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BUSINESS PARTNERfeature article

          An Update on Tax Reform

          The Trump administration released its framework for tax reform in late
          September, which aims to simplify the tax code by removing certain loopholes
          and lowering tax rates for individuals and businesses. The framework itself
          is quite simple, summarized in just nine pages; there’s even a “one-pager”
          on the Treasury’s website. The main objectives in the framework that could              Drew Simmons
          impact the $3.8 trillion municipal market include:                                    Senior Vice President
                                                                                                   The Baker Group
            •   Reducing the current seven tax brackets down to three: 12%, 25%, and           Contact: 800-937-2257
                                                                                      Simmons  works  with  community
            •   Lowering the corporate tax bracket from 35% to 20%                    bank needs pertaining to interest rate
            •   Lowering the pass-through rate for Sub S businesses to 25%            risk, asset/liability management, and
                                                                                      fixed income portfolio management.
            •   Eliminating the Estate Tax and the Alternative Minimum Tax (AMT)      He  created  the  firm’s  municipal
            •   Repealing the state and local tax deductions                          credits database, and is a frequent
                                                                                      speaker at banking schools and
          As of this writing, the market is showing very little reaction to the proposed   financial seminars.
          changes in the tax code. Last November, we published a brief on the impact
          that Trump’s tax policies might have on the municipal sector. Yesterday’s
          framework provides additional detail, but there are still more questions
          than  answers.  What  we  do  know  is  that,  on  the  margin,  lower  tax  rates
          should imply less demand for tax-exempt income. The math of it is quite
          simple. Figure 1 shows the increase in the net yield for municipals under
          the proposed tax rates that is necessary to earn the same tax equivalent
          yield (TEY). Here, we assume a 2% net yield as our starting point, which
          produces TEYs at today’s tax rates of 2.98% and 3.53% for C-Corp and Sub
          S banks respectively. If investors demand the same TEY under the new tax
          rates of 20% for C-Corps and 25% for Sub S banks, net yields would need
          to be 40bps and 65bps higher, all things equal. But all things aren’t equal.
          Future changes in supply, spreads, and credit quality are just a few of the
          many unknowns.

          Figure 1: Changes in Municipal Yields at Lower Tax Rates

          Figure 2 shows a 1-year history of net yields for Bloomberg’s 10-year AAA
          Bank Qualified Municipal Bond Index. After the election, muni yields sold
          off by more than 100bps. This reflected the market’s expectation that tax
          reform would be a priority for the Trump administration. Fast-forward to
          today and yields have erased about 60bps of that move.

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