By Laura Saunders

Thousands of municipal-bond investors have benefited from tax advantages for much of the past three decades. Pretty soon, those advantages could shrink dramatically.

That is because both President-elect Donald Trump and Republicans in the House of Representatives have proposed lower rates on taxable investment interest. Such moves would lessen the advantages of tax-free munis in ways that range from relatively minor to severely disruptive.

The most radical proposal, advanced by House Republicans led by Paul Ryan (R., Wis.) and Ways and Means Committee Chairman Kevin Brady (R., Texas), would lower the top rate on interest on taxable bonds, such as Treasurys and corporate debt, to 16.5% from 43.4%, a 62% drop.

Here is how the math works: Say an investment in a taxable bond pays annual interest of 5%. Of that interest, the government currently collects as much as 43.4 cents on every dollar. If the tax rate drops, the investor keeps more of the payout on the bond.

By comparison, tax-free municipal bonds are just that, tax-free, meaning that they don't benefit from a tax-rate cut, while taxable bonds do. This means tax-free bonds would be less desirable to investors, potentially denting prices, while demand would rise for taxable bonds.

"The math on munis is changing, and structurally the tax exemption will be less valuable -- we just don't know to what degree," says Robert Gordon, who heads Twenty-First Securities, a tax-strategy firm in New York.

The smallest change, and the one with the broadest support, is repeal of a 3.8% surtax on net investment income such as interest, dividends and capital gains. This levy takes effect at a threshold of $250,000of income for married couples and $200,000 for singles, and both Mr. Trump and many in Congress have called for its elimination.

Without this surtax, the top rate on interest from munis' taxable competition would be 39.6% rather than the current 43.4%. Other things being equal, the recent benchmark yield of 2.37% on a 10-year muni would need to rise to about 2.55% for top-bracket investors in order to provide an equivalent return, says Richard Ciccarone, a muni specialist who heads Merritt Research Services in Chicago. Bond yields rise as prices fall.

In another proposal, Mr. Trump has called for lowering the top rate on "ordinary" income such as wages and interest to 33% from 39.6%. If this is enacted along with the surtax repeal, then the recent benchmark yield would need to rise to about 2.80%, says Mr. Ciccarone. Absent other market changes, the value of a $10,000 investment would shrink to $9,627, according to Mr. Gordon.The third and most disruptive proposal is in the House GOP tax reform blueprint. It would give investment interest the same tax-favored treatment that long-term capital gains and certain dividends now receive, ending the decadeslong practice of taxing interest at ordinary-income rates.

The blueprint's proposed top rate on taxable interest is 16.5%. In that case, the yield would need to rise nearly 50%, from 2.37% to 3.50%, according to Mr. Ciccarone, in order to provide an equivalent return for top-bracket investors.

Not since the 1986 tax reform lowered the top rate on taxable interest from 50% to 28% have munis faced such a big shift. During that period, the yield on a common muni index rose from 6.54% to a high of 9.17% as Treasury yields also rose, says Mr. Ciccarone.

How likely is a 16.5% top tax rate on interest for individuals? It's a serious proposal, say tax policy specialists, but it's part of a package that also denies net interest deductions to businesses. This denial "will face opposition from leveraged businesses that don't want to lose deductions," says Alan Cole, an economist with the Tax Foundation in Washington.

Ahead of possible tax shifts, Natalie Cohen, who heads municipal-bond research at Wells Fargo Securities, counsels caution both in buying and selling. Other factors besides tax rates affect munis, she says, such as the perception that they are a safe investment.

Muni-fund investors raced out of the sector immediately after the election, sending yields higher, but prices have rebounded a bit lately. Meanwhile, holders of individual bonds can collect their coupons regardless of what happens in the market.

"Tax reform is still full of unknowns," says Ms. Cohen.

Write to Laura Saunders at laura.saunders@wsj.com

(END) Dow Jones Newswires

December 16, 2016 11:17 ET (16:17 GMT)

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