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Tax Expenditure of the Week: Tax-Exempt Bonds

Counting Down the Country’s Biggest Tax Breaks, Week by Week

This is part of a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average taxpayer can understand. Every Wednesday we will focus on one tax expenditure, explaining what it is, what purpose it is intended to serve, and whether it is effective toward that purpose. We will also review relevant reform proposals.

Subjecting these dozens of tax breaks to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project.

This week, we’re looking at the tax exemption for municipal bonds, which will cost the Federal Treasury $37 billion in the upcoming fiscal year.[1] The government’s decision not to tax municipal-bond interest is intended to help state and local governments borrow more cheaply, but it generates a windfall for wealthy investors.

What is a tax-exempt municipal bond?

When a state or municipality wants to build a capital project—for example, roads, transit systems, public works, and schools—it can raise money by selling bonds, or IOUs, to the public. Under current tax rules, investors don’t have to pay federal income tax on the interest payments they receive from these bonds. Because the interest is tax free, investors demand lower interest rates than they do on taxable bonds of similar risk. That saves local and state governments money, making it cheaper for them to borrow.

Why are tax-exempt bonds considered a “tax expenditure”?

The federal government forfeits almost $40 billion in revenue each year by choosing not to collect taxes on municipal-bond interest. Since the exemption is a departure from the general rule that you have to pay taxes on interest income, this loophole is considered a tax expenditure.

The word “expenditure” fits because the tax exemption is equivalent to a spending program. The federal government could subsidize state projects by making direct payments to state and local governments. Instead, it provides an indirect subsidy through the tax code. The effect is the same: State and local governments can finance projects at less cost to them but at significant cost to the federal government.

How much does this tax expenditure cost?

The tax exemption for state and local public-purpose bonds is estimated to cost the federal government $230 billion over the 2012-2016 period, according to the Office of Management and Budget. This makes it the country’s eighth-most expensive tax expenditure.

Who benefits from the tax exemption?

The primary beneficiaries of the municipal-bond exemption are the state and local governments who issue the bonds. They save tens of billions of dollars each year on financing costs. Those savings lower the overall cost of important public projects like schools, hospitals, and roads.

High-income bond buyers also benefit from the tax exemption. Because of the way these bonds are issued, 20 percent of the benefit from the municipal-bond exemption unintentionally leaks to bond buyers from higher-income tax brackets.[2]

To understand why, consider that bond investors in lower tax-rate brackets get less benefit out of the tax exemption than do buyers in higher tax-rate brackets. Since there aren’t enough top-bracket investors out there to absorb all the bonds governments want to sell, the issuers have to increase their interest payments to appeal also to lower-bracket investors. That boost of tax-free interest income generates a windfall only for the wealthiest investors—a windfall paid for by both the Federal Treasury and municipal issuers.

Should the tax exemption on municipal bonds be reformed?

Critics have for decades pointed out that the tax exemption on municipal bonds is a costly and inefficient means of subsidizing state and local governments. In 2009, the Obama administration and Congress created Build America Bonds, which are taxable bonds for which the federal government directly subsidizes a portion of the interest costs. This ensures that 100 percent of the federal subsidy benefits state and local governments, and none to wealthy investors.

The Build America Bonds program was successful. It expanded the municipal market to a broader pool of investors at a time when demand for tax-exempt bonds was weak, and saved state and local governments an estimated $12 billion on bond issuances. While the program’s authorization expired at the end of 2012, several bills have been introduced in Congress to reinstate it.

At a cost of $37 billion, the tax exemption for municipal bonds is a massive government spending program. Its inefficient design warrants greater scrutiny and Congress should consider more efficient alternatives like Build America Bonds.

Jordan Eizenga is a Policy Analyst and Seth Hanlon is Director of Fiscal Reform at the Center for American Progress.


[1]. This figure represents the cost to the federal government for fiscal year 2012.

[2]. T.J. Atwood, “Implicit Taxes: Evidence from Taxable, AMT, and Tax-Exempt State and Local Government Bond Yields,” Journal of the American Taxation Association 25 (1) (2003): 1–20.