This article is part of ongoing series of essays that focus on individual tax expenditures that policymakers should consider eliminating or reforming to address America’s dire fiscal trajectory. The previous article in the series discusses the low-income housing tax credit.
The interest on municipal bonds—debts issued by states, cities and other government entities to fund their daily operations and finance capital projects—has been exempt from federal income tax since the tax was established in 1913. But the federal government has been trying to get rid of this exemption ever since. The Coolidge, Harding and Hoover administrations all supported amending the Revenue Act of 1913 to eliminate the tax exemption of municipal bond interest. Unfortunately, none of them followed through, and the tax treatment of municipal bonds was left unchanged.
Even in more recent decades, some have called for the tax exemption on municipal bonds to be limited or repealed. For instance, in 2010, the Simpson-Bowles Commission on Fiscal Responsibility and Reform called for eliminating the tax exemption on all interest from new municipal bonds.
Supporters of the tax-exempt status of municipal bonds argue that taxing municipal bond interest would violate the constitutional doctrine of intergovernmental tax immunity. However, the Supreme Court ruled in 1988 that taxing interest received by someone who owns a municipal bond is constitutionally permissible because it isn’t a tax on state government.
In terms of fiscal costs, the exempt status of municipal bonds is estimated to cost the government an average of $33 billion annually. The Treasury estimates that over the coming decade (2024-2033), the total cost of this tax subsidy will be $372 billion.
State and Local Overinvestment
Tax-exempt municipal bonds can be characterized as either government bonds or private activity bonds. Most newly issued municipal bonds are government bonds, which typically fund public education facilities, utilities, transportation and other state and local projects. A smaller share of municipal bonds is categorized as private activity bonds if at least 10% of the bond proceeds are dedicated to or secured by private business. These typically fund hospitals, private education facilities and housing initiatives.
Of the $479 billion of tax-exempt municipal bonds issued in 2020, $371 billion (77.5%) were government bonds, while the remaining $108 billion (22.5%) were private activity bonds. This is largely consistent with historical data, which typically indicate that about three-quarters of newly issued bonds are government bonds, while one-quarter are private activity bonds.
Another noteworthy feature of municipal bonds is that they are quite concentrated, with most bonds being issued among just a handful of states. For example, half of all newly issued bonds in 2020 were issued in seven states: California, Florida, Illinois, Massachusetts, New Jersey, New York and Texas.
States with large municipal bond markets can offer lower yields to investors because the exemption on bond interest means most of those yields won’t be taxed. On the contrary, states with smaller markets have to offer higher yields to attract buyers by offsetting the cost of the taxes. This gives the large-market states an unfair advantage in attracting investment and economic development, while smaller states fall behind in the competition for investment, contributing to economic deprivation.
By indirectly subsidizing state-level infrastructure, the federal government encourages state and local governments to overinvest. It should come as no surprise, then, that five out of the seven states that issue half of all municipal bonds are ranked in the bottom 10 states in both Truth in Accounting’s Financial State of the States indices and the Mercatus Center’s state fiscal rankings.
Private Sector Crowd-Out
State and local governments should not be in the business of picking winners and losers through the tax code, as doing so can lead to fiscal profligacy and misaligned economic incentives.
Tax-exempt municipal bonds distort markets by crowding out the unsubsidized private provision of infrastructure. One analysis conducted by the Cato Institute noted how tax-exempt municipal bonds have prevented the privatization of air transportation in the U.S., though many other countries have embraced privatization. Half of Europe’s airports are privately owned, with three in four air passenger trips being taken through privatized airports. Meanwhile, in the United States all major airports are government owned and operated.
Through its favorable tax status, the municipal bond gives an unfair advantage to government funding of projects over private investment. For example, a 2020 study examined 57 professional sports stadiums built since 2000 and found that 43 of those stadiums were partly funded by tax‐free municipal bonds. This represents an opportunity cost to private investors who might have otherwise taken up these projects, leading to more competitive and diverse investment in the infrastructure sector.
Inefficient and Regressive
State and local governments should not prioritize borrowing as the primary means of funding infrastructure but should instead finance projects on a pay-as-you-go basis. This would reduce the burden on federal taxpayers of funding state and local infrastructure projects. And with issuance costs amounting to 1.0-1.7% of the total value of the bonds issued, this would also save about $5-8 billion in interest costs and fees for state and local governments.
One final feature of the tax-exempt status of municipal bond interest is the regressive nature of this tax subsidy. A 2007 Tax Notes article estimated that between 72% and 93% of the tax expenditure for municipal bonds is captured by high-income households, with the remainder going to state and local governments. In other words, it’s the government and rich people who benefit from this tax expenditure, while low-income individuals don’t get much benefit.
A research paper published by the Brookings Institution found that almost half (42%) of tax-exempt municipal debt is held by the top 0.5% of American households. This is a trend that has been getting increasingly regressive over time—in 1989, only 24% of municipal debt was held by this small group of ultrawealthy households.
In a similar vein, a recent article published in the Journal of Financial Planning examined empirical aspects of municipal bonds investments. The authors found that municipal bond holders had a median net worth of over $2.9 million in 2019, while those with investments that don’t include municipal bonds had a median net worth of only $507,000. In other words, federal taxpayers are effectively subsidizing very wealthy households who are six times wealthier than those who don’t hold municipal bonds. Hardly the sign of a well-targeted government subsidy program.
It’s Past Time To Axe This Tax Subsidy
The economic literature on the tax-exempt status of municipal bond interest is abundantly clear—this tax subsidy distorts markets, crowds out private investment and redistributes the tax burden in regressive ways. And all at the cost of almost $400 billion in the coming decade.
As policymakers continue to debate tax policy reform and consider options for closing our fiscal gap, they should do what prior administrations intended but ultimately failed to do—eliminate the tax-exempt status of municipal bond interest. The time to pluck this low-hanging fruit is well past.
