Will the "Big Beautiful" Tax Bill Affect Munis?

Municipal bonds generally pay interest income that's exempt from federal and potentially state income taxes and can therefore be sensitive to changes in tax law. On May 22nd, the House of Representatives passed a tax-and-spending bill known as the "One Big Beautiful Bill Act," which now has moved on to the Senate. Although it contains several tax-related provisions that may have an effect, we don't think it will significantly alter the muni market.

Which provisions could impact the muni market?

The bill contains several tax-code changes but here are a select few that we think could have the greatest impact on the muni market.

It would maintain the tax-exempt status of munis and issuers. There were early concerns that the municipal bond tax exemption would be repealed or significantly curtailed, but that isn't part of the House bill. There were also concerns that some types of issuers, like airports, higher-education issuers, and others, would have their ability to issue tax-exempt munis restricted, but that too isn't part of the House bill. For now, it appears that the municipal bond tax exemption is safe, but it could be altered in the Senate's version of the bill. Even then, a full repeal of the muni tax exemption is a low probability, in our view.

It would maintain current brackets and rates. One of President Donald Trump's domestic policy goals was to extend the 2017 Tax Cuts and Jobs Act (TCJA), which this bill does. It would maintain the current tax brackets with the top remaining at 37%. Additionally, it leaves in place the 3.8% Net Investment Income Tax (NIIT) for taxpayers with a modified adjusted gross income (MAGI) above $250,000 for married filing jointly, or $200,000 for single filers.

After-tax yields for munis vs. corporates at various tax brackets

It would increase the state and local tax (SALT) deduction. The bill would increase the SALT deduction from the current cap of $10,000 to $40,000 for taxpayers with an annual income of less than $500,000. This was a major point of contention and could face additional changes as the bill makes its way through the Senate. The $10,000 SALT cap was part of the 2017 TCJA and effectively served as a tax hike for investors in high-tax states. At the time, it resulted in increased demand for munis because munis are generally more attractive relative to taxable alternatives at higher tax rates. Although the SALT cap mostly impacts individuals from a few states, it had a larger impact on the muni market because a few high-tax states—California, New York, and New Jersey—account for 36% of all munis outstanding.

Although the 2017 cap likely impacted demand for munis, we don't expect a higher cap to have the opposite effect and slow demand materially, mostly because of the $500,000 income limit.

Taxpayers in high-tax states will likely benefit the most from a higher SALT cap

It would increase taxation of private higher education institutions. The bill would increase the tax on college and university endowments from the current rate of 1.4% up to as high as 21%. The tax rate would be a tiered rate based on the size of a university's endowment relative to its student base. Universities with very large endowments could pay a 21% tax. In addition to potentially increasing the tax on private college and university endowments, the bill would also reduce access to Pell Grants, which are federal grants that help low-income individuals pay for college. This could lead to lower enrollments and therefore less revenues for some higher education institutions.

Given the headwinds that the higher-education sector faces, like the tax-law changes, reduced grant and federal funding, and the potential for some institutions to lose their tax-exempt status, we're cautious on the sector. Currently, spreads are not that attractive for education issuers and don't justify the headwinds in our view. It's worth noting that the higher-ed sector is not a homogeneous sector, with many issuers facing differing degrees of risk.

Spreads for education bonds are below longer-term averages in some cases

It would shift more of the cost of Medicaid to states. Medicaid is a state-administered program that is jointly funded by both states and the federal government. Medicaid helps cover medical costs for some lower-income individuals. States administer the program but receive funding from the federal government based on a complex formula, and the amount of federal funding varies by state. For example, California, Colorado, New York, and others receive 50% of the cost of Medicaid from the federal government, whereas Mississippi receives the largest federal percentage at nearly 77%.

The federally funded portion of Medicaid varies by state

Moody's Investor Services estimates that the possible federal actions could "shift as much as $440 billion of Medicaid and CHIP [Children's Health Insurance Program] costs to states over the next 10 years…" If these cuts come to fruition, states could either reduce benefits and eligibility or take on a greater burden of the costs. Although the cuts and potential additional costs are a headwind, Moody's believes that "most states are well-positioned to absorb the short-term Medicaid spending increases."

Is the bill likely to become law?

It's unlikely that the current version of the bill will become law without changes. That doesn't mean that a tax bill won't be passed this year. Instead, the bill that the House passed now goes to the Senate, where changes likely will be made to it. Once the Senate passes their version of the tax bill, it will go back to the House, where lawmakers will have to pass the version that the Senate passed.

The process is important for the muni market because passing a tax bill is a math problem. If there aren't enough spending cuts to offset the tax cuts it will raise the deficit. Some senators already have pushed back about increasing the deficit and specific cuts. The version that the House passed includes many spending cuts to domestic programs like Medicaid and the Supplemental Nutrition Assistance Program, or SNAP (more commonly known as food stamps), while boosting spending on defense, border security, and immigration policy.

The Congressional Budget Office (CBO) estimated that the spending cuts don't offset the tax cuts and that the bill would increase the national debt by more than $3 trillion over the next decade. To reduce the cost of the tax bill, Congress could pursue a few options. One option is finding additional revenue raisers, which could include changes to the municipal bond tax exemption, although we think the odds of restricting the muni tax exemption is low.

Bottom line

The tax bill will likely undergo revisions, so the muni market isn't out of the woods yet. However, the current version of the bill doesn't alter the attractiveness of the broad market in our view. We like munis for investors in higher tax brackets who are looking for relatively conservative income options, and the current version of the tax bill hasn't changed that.

A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our webcasts.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Past performance is no guarantee of future results, and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk, including loss of principal.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab Center for Financial Research does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

This information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, you should consult with a qualified tax advisor, CPA, Financial Planner, or Investment Manager.

All names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. For more information on indexes, please see schwab.com/indexdefinitions.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Investment and Insurance Products Are: Not FDIC Insured • Not Insured by Any Federal Government Agency • Not a Deposit or Other Obligation of, or Guaranteed by, the Bank or any of its Affiliates • Subject to Investment Risks, Including Possible Loss of Principal Amount Invested

The Charles Schwab Corporation provides a full range of brokerage, banking and financial advisory services through its operating subsidiaries. Its broker-dealer subsidiary, Charles Schwab & Co. Inc. (Member SIPC), and its affiliates offer investment services and products. Its banking subsidiary, Charles Schwab Bank, SSB (member FDIC and an Equal Housing Lender), provides deposit and lending services and products.

This site is designed for U.S. residents. Non-U.S. residents are subject to country-specific restrictions. Learn more about our services for non-U.S. residents, Charles Schwab Hong Kong clients, Charles Schwab U.K. clients.