The Case for Tax-Exempt Bonds

August 4, 2016

The ordinary income tax is biased; it hits saving and investment harder than consumption. The result is a much smaller capital stock and lower wages and employment. Workers and savers are better served by a tax system that treats saving and consumption evenhandedly. Tax-exempt bonds are one way to get to an unbiased tax system.

The income tax hits income used for consumption once, except for a few excise taxes. One can earn income, pay tax, and buy a television and watch a stream of programming with no further federal tax. By contrast, the income tax is imposed twice on income used for saving: once when the income is first earned and saved, and again on the return on the saving. If one saves some after-tax money and buys an asset that pays a stream of interest or dividends, the streams of these payments are taxed.[1] This feature of the income tax raises the cost of saving relative to consumption.

There are two ways to eliminate the double tax on saving, and put saving and consumption on a level tax-playing field. One way, the “saving-deferred” method, is to defer tax on income that is put into saving, and only tax the saving and its earnings when they are later withdrawn for consumption. We see this in the limited amounts of income that may be put into tax-deferred retirement plans such as pensions, 401(k) plans, and regular IRAs. Another way, called the “returns-exempt” method, is to tax income when it is first earned, but not tax any subsequent earnings on any after-tax income put into saving. This approach, called the “returns-exempt” method, is allowed for a limited amount of saving put into Roth IRAs, provided it is kept in the account for five years or more.

The basic income tax bias against saving would be eliminated if all saving were treated in one of these ways, with no limits on the amounts involved, no minimum holding periods, and no mandatory withdrawal requirements. Unfortunately, all these arrangements are limited by law as to contribution amounts and minimum time held, and may require taxable withdrawals beyond a certain age.

One area in which the limits do not apply is in tax-exempt bonds. Current law treatment of tax-exempt bonds is identical to that of assets in a Roth IRA, except that people may buy the bonds without limit, and there is no minimum holding period. Tax-exempt bonds can be thought of as extending saving-consumption neutral treatment to more saving, with fewer limitations. This tax treatment of state and local government bonds is a step toward a saving-consumption neutral tax system. This is the most constructive justification for maintaining the current tax status of tax-exempt state and local government securities. This is one way that saving should be taxed.

Two other often-cited rationales for the tax exempt status of such securities are clearly wanting. Federal court rulings have clearly discredited the idea that there is any constitutional prohibition against federal taxation of interest on bonds of other levels of government. Nor is the tax exemption of state and local government bonds a good means of subsidizing state and local infrastructure spending. Even if there were a good reason to subsidize such spending (which is doubtful), there are better ways of doing so. The best justification for the exemption is in terms of the optimal tax treatment of saving under a uniformly non-distorting tax system.

With neutral tax treatment of saving clearly in mind, let’s consider some other aspects of tax-exempt bonds. Most of the saving from the tax exemption comes in the form of lower interest payments that benefit the issuers, not the interest recipients. Interest rates on taxable bonds contain a “tax premium” to enable lenders to get an acceptable after-tax return on their savings. Therefore, interest rates are generally lower on tax-exempt bonds than on taxable bonds, and the interest recipients receive less interest. This interest rate differential eliminates most of the presumed tax saving for upper income, higher tax bracket investors buying state and local government bonds.

If, in spite of the lower interest rate, higher bracket taxpayers have marginally more residual benefit from the exemption than lower bracket savers, it is only because the high bracket savers are hit harder by the income tax penalty on saving to begin with. The idea that the exemption favors the rich evaporates if one accepts that the ordinary tax treatment of interest is a form of double taxation. With tax-exempt bonds, all savers, whatever their tax brackets, get the same after-tax interest rate. (There is one exception: higher income taxpayers may be subject to taxation of Social Security benefits if their incomes, including tax-exempt bond interest, exceed certain thresholds. This is an indirect implicit extra tax on the otherwise tax-exempt bond income of higher income retirees.)

When looking at it this way, the tax exemption does not necessarily favor state and local government borrowing over private sector borrowing. On the contrary, the exemption provides that both sectors face the same borrowing costs after taxes (on bonds of equal risk). A profitable private sector business deducts its interest expense against taxable income. Its net-of-tax borrowing cost is the after-tax interest rate. The savers who buy the taxable bond pay tax on the interest. Their net-of-tax return is the after-tax interest rate. A state or local government is inherently a not-for-profit, nontaxable entity. It has no taxable income against which to deduct interest. Its borrowing cost is the tax-exempt market interest rate, which is usually about the same as the after-tax market interest rate on taxable securities. The savers who buy the state or local government tax-exempt bonds get about the same interest as they would receive after taxes on taxable private sector bonds. State and local governments do have an advantage relative to unprofitable private sector borrowers who cannot immediately deduct their interest payments, but that same advantage is enjoyed by profitable private sector borrowers too.

One exception to the non-distorting nature of tax-exempt bonds involves so-called “private activity” bonds, where a local government issues a tax-exempt bond on behalf of a private sector project, such as a sports arena or a shopping center. Private activity bonds may lower the interest rates at which developers could otherwise borrow, which would create a distortion in favor of the selected private activities compared to other private investments. They are a questionable use of the state and local government tax exemption. Interest on such bonds is currently exempt from the ordinary income tax. However, interest on such bonds issued since the Tax Reform Act of 1986 is subject to the alternative minimum tax.

[1] There is also the problem of the double taxation of corporate income: first by the corporate tax, then again as dividends when they are paid out, and of retained earnings when they result in a taxable capital gain. Another layer of tax is imposed if the savings become subject to the estate and gift taxes. The income tax also assumes long asset lives for tax depreciation that overstate profit and overtax investment, especially in long-lived assets like buildings. Acceleration or immediate expensing of capital outlays is ideal for growth.

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