Tax-Exempt State and Local Bonds: A $20 Billion Waste

November 4, 2005

One notable omission from the Tax Reform Panel’s final report is any recommendation for cutting the tax preference enjoyed by state and local government bonds. Currently, interest earned on them is deductible for federal income tax purposes, effectively subsidizing state and local governments at the expense of federal income taxpayers.

This is unfortunate. There’s wide agreement among economists that the tax-exemption for municipal bonds leads to enormous economic waste, and doesn’t do a very good job of subsidizing state and local governments anyhow.

Here’s the case against the state and local bond exemption from “Taxing More, Taking Less: How Broadening the Federal Tax Base Can Reduce Income Tax Rates,” our newest study from chief economist Patrick Fleenor:

Tax-Exempt State and Local Bonds: A $20 Billion Waste

One way individuals can earn income free of federal tax is to buy tax exempt bonds issued by state and local governments. Even though the interest that investors earn on these bonds clearly increases their ability to consume in the same way that taxable income does, Uncle Sam doesn’t touch it at tax time.

The tax deduction for interest on government bonds distorts economic choices and leads to greater “horizontal inequity.” That is, people with identical income shoulder different tax burdens. To make matters worse, the deduction is an inefficient way to accomplish its stated purpose – to help state and local governments.

To see why, let’s look at who buys government bonds now, and how those investors might change if the deduction were repealed. Let’s assume that with no special tax incentive, a $1,000 state or local government bond would have to pay a 10 percent return annually, or $100, to attract enough bond buyers. Any investor looking for a relatively safe investment that paid 10 percent would buy it, and investors at all income levels would benefit equally from purchasing it.

However, with the deduction, investors do not all earn the same. Individuals in the highest tax bracket (35 percent) would be willing to lend state or local governments funds for as little as 6.5 percent since the $35 in tax savings they receive from owning the bond brings their annual earnings from the bond to the desired 10 percent. In such a case, the $35 gain to state and local governments would equal the $35 in lost federal tax revenue.

However, state and local governments need to attract other investors who don’t have enough taxable income to reach the 35 percent bracket. To do this, state and local governments must raise the interest rate they pay to everybody. For example, to attract investors whose annual taxable income puts them in the 25 percent bracket, tax-exempt bonds 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 up to the desired level of 10 percent.

Because there is no practical way of selectively selling bonds with different interest rates to investors in different tax brackets, the highest rate necessary to clear the market for these bonds must be given to all bond holders. Returning to the example above, investors in the highest tax bracket, 35 percent, get a better deal on the bond, earning $110 annually instead of the $100 earned by people in the 25 percent bracket.

In fiscal year 2005 the U.S. Treasury estimates that the lopsided nature of this provision will cost the federal government more than $20 billion. This loss could easily have been avoided by directly transferring funds from the federal government to state and local governments, rather than transferring it indirectly through the tax system.

That’s an important point, and it’s not obvious to many non-economists. Let’s hope somebody teaches it the folks on Capitol Hill as they debate the Panel’s recommendations. Be sure to check out the full paper here (PDF).


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