Is the Tax-Free Muni a Financial Dinosaur?

Have tax-free municipal bonds outlived their usefulness? I would argue that they have.

The tax exemption for municipal bonds has been around since 1913, when the federal income tax was established. Its purpose was to comply with the current thinking in constitutional law, which prohibited the federal government from taxing state or municipal financial instruments.

However, the legal doctrine of “intergovernmental tax immunity” was steadily undermined over subsequent decades. In 1988, the Supreme Court declared it in 1988 to be “thoroughly repudiated.” The original premise for tax-free munis may have disappeared, but the vested interests benefiting from the exemption were so powerful that they defeated any effort to repeal the exemption.

Now a new paper by the Center for American Progress, “Bring Back BABs,”argues that tax-free munis are an inefficient way for the federal government to help state and local governments raise money for capital expenditures. Authors Jordan Eizenga and Seth Hanlon categorize the tax exemption for municipal bonds as a “tax expenditure” representing a claim against federal government revenue. That implicit expenditure will amount to $230.4 billion over the 2012-2016 period. Moreover, the tax exemption is economically inefficient. An estimated 10 percent to 20 percent of the subsidy is captured by bond buyers in higher tax brackets at a cost to U.S. taxpayers of more than $6 billion per year.

The authors’ preferred alternative is Build America Bonds, in which the federal government directly subsidizes state and local governments by paying a portion of the interest payments on the bonds. BABs were enacted in 2009 as part of the Obama administration’s recession-fighting strategy, but Congress let the program die at the end of 2010 on the grounds that the program was costing billions of dollars.

Bacon’s bottom line: I say, end the municipal bond tax exemption and spike the BABs bonds. Let state and local governments pay the same price as everyone else for capital.

Eizinga and Hanlon are right: the tax-free bond status is a hidden subsidy. People don’t notice it because it doesn’t represent a spending line item in the federal budget. Taxes not collected are difficult to measure, so the federal government’s commitment of resources is more or less invisible. If Americans want to achieve transparency in government spending, we need to get all such implicit spending commitments out in the open where people can see them and prioritize them. So, BABs are probably a better way to subsidize state-local governments than municipal bonds are.

What the authors fail to do is make a case that state-local governments should enjoy a privileged access to financial markets. Without question, some bond-backed projects are worthwhile. But how many useless projects have been financed with munis that never would have seen the light of day without the tax exemption? All issuers of debt should compete on a level playing field.

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