This week the Indiana legislature passed a measure that will make out-of-state municipal bonds taxable at the state and local tax level to Indiana residents. According to The Bond Buyer, the law will take effect in 2012, and it is expected to generate “about $66 million annually,” and will go toward offsetting the $78 million loss of revenues from cutting the state’s corporate tax rate.
Up until now, Indiana residents have enjoyed triple-tax exemption on interest received on all non-taxable municipal bonds, which is unlike the arrangement in most states. In most states it is common to tax out of state municipal bond interest, and in many states it isn’t uncommon to see only certain in-state municipalities tax-exempt at the state and local tax level. All tax-exempt municipal bonds remain exempt from federal tax, regardless of where from, and some particular issuers–Puerto Rico comes to mind–enjoy triple-tax exemption in all states.
At the margin, this change will have the following effects. First, the demand for Indiana bonds will increase as Indiana residents who want to generate income exempt from Indiana state tax will be forced to buy Indiana municipal bonds. Admittedly, the effect might be quite small as our state income tax rate of 3.4% (plus local taxes) doesn’t mean as much as, say, New York’s 10% tax. Second, and related to the first, yields should drop on Indiana bonds (i.e. prices will increase). Historically, Indiana municipal bonds have always traded cheap; this is, their yields were amongst the highest available. That’s unlikely to change significantly, only slightly.
In spite of the lower after-tax yields of out-of-state bonds to Indiana residents, the tax effects are small enough that the crucial diversification benefits of non-Indiana muni bonds should still be considered. In client accounts we will look at give-up yields, or the yield based on what someone is willing to pay us for the non-Indiana bonds, versus the yield on Indiana bonds. If we can get a after-tax yield on the Indiana bond that is better than the after-tax give-up yield on the bond we’re looking to sell, then we swap; if not, we pay the tax and hold the bond.
May 6 update
** There appears to be a provision to grandfather all bonds held as of December 31, 2011. For now that is unconfirmed. **