Key Issues in Tax Reform: Federal Subsidies for Interest Income Generated from Municipal Bonds

Updated November 15, 2017

Key Issues in Tax Reform: Federal Subsidies for Interest

Income Generated from Municipal Bonds

Changes to tax expenditures have been a core component of

several recent tax reform proposals. Tax expenditures are

special provisions that move the tax code away from a

“theoretically normal” tax system. In most cases, these

special tax provisions result in a revenue loss for the federal

government. Among the tax expenditures modified by tax

reform proposals in the 115th Congress are the exclusions

for interest income generated from certain state and local

bonds. State and local (municipal) governments issue bonds

to investors to finance investments in exchange for interest

payments and the eventual repayment of the principal

(amount borrowed).

Current Law

The federal government subsidizes state and local debt

through three policies: (1) all interest income earned from

public purpose bonds is excluded from federal income

taxation; (2) a tax credit may be claimed on interest income

in lieu of the exclusion in some cases; and (3) interest

income earned from qualified private activity bonds (PABs)

is excluded from federal regular income taxation.

Table 1. Estimated Combined Expenditures on

Federal Bond Subsidies, FY2016-FY2020

(billions of dollars)

Reduced

Revenues

Increased

Outlays

Total

Tax-Exempt

Bonds

194.7

-

194.7

Tax Credit

Bonds

1.8

24.0

25.8

Qualified

PABs

60.8

-

60.8

Source: JCT, Estimates of Federal Tax Expenditures for Fiscal Years

2016-2020, December 2016.

Table 1 shows Joint Committee on Taxation (JCT)

estimates of the budgetary effects of federal bond subsidies

from FY2016-FY2020. The federal bond subsidies are

projected to provide a total of $281.3 billion in benefits

over five years. That annual subsidy represents roughly 2%

of the current municipal debt stock: the Federal Reserve

estimated that state and local governments had $3.05

trillion in debt issuances outstanding in the first quarter of

2017.

Tax-Exempt Bonds

Bonds are considered to be for a public purpose if they

satisfy either of two criteria: (1) less than 10% of the

proceeds are used directly or indirectly by a non-

governmental entity; or (2) less than 10% of the bond

proceeds are secured directly or indirectly by property used

in a trade or business. Bonds that satisfy either test are

termed “governmental” bonds and can be issued without

federal restriction. The federal government subsidizes the

cost of governmental bonds by excluding interest income

earned by investors on those bonds from federal income

taxation. The exclusion lowers the cost of debt for state and

local governments by allowing them to borrow at lower

interest rates than would otherwise apply if the interest

income were taxable.

The lower cost of capital arises because in most cases

investors will be indifferent between taxable and taxexempt bonds of equivalent risk if their after-tax return is

identical. For example, consider a taxpayer in the 35% tax

bracket who is considering investing in a taxable bond with

a 10% interest rate and a tax-exempt bond with a 6.5%

interest rate. The taxability of the bond with the 10%

interest rate makes the investor’s after-tax income identical

to that of the tax-exempt bond with a 6.5% interest rate.

Thus, state and local governments could raise capital from

investors at an interest cost 3.5 percentage points (350 basis

points) lower than a borrower issuing taxable debt.

The direct cost to the federal government of tax-exempt

bonds is the individual and corporate income tax revenue

forgone. In the example above, the taxable bond with a 10%

interest rate would have generated federal tax liability equal

to 3.5% (or 35% x 10%) of the bond’s principal value each

year.

Tax Credit Bonds

Tax credit bonds (TCBs) are an alternative to tax-exempt

bonds. TCBs provide a tax credit or direct payment

proportional to the bond’s face value in lieu of the tax

exemption. Unlike tax-exempt bonds, the value of the credit

(and subsequent cost to the federal government) is not

dependent on the investor’s marginal income tax rate.

Most TCBs are designated for a specific purpose. For

example, TCBs have been used by issuers for financing

public school construction and renovation, clean renewable

energy projects, refinancing of outstanding government

debt in regions affected by natural disasters, conservation of

forest land, investment in energy conservation, and

economic development purposes.

All of the TCBs currently in circulation were established as

temporary tax provisions. Many recent TCBs are not

eligible for new issuances, due either to the expiration of

issuing authority or to full subscription of the TCB issuing

limit. Bonds that are no longer issued may still be held by

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Key Issues in Tax Reform: Federal Subsidies for Interest Income Generated from Municipal Bonds

the public. The relative appeal of TCBs and tax-exempt

bonds varies with bond interest rates, tax status of the

investor, and underlying economic conditions.

Qualified Private Activity Bonds

Bonds that fail both public purpose tests are termed privateactivity bonds (PABs) because they provide significant

benefits to private individuals or businesses. These projects

are generally ineligible for tax-exempt financing. Activities

that fail each test but that Congress considers to provide

both public and private benefits are categorized as qualified

and can be financed with qualified PABs, which are tax

exempt. Only qualified activities included in the federal

code can be financed with tax-exempt PABs.

Qualified PABs are subject to restrictions that do not apply

to governmental bonds, such as being required to include

subsequent interest income in the alternative minimum

income tax (AMT) base. Some qualified PABs are also

subjected to an annual, state-specific issuance cap intended

to limit the benefits provided through the subsidy. The

value of bonds issued for some of these activities by all

governmental units within a state was limited to the greater

of $100 per resident or $305.3 million in 2017. Qualified

PABs issued for several activities are not subject to the cap,

including for all bonds issued for government-owned

facilities.

Recent Reform Proposals

Tax reform proposals in the 115th Congress have included

several modifications to the exclusion for bond interest

income. H.R. 1, as reported by the Committee on Ways and

Means, would eliminate the ability to issue TCBs and

qualified PABs beginning in 2018. H.R. 1 would also repeal

the exclusion of interest income earned on advance

refunding bonds from federal income taxation. Refunding

bonds are bonds that are typically issued to replace

outstanding bonds with bonds that carry more favorable

terms; advance refunding bonds are refunding bonds that

are issued in such a way that both the original and

refunding bonds are outstanding for a period of time.

Finally, H.R. 1 would amend the definition of tax-exempt

bonds so that issuances for the construction of professional

sports stadiums do not qualify for the exemption. The JCT

estimated that those proposals would increase revenues by a

combined $56.9 billion over the FY2018-FY2027 window.

The Senate Finance Committee chairman’s mark to the

“Tax Cuts and Jobs Act” as scheduled for markup the week

of November 13, 2017, would repeal the income exclusion

for advance refunding bonds but would make no other

changes to federal bond subsidies, including to TCBs and

qualified PABs. The JCT estimated that the proposal would

increase revenues by $16.8 billion over the FY2018FY2027 period.

The Congressional Budget Office published an option

modifying the bond exclusion in its December 2016

Options for Reducing the Deficit report. That option

restricts the tax exemption for future municipal debt

issuances to governmental bonds only. The JCT estimated

that proposal would increase revenues by $27.5 billion over

the FY2017-FY2026 period.

Policy Issues

Certain goods and services provided by state or local

governments benefit both residents, who pay municipal

taxes, and nonresidents, who pay minimal if any municipal

taxes. State and local taxpayers may be unwilling to provide

these services to nonresidents without compensation, which

could cause the services to be underprovided relative to

their public benefits. In theory, the cost reduction provided

by the exemption of interest income compensates state and

local taxpayers for benefits provided to nonresidents.

It may be appealing to finance public capital facilities over

a long period of time to match the period over which those

facilities provide services. This is particularly true for state

and local governments, whose taxpayers lay claim to the

benefits from these facilities through residency and

relinquish benefit claim when they move. State or local

officials may therefore elect to match the timing of the

payments to the flow of services, precisely the function

served by long-term bond financing. Federal subsidies for

municipal debt encourage state and local governments to

engage in more debt financing.

State and local governments are also faced with the

necessity of planning their budget one to two years in

advance, and often are required to balance some or all of

their incoming and outgoing payments. Unforeseen

circumstances can undermine such plans and cause a

revenue shortfall, which must be financed with short-term

borrowing. Even when forecasts are met, timing issues may

create the necessity to borrow within an otherwise balanced

fiscal year. Finally, temporarily high interest rates that

prevail at the time bonds are issued may induce short-term

borrowing in anticipation of a drop in rates. Federal

subsidies reduce the costs of these activities, though the

economic rationale behind the transfer of such costs from

municipal taxpayers to federal taxpayers is less clear.

Critics of the subsidies for municipal debt believe that they

represent a suboptimal allocation of federal resources.

Spending incurred for one program directly reduces

amounts available for others, and some observers believe

that the subsidies for municipal debt could be better used on

some combination of direct federal investment in municipal

infrastructure, other federal programs, or deficit reduction.

Moreover, since the amount of capital investors are willing

to loan is limited, offering subsidies for municipal debt may

increase the interest costs for other types of debt issuances,

including for federal borrowing and private financing.

The bond subsidies also affect the distribution of the federal

tax system. Benefits from tax-exempt bonds and qualified

PABs are directly proportional to the investor’s marginal

tax rate, meaning that higher-income taxpayers benefit

more than lower-income taxpayers using the program.

Higher-income taxpayers also tend to have more disposable

capital to loan to municipal governments, making them

more likely to receive such benefits even without the

incremental marginal tax benefits described above.

Grant A. Driessen, Analyst in Public Finance

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Key Issues in Tax Reform: Federal Subsidies for Interest Income Generated from Municipal Bonds

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