(Bloomberg) Property and casualty insurers are voicing concerns that longstanding tax exemptions for municipal bonds could be disrupted as part of a broader U.S. tax-code changes being considered by Congress.

Insurance companies rely on income from municipal bonds to cover claims paid to policyholders. Property and casualty insurers held $329 billion in outstanding state and local debt as of December, making them the fourth-biggest institutional holder after mutual funds, money-market funds and banks, according to U.S. Federal Reserve data.

The century-old exemption for interest on municipal bonds is under scrutiny as lawmakers and the Obama administration seek revenue to help cut U.S. deficits. While few lawmakers and lobbyists think that Congress will take away the tax exemption altogether, insurers want to make sure that their revenue from state and local bonds isn’t disrupted, Bloomberg BNA reported.

“Any change to the taxation of municipal bonds must take into account the settled expectations of investors with respect to existing bonds, and should apply only to bonds issued after enactment,” wrote the Property Casualty Insurers Association of America, in public comments last month to the House Ways and Means Committee.

Local governments sell tax-exempt municipal bonds to pay for sewage treatment plants, sidewalks, and stadiums. The tax preference is among many breaks under fresh scrutiny by the tax-writing House Ways and Means Committee as it considers revisions to U.S. tax code.

Obama Proposal

President Barack Obama’s budget proposal for fiscal 2014 recommended capping the exemption for interest on municipal bonds at 28 percent for the wealthiest U.S. households. That’s a less-extreme change than the full repeal recommended by the Simpson-Bowles deficit-reduction commission in 2011.

Repealing the break altogether would raise $124 billion over a decade, according to estimate last year from the Joint Committee on Taxation.

Lawmakers and lobbyists interviewed by Bloomberg BNA last week said they doubt Congress will eliminate the municipal-bond exemption. Still, leaders of the tax-writing committees have said all ideas for tax reform will be considered, including scaling back the exemption in some way.

Representative Richard Neal, a Massachusetts Democrat and a member of the Ways and Means Committee, said during a panel discussion in Washington May 8 that he was surprised to learn through the committee’s tax-reform working groups that property and casualty insurers rely so heavily on municipal bonds.

Public Projects

The insurers’ concern illustrates a wrinkle in the debate over the tax preference for municipal bonds, a sensitive point of tax reform. So far, the debate has been dominated by state and local officials warning that scaling back the tax preference could undermine the financing of public works projects.

As important as insurers are to the municipal bond market, their role has actually diminished since the tax reform law of 1986, Christopher Taylor, former executive director of the Municipal Securities Rulemaking Board, told the Ways and Means Committee at a March 19 hearing on the effects of tax reform on state and local government.

The 1986 law enhanced the role of individuals as bond investors and reduced that of insurers, in part by eliminating certain tax shelters, Taylor said in prepared testimony.

Top Earners

While Neal and other lawmakers are pushing for no change in the tax status of municipal bonds, the recommendations from the Obama administration and the Simpson-Bowles panel make some change more possible, an aide to a House Ways and Means Committee member told Bloomberg BNA.

The Tax Policy Center, a non-partisan group based in Washington, has estimated that eliminating the state-and-local bond exemption for high-income earners would generate about $25 billion in revenue -- only if the preference were taken away from outstanding bonds as well as new ones.

Any fiscal benefit would sharply diminish if the exemption were taken away only from newly issued bonds, a compromise the insurance industry has indicated it could accept as a last resort, the Tax Policy Center said.

Revoking the exemption from existing bonds would amount to making bondholders pay taxes on bonds they bought under the opposite assumption, Howard Gleckman, a TPC analyst, wrote in an entry on the group’s TaxVox blog in August 2012. If only new bonds become taxable, he said, municipalities trying to borrow would have to compete for buyers with their own old and tax-free debt, he wrote.

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