-income earners, which would likely cause municipal bond prices to rise and yields to fall.
- Regardless of who wins the election, changes to tax policy rely on approval by Congress, which likely will be difficult in the current political climate.
The election analysis provided by Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any candidate or political party.
It may seem a distant prospect, but we will eventually have a new president. While this election has often favored personal attacks over substantive policy discussions, it's important to understand that the two main candidates do actually differ on a number of issues that may be important to investors.
Tax policy is one of them. Of course, Congress sets tax law, and we believe that no matter who becomes president, it's unlikely they will get everything they want. Still, given the differences between Hillary Clinton and Donald Trump's policy platforms, it's worth looking at how their tax plans stack up.
Here, we'll focus our discussion on municipal bonds. The interest income from munis is usually exempt from federal income taxes, making them an attractive option for investors in high-income tax brackets. Those tax advantages also mean changes to the tax code could affect the muni bond market. Let's take a closer look.
The candidates’ plans
Before getting into the particular implications for munis, we’ll review the two candidates’ tax proposals. (You can read additional analysis of their tax plans here.)
Trump has proposed cutting the number of income tax brackets from seven to three, with the top rate dropping from 39.6% to 33%. He has also proposed eliminating the Alternative Minimum Tax (AMT) and the 3.8% net investment income (NII) tax that was enacted as part of the Affordable Care Act. While the NII tax doesn’t apply to interest from munis, it does affect most other forms of investment income, such as dividends, interest, and capital gains. That made munis more attractive to investors whose high incomes made them subject to the NII tax.
Clinton has proposed a number of changes that would raise rates for high-income earners, including a 4% surcharge on both married and single filers with taxable incomes of more than $5 million. This would effectively create a new top marginal tax rate of 43.6% for taxable income over $5 million. Combined with the 3.8% NII tax, the top tax rate on investment income would be 47.4%. She has also proposed a 30% minimum effective tax, also known as the “Buffett Rule,” on taxpayers with adjusted gross incomes of more than $1 million. And she has proposed changes to capital gains rates, but we believe such changes would affect munis less than the proposed changes on investment income tax rates.
Where the candidates stand on investment income taxes
Marginal tax rates
Seven brackets ranging from 10% – 39.6%
Leave as is
Three brackets: 12%, 25%, and 33%
Net Investment Income
3.8% tax on Net Investment Income for couples with a MAGI over $250,000*
Leave as is
Repeal 3.8% NII tax
Alternative Minimum Tax (AMT)
A 26% or 28% tax that some municipal bonds may be subject to
Leave as is
Levy an extra 4% tax on taxpayers earning
Ensure that taxpayers earning over $1 million per year pay at least a 30% effective tax rate (Buffett Rule)
Sources: Tax Policy Center, HillaryClinton.com and DonaldJTrump.com. Note: MAGI is Modified Adjusted Gross Income
*Also applies to individuals with MAGIs above $200,000.
Of more immediate interest to muni investors is where Clinton may stand on her party’s proposal to cap the amount of municipal bond interest that is exempt from income taxes. Although Clinton, to our knowledge, hasn’t said she favored such a cap, members of her campaign have said that some the details of her plan would be similar to previous Democratic budget proposals—which have included the cap.
How might a cap affect individual investors? The party has proposed placing a 28% cap on the amount of muni bond interest investors can deduct from their taxable income. For example, that would mean an investor in the 33% tax bracket would have to pay a tax of 5% (marginal tax rate of 33% less 28% cap) on their muni bond interest. That would likely dent the appeal of munis, in our view.
That said, we don't think a cap is likely. This policy has been proposed before but hasn't gained enough support among Republicans to pass. We believe that if Republicans maintain their majority in the House of Representatives, a cap would again face an uphill battle.
Likely effects on munis
In general, higher marginal tax rates tend to make munis more attractive, while lower rates make them less so. In other words, if Trump’s plan were enacted in its entirety, the case for munis wouldn’t be as strong, so muni prices would likely fall and yields would rise. If Clinton’s plan—excluding the cap on deductible interest income from munis—were passed, munis might actually look more attractive, which could push prices up and yields down.
We looked at how munis have performed in previous periods when the tax rate on investment income changed. As you can see in the chart below, in the year before an increase in the top marginal rate, munis outperformed the broad bond market by an average of 0.8%. Tax cuts led munis to underperform the broad bond market by 4.2% on average.
An increase in the top marginal tax rate has historically lead to municipal bonds outperforming
Source: Schwab Center for Financial Research using data from Barclays and the IRS, as of 10/13/16. For illustrative purposes only. Past performance is no guarantee of future results.
Note: Historical averages are calculated by observing the difference in the annual total return of the Barclays Municipal Bond Index (“municipals”) and the Barclays U.S. Aggregate Bond Index (“broad bond market”) from 1980 to 2015 in the year before the top marginal tax rate increased, decreased or stayed the same.
It’s up to Congress
Again, Congress sets tax law, so we would caution investors against overreacting to the candidates’ proposals in isolation. We believe that Congress—particularly the Senate—will remain narrowly divided after the electoral dust settles and the new year starts. If Clinton wins, she could struggle to get major changes to the tax code passed, which would leave munis unaffected. If Trump wins and the Republicans maintain control of the House, tax cuts could follow. Regardless of who wins, consensus will likely be elusive, so we don’t expect any major changes.
More broadly, the way the candidates approach the economy could also affect munis. For example, the direction of Treasury rates will likely have a bigger impact on muni yields than changes to tax laws, in our view. So how do the candidates’ proposals fare on that point?
According to an analysis by Moody’s Analytics, Clinton’s proposals would lead to greater long-term economic growth, less federal government debt and a lower debt-to-gross domestic product ration, than Trump’s proposals.1 However, Trump’s proposals would cut unemployment more.2
Impact of candidates' proposals on select economic indicators
Source: Moody’s Analytics, as of 6/2016 for Trump’s plan and 7/2016 for Clinton’s plan.
Of course, there are many views about how a Trump or Clinton presidency may or may not affect the economy—and you may have your own view. Our take is that neither candidate will likely be in a position to radically remake the economy. That said, if the next president succeeds in accelerating economic growth, investment grade bond yields would likely rise, pulling muni yields up with them.
What to do now
With just a few weeks to go until the election, Michael Townsend, Schwab’s Vice President of Legislative and Regulatory Affairs, believes Congress will remain narrowly divided in 2017. We think that will be an obstacle to any major policy changes that could affect the muni market.
We do suggest investors try to avoid overreacting or altering their portfolios solely in response to the election results. We think the makeup of the House will have a larger impact on tax policy going forward, and that the likelihood of truly drastic changes to tax policy is small.
1 Moody’s Analytics, “The Macroeconomic Consequences of Secretary Clinton’s Economic Policies,” 7/2016.
2 Moody’s Analytics, “The Macroeconomic Consequences of Mr. Trump’s Economic Policies,” 6/2016.
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Schwab does not provide tax advice. Clients should consult a professional tax advisor for their tax advice needs.
Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, business, and other conditions.
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Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more.
The Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds. The Barclays U.S. Corporate Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.