A Senate proposal to eliminate the tax–exempt status of municipal bonds may change the municipal bond market after 2011 and is an important piece of legislation to follow in the coming months.

The tax break for investors has been under pressure since Congress began focusing on strategies to cut back on government spending and reduce the federal budget deficit.

In recent weeks, Senate Finance Committee Chairman Ron Wyden (D–OR) and Senator Dan Coats (R–IN) proposed the Bipartisan Tax Fairness and Simplification Act of 2011 that would eliminate the interest deduction for municipal bonds issued after December 31, 2011. Instead, bond buyers would receive a tax credit on earned interest. Compared with the current deduction, which gives investors reduction on taxable income, the proposed tax credit would be 25% of the bonds’ interest cost and would apply directly to the tax bill. The value of the credit depends on the investor’s tax bracket.

If the bill becomes law, it would go into effect immediately, but the proposal includes a grandfather provision for bonds issued prior to 2011.

The bill also proposes other tax code reforms including the elimination of the alternative minimum tax. Another proposal by the bill is the reduction in the number of income tax brackets for individuals — from six to three — with rates set at 15%, 25%, and 35%.

The proposal has gone to the Finance Committee for further review.

Last year, Senator Wyden introduced a similar proposal around municipal bonds. Eliminating the interest deduction for municipal bonds was also one of the recommendations offered by the President’s National Commission on Fiscal Responsibility and Reform last fall.

According to the House Joint Committee on Taxation, the current tax exemption of municipal bond interest is projected to cost the government $161 billion from 2010 through 2014. While notable, the amount still did not make the list of top 10 individual tax expenditures included in that report over the same period.