Municipal Bond Exclusions Help Shield High-Tax States From Tax Competition

May 27, 2008

A reader wrote in after reading this post on the Kentucky v. Davis outcome, asking for more information about why states’ practice of excluding municipal bond interest income is problematic. There are many reasons, of course, one of which is that the exclusion helps shield high-tax states from interstate competition that could bring down tax burdens. Our brief points to previous Tax Foundation research on the topic:

To understand why high-tax states benefit from the exclusion, first assume that the exclusion did not exist. If a $1,000 state or local government bond had to pay a 10 percent return annually, or $100, to attract enough bond buyers, every investor would benefit equally. See generally Patrick Fleenor, “Tax-Exempt State and Local Bonds: A $20 Billion Gift to the Nation’s Wealthiest Investors,” in Fixing the Alternative Minimum Tax: AMT Reform Requires Changes to Regular Tax Code, Tax Foundation Special Report No. 155 (May 2007), at 9.

However, because of the exclusion, investors who pay higher taxes get a better interest rate. Again assuming a $1,000 bond paying 10 percent, investors in the highest federal tax bracket (say 35 percent) are willing to buy the bonds for interest payments of 6.5 percent since the $35 in tax savings brings their annual earnings from the bond to the desired 10 percent. The $35 gain to state and local governments would equal the $35 in lost federal tax revenue. Investors in the 25 percent tax bracket would have to have a minimum interest rate of 7.5 percent, the point where the amount they save in taxes, $25 (25 percent of $100), brings their annual earnings from the bond to 10 percent.

Because state and local governments need to attract other investors, and not just those in the highest tax brackets, the highest rate necessary to clear the market must be given to all bond investors. So if a state offers a 7.5 percent interest rate to attract investors in the 25-percent tax bracket, bondholders in the 35-percent tax bracket get a better deal. They annually earn $110, instead of $100.

Consequently, the greater a state’s income tax rate, the greater the benefit from the exclusion, and the interest rate the state must offer can be lower. States with the highest-tax individual income tax rates therefore have a stronger interest in preserving the municipal bond tax exclusion, because it enables them to protect those high tax rates from interstate competitive pressures. States with the lowest tax rates suffer because their comparative advantage in lower tax rates is eroded. This protectionist motivation for the exclusions is additional evidence that their purpose is, at least in part, to discriminate against interstate commerce.


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