There is much in the news these days about efforts by the Bush administration to pass major tax cut legislation. Included in this plan is a complex tax exemption for dividends and repeal of the estate tax. While nice to dream about, in my opinion neither of these two efforts will likely be passed as proposed. In addition, what federal tax cuts do get passed are more than likely to be offset by state and local tax increases. This is not the time to sell your tax-exempt municipals, quite the contrary, you should be adding to your positions. Here’s why.

The well intended tax cut legislation is already in trouble in Congress, even from the Republican side of the aisle. At a minimum, the total amount of the cuts will be reduced and in some cases outright eliminated. In my opinion, the dividend tax cut provision is one of the most likely to be changed or eliminated. While entirely justified in intent and principle, the mechanics of the proposal are virtually impossible to handle. Without going into too much detail, the proposal would easily double or triple your record keeping on individual stocks and create a nightmare of accounting for mutual funds. At best, I believe we might see a compromise where individuals are given a flat annual dollar deduction, say up to $10,000, for dividend income. Besides being easy to administer, it is more politically palatable and has the precedent of having been used before (it was part of the tax law in the 70s and 80s until the Regan Administration eliminated the deduction as part of the tax simplification act).

Elimination of the estate tax is even thornier. While a total elimination of estate taxes is scheduled for 2011, it will revert to the 2002 tax law in 2012 unless Congress acts to extend it. Here again a compromise is probably the best we can hope for with an accelerated increase in the exemption to several million dollars but no actual elimination of the tax. In my opinion, this is not a bad scenario. The problem is that since this is a clear priority of the Bush administration it is likely that other personal tax cuts will be sacrificed to achieve a compromise on the estate tax revision. This of course only further diminishes hopes of meaningful personal tax cuts.

Perhaps the worst aspect of the "tax cut" is the likelihood that it will be completely offset by state and local tax increases. New York and California are especially likely to have to raise taxes. Look at California as an example. The good news for California is that legislators agreed on $3.6 Billion in budget cuts to narrow the state’s anticipated deficit. The bad news is they have another $29 Billion to go. While California has the biggest deficit on an absolute basis, many other states have the same problem proportionately. Furthermore, even if they economy recovers, the enormous tax loss carry forwards accumulated over the last few years will mute tax revenue increases for years to come. I’m afraid increased taxes are inevitable because most states can’t eliminate their deficits through budget cuts and borrowing alone.

Fortunately, the economics that create big state budget deficits usually mean plentiful and relatively cheap muni bonds. States will undoubtedly do what they have in the past, finance at least a portion of their deficits with debt. As is usually the case, the markets have reacted in advance of the actual events and municipal bonds have gotten cheaper as bond traders and investors have anticipated the increased supply. In fact, most muni bonds now offer yields well in excess of U.S. Treasuries and corporate bonds on an after tax basis. But be careful, not all munis are a smart buy. All the cautions I’ve discussed in previous newsletters about owning bonds still apply and bear repeating.

Diversify: If you want to own actual bonds make sure you limit your exposure to names and geographic locations. With municipals, state issued General Obligation bonds are generally the safest. Be careful of revenue bonds or bonds from smaller counties that have limited taxation opportunities. Also, if you buy insured bonds, be conscious of your overall exposure to the insurers themselves. The insurance is only as good as the insurer’s ability to pay. Obviously mutual funds are great way to get diversity.

Limit Maturities: Interest rates are still at cyclical lows and will go up sometime in the future. Since we don’t know when that will happen and very short tern rates are so low, it makes sense to focus attention to 3-7 year maturities where you get paid extra yield but are not extending your maturities too far. If you anticipate specific needs for this money in the near term, keep it in cash or cash equivalents only. In most cases, the extra yield 3-7 year muni bonds offer will offset moderate increases in interest rates provided you can own them long enough to benefit from the extra income.

Tax Brackets Matter: If you are in the highest tax brackets you will almost certainly find a muni strategy attractive. If you are taxed at a lower rate, you may also want to consider some corporate bonds.

Don’t Double Up: My recommendation to buy municipal bonds is not meant to be in addition to your fixed income allocation but rather as part of it. Municipal bonds in general are far more attractive than Treasury or Agency bonds right now so for most people, selling a treasury heavy fund or bond portfolio to buy tax-exempt bonds makes sense. Your stock/bond allocations should on balance remain the same unless other events trigger a reevaluation of that allocation.

Taxable Accounts Only: This may seem obvious but it is worth repeating here. Tax advantaged investments, including munis, have no place in a tax exempt or tax deferred portfolio. I personally have yet to see a case where having a "duplicate" tax advantage is worthwhile. Municipal bonds should be held in taxable accounts.

Signs of a gradually improving economy and a return of post war consumer confidence are not reasons to focus on stocks to the detriment of your fixed income portfolio. Now is the time to limit your exposure to treasuries and add to a carefully constructed, diverse, and limited duration municipal portfolio or mutual fund. Please call if you’d like help in making choices that are appropriate for your specific situation.

Randy Gridley

May, 2003