Having it Both Ways
Today's WSJ comments on the opposition to the dividend tax elimination coming from Freddie Mac, Fannie Mae and the municipal bond market. I have no deep love for Fannie or Freddie and their secretive business practices, but I do feel compelled to defend the muni market. I am certainly glad that the WSJ is finally realizing that the elimination of the dividend tax would have an effect on munis, even though I pointed this out months ago.
But the Journal gets a bit confused on the issue and argues out of both sides of its rhetorical mouth. I'll quote directly from the editorial-

Munis currently have a big advantage over taxable investments like stocks. Although after-tax returns on both types of investments are about the same -- after adjusting for risk -- the muni market's complaint is that diminished demand will drop the price of these bonds and that yields will then have to rise to support the market size. And higher yields will make munis less attractive to issuers.

This argument follows the molehill-into-a-mountain construction. Yields on munis might not be affected if tax-free dividends don't shrivel the demand for them. In the competition between bonds and stocks, the inherent higher riskiness of stocks, which makes them inappropriate for certain investors, would dampen any surge out of bonds and into stocks. Many equity investors might also continue to prefer higher stock prices to bigger dividends. And finally, about half of all investors in stocks already hold them in tax free accounts.

So, let's see if we can make sense of this argument. The Journal claims that munis have a big advantage that will be narrowed, or eliminated, if the dividend tax is repealed. Yet, they claim that half of all investors in stock hold them in tax free vehicles. If that is the case, then why is it that munis have a "big advantage" over stocks? Munis would only have appeal to the half of investors who do not already invest in tax free vehicles, but then they have to compare the returns to other vehicles, such as stock, which very likely would have a higher rate of return even factoring in tax treatment.

The reality of the situation is that individuals chose to invest in munis partly for their low risk and partly for their tax free returns. It is difficult to quantify the effect of each aspect, but it does follow that if stock dividends were no longer taxed municipal bond yields would have to rise, at least at the margin, in order to continue to attract investors. Now, there will be those low risk investors who will always stay with bonds, but for the more average investor the prospect of tax free higher returns on stocks will be enough to exit the bond market, or at least scale back their investment in munis unless the yield on munis increased to offset the loss of tax preference. How much muni yields would be forced up is an open question.

But what is not open to question is who bears the cost of increased municipal bond yields- the taxpayer. Whether it is in the form of higher taxes or cuts to services, the money to service municipal bond debt has to come from somewhere. And, either option directly affects the taxpayer. So, as I have noted before, elimination of the dividend tax will only redistribute wealth from taxpayers in general to investors. At a time when most local and state governments are facing budget shortfalls making their borrowing more costly is the wrong thing to do.