With $2 trillion in federal recovery money being deployed, another $2+ trillion in spending earmarked by the Biden administration's infrastructure plan, and widespread expectations for higher taxes, the case for investing in municipal bonds has rarely seemed stronger. Dennis DiCicco, portfolio manager of John Hanccock Tax-Free Bond Fund, discusses the current backdrop and outlook for tax-advantaged investing.
Just last month, the American Rescue Plan was passed by the federal government extending over $2 trillion in fiscal stimulus across the country with a large amount to be paid out in just the first 5 months. This is one of the broadest stimulus bills to pass to date, with a significant amount of money being distributed both directly and indirectly to state and local governments. Prior to passage, however, revenues for state and local municipalities had continued to surprise to the upside month over month, with many states being able to close budget gaps and others, like the state of California, being able to forecast budget surpluses at the end of fiscal year 2021.
All in all, California will have received about $60 billion in federal assistance since the start of the pandemic across all revenue sources. And when you combine that with their projection of $15 billion surplus at the end of fiscal year, 2021, this will greatly ease the burden on their roughly $145 billion annual state budget.
Early expectations for 2021 assume a decline in revenues nationwide, somewhere in the 5% decline area. But since passage, some are now calling for revenue increases of as high as 10% nationwide. We expect to see positive revenue growth in 2021 as reopenings continue and heavily hit tourism states such as Florida and Hawaii bounce back significantly.
Between the revenue surprises, vaccine rollouts, reopenings, and massive stimulus, municipal credit is truly as well supported as it ever has been in the past.
The new administration has been very forthcoming and the municipal market has priced in the fact that tax changes are coming. Higher taxes are all but a foregone conclusion. And most of these changes would have a very positive effect on the municipal market because higher corporate and individual income taxes would attract inflows into the market due to the tax shelter that munis provide. We don't foresee corporations rushing back into munis under a 28% tax regime, mainly because current valuations don't support crossover buying, even at that tax rate. But given that munis will be more attractive to corporations going forward, it adds a welcome market participant in the event that the market does sell off, essentially adding a bit of a backstop to the market overall.
We are also of the mind that tax-exempt advance refundings could be brought back to the market, which would help alleviate some of the net negative supply dynamic that has contributed to municipals’ overall richer valuations.
And then lastly, the SALT deduction cap is on the table to be eliminated as well. This is the state and local government tax deduction that was capped at $10,000 in 2018. This drove significant demand for municipal bonds and was one of the catalysts for the record inflow cycle in 2019. Yet, given the increase on the top tax bracket for the top earners, we see a muted response if this cap were to be eliminated at this point in time.
President Biden is aggressively pursuing a massive infrastructure bill. Due to its size and overall complexities, this bill will most likely be broken into a few smaller pieces of legislation in order to pass through Congress in the coming months. What is certain is that a lot of money will be spent, and at the very least, we can count on a short-term boost to GDP. This would be positive for municipal credit going forward, and the market would react accordingly.
In order to pay for this spending, however, not only will the tax code be changing, but we believe other funding mechanisms will be introduced similar to the Obama-era taxable municipal Build America bond program. If a program like this were to be introduced, it would be positive for municipal credit; however, it would cannibalize some of the tax-exempt issuance in the coming years, offsetting the effects from the potential reinstatement of the tax-exempt advance refundings that is being discussed alongside with some of the tax increases in the new tax reform bill.